---

Exhibit 99.4



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TEMBECFINANCIAL REPORT 2012

|01  | Message to Shareholders                   
|--- | ------------------------------------------
|    |                                           
|04  | Managements Discussion and
      Analysis
|    |                                           
|52  | Management Responsibility                 
|    |                                           
|53  | Independent Auditors Report              
|    |                                           
|54  | Consolidated Financial Statements         
|    |                                           
|111 | Directors and Officers                    
|    |                                           
|112 | Shareholder Information                   

The covers are printed on 10pt. FSC-certified Kallima® Coated
Cover C1S Plus, manufactured by Tembecs Temiscaming, Quebec, coated
bleached board mill.

TEMBEC INC.©2012 All rights reserved Printed in Canada

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MESSAGETO SHAREHOLDERS

The financial results for 2012 were below expectations,
primarily due to poor market conditions for paper pulp. External economic
factors continue to hamper the Companys ability to achieve its full economic
potential. The Company did continue with strategic investments in certain energy
projects, the most significant being the $190 million energy investment at the
Temiscaming specialty cellulose site. The focus remains to increase profit
margins and reduce volatility of earnings.

The Company continued to make significant strides in its health
and safety performance, achieving a 32% reduction in recordable incidents in
2012 versus the previous year. This follows a 25% reduction in 2011 and marks
seven consecutive years of improvement in the Companys health and safety
performance. The focus will remain on transforming the health and safety culture
to achieve world class levels.

Adjusted EBITDA for 2012 was $64 million versus $98 million in
the previous year. Market conditions were generally favorable for the Specialty
Cellulose business throughout the year, providing the primary driver for the
earnings. The Paper business was stable with very little volatility in price,
allowing this business to be a steady contributor of cash flow. The Forest
Products business, which has had a negative impact on profitability for the last
several years, finally turned profitable in the final quarter of the year. The
Companys Paper Pulp business, the largest of all the Companys businesses,
suffered from poor product pricing and generated negative adjusted EBITDA.

The Company has embarked on the implementation of a Business
Improvement Plan focusing on capital expenditures on key projects to increase
overall adjusted EBITDA margins and to reduce the volatility of earnings.
Several of these projects were completed last year and a new $190 million
project was launched in 2012. These projects have placed demands on the
Companys cash flow as expected. The Companys defined benefit pension plans are
being greatly impacted by declining interest rates, increasing funding
requirements and making extra demands on cash flow. Given the challenging
conditions in some of the Companys major markets, and the cash requirements to
fund the strategic projects and excess pension funding obligations, the Company
will continue with judicious cash flow management to maintain adequate levels of
liquidity.

INVESTMENTS

In 2012, the Company began construction of the $190 million
energy investment at its Temiscaming specialty cellulose mill. This will replace
three old low pressure recovery boilers with a new high pressure boiler. A new
50-megawatt (MW) steam turbine will also be installed to produce electricity
from the steam generated by the new boiler. The project will result in an
adjusted EBITDA improvement of approximately $42 million per year through a
combination of electricity revenue, cost reduction and productivity
improvements.

A critical element of the Temiscaming energy investment is a
power purchase agreement with Hydro-Quebec that was signed in 2012. The
agreement provides for a guaranteed purchase of electricity produced by the new
turbine at a fixed price of $106 per MW/hour (based on 2012), which is adjusted
for inflation annually, for a 25 year-term.

The Company began construction of the Temiscaming energy
project in 2012. Procurement of the major equipment and most of the civil
construction work is complete. The Company targeted an aggressive construction
schedule with the boiler starting up in December 2013 and the turbine starting
April 2014. It has now been determined that the construction will be delayed and
the start-up of the boiler will be postponed until the Spring of 2014 due to the
high demand for contractors and construction workers in the Province of Quebec.
It will be impossible to achieve the December 2013 boiler completion cost
effectively in the over-heated construction market in Quebec.

After the completion of the $190 million investment, a second
phase is being planned, which will involve a capacity expansion of this
operation through the installation of new digesters. The new recovery boiler,
turbine and power purchase agreement with Hydro-Quebec have been upsized to
accommodate this second phase of investment.

Tembec Financial Report 2012 1

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Message to Shareholders

Several other green energy projects were brought to completion
in 2012 and will contribute to improved profitability in 2013. The new turbine
installed at the Tartas specialty cellulose mill is now in full operation. The
biomass boiler installed at the Béarn sawmill has been successfully commissioned
and is operating at the expected level. The anaerobic treatment plant at the
Matane high-yield pulp mill was commissioned in September and is in ramp-up
mode. Once the Matane project is fully optimized, it is expected that these
three green energy projects will generate an additional $21 million of adjusted
EBITDA per year.

Defined Benefit Pension PlansThe Company administers
several defined benefit pension plans in Canada on behalf of current and past
employees. The progressive declines in interest rates over the last several
years have led to increases in the estimated present value of future pension
obligations. This in turn led to the creation of solvency or wind up
deficits, which required that the Company fund amounts well in excess of normal
annual costs. In fiscal 2012, the Company made $34 million of excess payments
into its defined benefit pension plans. When combined with investment returns
that exceeded the plan assumptions, the Companys defined benefit pension plans
are now approaching fully funded status on a going-concern basis. The Company is
now in a better position to reduce defined benefit pension plan risk should
future investment returns permit or discount rates increase.

As well, the Company has taken steps to reduce defined benefit
pension risk by making a number of changes to its plans. All salaried employees
are now on a defined contribution pension plan. As collective agreements have
been renewed with unionized employees at several of the Companys facilities,
the pension plans have been changed to require all new employees to participate
in defined contribution plans.

Forest ProductsThe Companys lumber business has
experienced several years of very poor results due to the low levels of new home
construction in the United States. As expected, this market is taking several
years to recover and has yet to hit normalized levels. Despite near record
levels in housing affordability in the U.S., tight credit conditions, high
unemployment and economic uncertainty have all created headwinds in the new home
construction market.

As highlighted in last years report, the emergence of China as
a new and significant market for North American lumber has helped keep the North
American market somewhat balanced and has effectively set a floor on prices.
While this market did not grow in 2012, shipments at levels comparable to 2011
continued, providing an important outlet for product and helping to maintain a
balanced market in North America.

The second half of 2012 began to show signs of improvement in
the U.S. housing market. Levels of existing home and new home inventories
declined in the U.S. and housing starts in this market increased substantially
over the same period of the previous year, but still remained below normalized
levels. During this period, demand at the box stores, which typically service
the repair and renovation market, also increased. These factors, combined with
the steady demand from China, created a favorable environment for lumber sales
in North America and pushed up prices materially. This allowed the Companys
lumber segment to generate positive adjusted EBITDA in the fiscal fourth
quarter, which was the first positive quarter in several years.

The U.S. demographic and household formation projections,
combined with continued high levels of affordability and increased consumer
confidence, point toward an improving housing market in the U.S. While some
lumber capacity will likely be restarted in North America in 2013, it is
anticipated that the positive conditions seen in the latter half of 2012 will
continue in the coming year.

Specialty CelluloseFiscal 2012 was another good year
for the Companys specialty cellulose business. Demand throughout most of the
year was strong, but did experience a slowdown in some sectors in the latter
part of the year. The Company successfully implemented price increases across
all of its specialty grades.

The Company continues to sell viscose grade pulp from the
Temiscaming operation. This market declined from the very strong conditions the
year prior. While the viscose demand is stable and is still expected to grow
over the next five years, capacity additions of viscose grade pulp have created
excess supply, which has driven down prices in the second half of 2012.

The long-term outlook for specialty cellulose remains strong. A
number of the Companys strategic customers have indicated aggressive growth
plans and that additional supply will be required from Tembec in order for them
to achieve their objectives. These needs will be accommodated in the short-term
by phasing out the viscose commodity grade, which began last year. The viscose
grade represented 15-20% of the total output of the Companys specialty pulp
mills in fiscal 2012. Additional specialty cellulose capacity will be added with phase two of
the Temiscaming investment plan, which will accommodate additional customer
requirements in the long-term.

2Tembec Financial Report 2012

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Message to Shareholders

In the short-term, growth in specialty cellulose markets will
be slowed by the current economic conditions impacting certain sectors,
particularly the construction business. The European situation is the biggest
concern and the effect that it is having on business prospects in China. It is
unclear how long it will take to resolve the situation.

The Company remains focused on the specialty cellulose business
due to the higher margins and reduced volatility that this sector offers. The
long-term prospects for overall growth in demand will benefit those companies
with the assets and technology to compete in this sector. As one of the largest
and most specialized companies servicing this business, Tembec feels confident
that its future prospects are excellent.

Paper PulpFiscal 2012 was a disappointing year for
both softwood and hardwood paper pulps. The dramatic slowdown in the European
economy and declining consumer confidence had a significant negative impact on
the demand for pulp. Europe is still the largest consumer of market pulp in the
world. Demand from China, while still increasing, was unable to pick up the
slack in the market. The result was a drop in both hardwood and softwood prices.
The price level in the September quarter reached the cash breakeven point for
many pulp mills, including the Companys high-yield pulp mills.

In the short-term, it is expected that supply and demand will
be in relative balance and prices should begin to recover for both softwood and
hardwood pulp. Softwood is likely to benefit from a stable supply and consistent
demand, potentially leading to a more favorable price environment. While the
situation will likely improve for hardwood producers in the short-term, the new
hardwood pulp capacity scheduled to start-up in 2013 and 2014 poses a threat to
the overall hardwood market balance.

It is expected that 4 million to 5 million tonnes of new
bleached eucalyptus pulp capacity will start up in Brazil in 2013-2014, bringing
substantial hardwood pulp capacity onto the market in a short period of time.
While mid-term projections indicate that this new supply can be absorbed into
the global pulp markets based on growing demand, it is unclear if it can be
absorbed as quickly as the new production enters the market. This potential
oversupply situation could keep downward pressure on prices. The Companys
high-yield pulp competes in a number of applications with eucalyptus pulp and
will be affected by low prices in this market. To prepare for a potential weak
pulp market, the Company has taken a number of steps to mitigate the downside
impact on its high-yield pulp business. This includes the indefinite idling of
the Chetwynd, BC, pulp mill.

PaperThe Company sells into both the newsprint and
coated paper board markets. The North American newsprint market has been stable
for a prolonged period of time. While demand by daily newspapers has continued
to decline over the past year, the rate of decline has decelerated. The loss in
volume in the U.S. daily newspaper market has been compensated by capacity
reductions, increased off-shore shipments and substitution for other grades. The
result has been price stability, allowing the Company to generate stable
earnings in this business.

The coated bleached board business suffers from declining
demand in North America. The Company has been successful in offsetting this
through product and customer diversification. This has resulted in stable sales
volumes and relatively stable product pricing. This business should continue to
be a consistent contributor of adjusted EBITDA for the Company.

SUMMARY

The Companys Management and Board of Directors remain focused
on the implementation of the strategic plan. This includes certain strategic
initiatives to improve liquidity and maximize shareholder value. Cash flow will
be managed prudently in the short-term during this period of economic
uncertainty and relatively high capital investment. Significant progress has
been made on the journey to becoming a world-class health and safety
organization, but there is more to be done.

|                                      |                      
|------------------------------------- | ---------------------
|JAMES M. LOPEZ                        | JAMES V. CONTINENZA  
|President and Chief Executive Officer | Chairman of the Board

Tembec Financial Report 2012 3

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MANAGEMENTSDISCUSSION
AND ANALYSISas at November 30, 2012

The Managements Discussion and Analysis (MD&A) section
provides a review of the significant developments and issues that influenced
Tembec Inc.s financial performance during the fiscal year ended September 29,
2012, as compared to the fiscal year ended September 24, 2011. The MD&A
should be read in conjunction with the audited consolidated financial statements
for the fiscal year ended September 29, 2012. Financial data has been prepared
in accordance with International Financial Reporting Standards (IFRS) as issued
by the International Accounting Standards Board (IASB). Effective September 25,
2011, Tembec adopted IFRS as the Companys basis for financial reporting
commencing with the interim financial statements for the three-month period
ended December 24, 2011, and using September 26, 2010, as the transition date.
Except where otherwise noted, all prior period comparative figures have been
restated for IFRS. All financial references are stated in Canadian dollars,
unless otherwise noted. All references to quarterly information relate to
Tembecs fiscal quarters. Adjusted EBITDA, net debt, total capitalization, free
cash flow and certain other financial measures utilized in the MD&A are
non-IFRS financial measures. As they have no standardized meaning prescribed by
IFRS, they may not be comparable to similar measures presented by other
companies.

The MD&A includes forward-looking statements within the
meaning of securities laws. Such statements relate, without limitation, to the
Companys or managements objectives, projections, estimates, expectations or
predictions of the future and can be identified by words such as may, will,
could, anticipate, estimate, expect, and project, the negative or
variations thereof, and expressions of similar nature. Forward-looking
statements are based on certain assumptions and analyses made by the Company in
light of its experience, information available to it and its perception of
future developments. Such statements are subject to a number of risks and
uncertainties, including, but not limited to, changes in foreign exchange rates,
product selling prices, raw material and operating costs and other factors
identified in the Companys periodic filings with securities regulatory
authorities. Many of these risks are beyond the control of the Company and,
therefore, may cause actual actions or results to materially differ from those
expressed or implied herein. The forward-looking statements contained herein
reflect the Companys expectations as of the date hereof and are subject to
change after such date. The Company disclaims any intention to update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise, unless required by applicable securities legislation. The
information in this MD&A is as at November 30, 2012. Disclosure contained in
this document is current to that date, unless otherwise stated.

Throughout the MD&A, Tembec or Company means Tembec
Inc. and its consolidated subsidiaries. Tembecs operations consist of five
reportable business segments: Forest Products, Specialty Cellulose and Chemical
Pulp, High-Yield Pulp, Paper and Corporate. On September 29, 2012, the Company
had approximately 3,700 employees, as compared to 4,250 at the end of the prior
fiscal year. The Company operates manufacturing facilities in Quebec, Ontario,
British Columbia, the state of Ohio as well as in Southern France. Principal
facilities are described in the subsequent sections of the MD&A.

4Tembec Financial Report 2012

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Managements Discussion and Analysis

2012 VS. 2011

|FINANCIAL SUMMARY                                             | 
|------------------------------------------------------------- | 
|(in millions of dollars, unless otherwise noted)              | 
|                                                              | 
|Sales                                                         | 
|Freight and other deductions                                  | 
|Lumber export taxes                                           | 
|Cost of sales (excluding depreciation and
      amortization) | 
|SG&A                                                          | 
|Share-based
      compensation                                | 
|Adjusted EBITDA                                               | 
|Depreciation and amortization                                 | 
|Other items                                                   | 
|Operating earnings
      (loss)                               | 
|Interest, foreign exchange and other                          | 
|Exchange
      loss (gain) on long-term debt                  | 
|Earnings (loss)
      before income taxes                     | 
|Income tax
      expense                                      | 
|Net loss                                                      | 
|Basic and diluted
      net loss in dollars per share         | 
|Net comprehensive
      loss                                  | 
|                                                              | 
|Total assets (at
      year-end)                              | 
|Total long-term
      debt (at year-end) (1)                  | 
|Total long-term
      financial liabilities (at year-end)     | 

(1)Includes current portion

|CONSOLIDATED SALES       | CONSOLIDATED SALES BY SEGMENT
|------------------------ | -----------------------------
|(in millions of dollars) | (in millions of dollars)     
|                         |                              

Tembec Financial Report 2012 5

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Managements Discussion and Analysis

|ADJUSTED EBITDA BY SEGMENT | FINANCIAL PERFORMANCE
|-------------------------- | ---------------------
|(in millions of dollars)   |                      
|                           |                      

SALES(in millions of dollars)Total
    
    
    Price
    
    
    Volume and2011
    
    
    2012
    
    
    variance
    
    
    variance
    
    
    mix
      varianceForest Products
    
    471
    
    
    432
    
    
    (39
    )
    
    26
    
    
    (65
    )Specialty Cellulose and Chemical Pulp
    
    693
    
    
    662
    
    
    (31
    )
    
    (6
    )
    
    (25
    )High-Yield Pulp
    
    378
    
    
    352
    
    
    (26
    )
    
    (12
    )
    
    (14
    )Paper
    
    339
    
    
    346
    
    
    7
    
    
    6
    
    
    1Corporate
    
    7
    
    
    13
    
    
    6
    
    
    
    
    
    61,888
    
    
    1,805
    
    
    (83
    )
    
    14
    
    
    (97
    )Less: intersegment
      sales
    
    (145
    )
    
    (139
    )
    
    6Sales
    
    1,743
    
    
    1,666
    
    
    (77
    )


Sales decreased by $77 million as compared to fiscal 2011.
Currency was favourable as the Canadian dollar averaged US $0.992, a 2.1%
decrease from US $1.013 in the prior year. Forest Products segment sales
decreased by $39 million as a result of lower shipments, partially offset by
higher prices. Specialty Cellulose and Chemical Pulp segment sales decreased by
$31 million due to lower shipments and prices. High-Yield Pulp segment sales
decreased by $26 million due to lower shipments and prices. Paper segment sales
increased by $7 million due primarily to higher prices.

In terms of geographical distribution, the U.S. remained the
Companys principal market with 37% of consolidated sales in fiscal 2012, as
compared to 34% in the prior year. Canadian sales represented 18% of sales,
unchanged from the prior year. Sales outside of the U.S. and Canada represented
the remaining 45% in fiscal 2012, as compared to 48% a year ago.

6Tembec Financial Report 2012

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Managements Discussion and Analysis

ADJUSTED
      EBITDA(in millions of dollars)Total
    
    
    Price
    
    
    Cost and2011
    
    
    2012
    
    
    variance
    
    
    variance
    
    
    volume varianceForest Products
    
    (47
    )
    
    (16
    )
    
    31
    
    
    26
    
    
    5Specialty Cellulose and Chemical Pulp
    
    140
    
    
    92
    
    
    (48
    )
    
    (6
    )
    
    (42
    )High-Yield Pulp
    
    (3
    )
    
    (29
    )
    
    (26
    )
    
    (12
    )
    
    (14
    )Paper
    
    29
    
    
    37
    
    
    8
    
    
    6
    
    
    2Corporate
    
    (21
    )
    
    (20
    )
    
    1
    
    
    
    
    
    198
    
    
    64
    
    
    (34
    )
    
    14
    
    
    (48
    )


Adjusted EBITDA of $64 million was $34 million lower than the
prior year. Forest Products segment adjusted EBITDA was up $31 million from the
prior year primarily as a result of higher prices. Specialty Cellulose and
Chemical Pulp segment adjusted EBITDA declined by $48 million due to higher
costs and lower prices. High-Yield Pulp segment adjusted EBITDA declined by $26
million due to higher costs and lower prices. Paper segment adjusted EBITDA
improved by $8 million due to higher prices and lower costs.

OPERATING EARNINGS
      (LOSS)(in millions of dollars)Adjusted
    
    
    
    
    
    OtherTotal
    
    
    EBITDA
    
    
    Depreciation
    
    
    items2011
    
    
    2012
    
    
    variance
    
    
    variance
    
    
    variance
    
    
    varianceForest Products
    
    (64
    )
    
    (4
    )
    
    60
    
    
    31
    
    
    4
    
    
    25Specialty Cellulose and Chemical Pulp
    
    121
    
    
    71
    
    
    (50
    )
    
    (48
    )
    
    (2
    )
    
    High-Yield Pulp
    
    (14
    )
    
    (92
    )
    
    (78
    )
    
    (26
    )
    
    (2
    )
    
    (50
    )Paper
    
    26
    
    
    35
    
    
    9
    
    
    8
    
    
    1
    
    
    Corporate
    
    (22
    )
    
    (42
    )
    
    (20
    )
    
    1
    
    
    1
    
    
    (22
    )47
    
    
    (32
    )
    
    (79
    )
    
    (34
    )
    
    2
    
    
    (47
    )


The Company generated an operating loss of $32 million compared
to operating earnings of $47 million in fiscal 2011.

The Forest Products segment generated an operating loss of $4
million, as compared to an operating loss of $64 million in fiscal 2011. In
addition to the previously noted improvement in adjusted EBITDA, the sale of the
British Columbia (BC) sawmills and the hardwood flooring operations led to lower
depreciation expense. During the most recent fiscal year, the Company recorded a
gain of $24 million related to the sale of the BC sawmills. The Company also
sold its Toronto, Ontario, hardwood flooring plant and concurrently closed its
Huntsville, Ontario, hardwood flooring plant. The combined effect was a charge
of $2 million.

Tembec Financial Report 2012 7

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Managements Discussion and Analysis

In the prior year period, the segment recorded a charge of $2
million relating to the permanent closure of the Taschereau, Quebec, sawmill.
The charge was for severance and other closure costs. The Company also absorbed
a charge of $1 million related to severance payments at an idled planer mill in
Cranbrook, BC.

The Specialty Cellulose and Chemical Pulp segment generated
operating earnings of $71 million compared to operating earnings of $121 million
in the prior year. The previously noted decline in adjusted EBITDA led to the
lower operating earnings.

The High-Yield Pulp segment generated an operating loss of $92
million compared to an operating loss of $14 million in the prior year. In
addition to the previously noted decline in adjusted EBITDA, the segment
absorbed an impairment charge of $50 million relating to the property, plant and
equipment, including supplies and materials, of the Chetwynd, BC, pulp mill.

The Paper segment generated operating earnings of $35 million
compared to operating earnings of $26 million in the prior year. The previously
noted improvement in adjusted EBITDA led to the higher operating earnings.

Corporate expenses increased by $20 million primarily due to
other items. The current year includes a $16 million charge relating to the
write-down of the loan receivable from Temlam Inc. The latter is currently under
creditor protection and owns an idled laminated veneer lumber (LVL) facility
located in Amos, Quebec. The Company has a 50% secured interest in the facility.
The cutting rights that were previously attached to the LVL facility were
granted to another company. In the absence of a guaranteed fibre supply, the
Company concluded that the re-start of the facility is unlikely and has adjusted
its carrying value to the amount anticipated to be realized upon liquidation or
sale. The current year also includes a gain of $4 million relating to the sale
of a minority equity interest in two dissolving pulp mills. The prior year
includes a gain of $4 million related to the filing of Tembec USA LLC under
Chapter 7 of the Bankruptcy Code of the United States. The gain was generated by
a reduction in the Companys accrued benefit obligation. The period also
included a gain of $3 million related to the sale of hydro-electric generating
assets located in Smooth Rock Falls, Ontario.

8Tembec Financial Report 2012

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Managements Discussion and Analysis

SEGMENT REVIEW  2012 VS. 2011

|FOREST PRODUCTS                            |  |       |    |  |      |   
|------------------------------------------ |  | ----- | -- |  | ---- | --
|(in millions of dollars)                   |  |       |    |  |      |   
|                                           |  | 2011  |    |  | 2012 |   
|Sales (1)                                  |  | 471   |    |  | 432  |   
|Freight and other deductions               |  | 47    |    |  | 41   |   
|Lumber export taxes                        |  | 13    |    |  | 7    |   
|Cost of sales (1)                          |  | 441   |    |  | 385  |   
|SG&A                                       |  | 17    |    |  | 15   |   
|Adjusted EBITDA                            |  | (47   | )  |  | (16  | ) 
|Adjusted EBITDA
      margin on sales      |  | (10.0 | )% |  | (3.7 | )%
|Depreciation and amortization              |  | 14    |    |  | 10   |   
|Other items:                               |  |       |    |  |      |   
|Gain on sale of BC sawmills                |  |      |    |  | (24  | ) 
|Loss on sale/closure of flooring assets    |  |      |    |  | 2    |   
|Taschereau sawmill closure charge          |  | 2     |    |  |     |   
|Cranbrook
      planer mill closure charge |  | 1     |    |  |     |   
|Operating loss                             |  | (64   | )  |  | (4   | ) 
|                                           |  |       |    |  |      |   
|Identifiable
      assets (excluding cash) |  | 267   |    |  | 216  |   

(1)Includes intersegment sales eliminated on
consolidation

The Forest Products segment is divided into two main areas of
activity: forest resource management and manufacturing operations.

The Forest Resource Management group is responsible for
managing all of the Companys Canadian forestry operations. This includes the
harvesting of timber, either directly or by contractual agreements, and all
silviculture and regeneration work required to ensure a sustainable supply for
the manufacturing units. The group is also responsible for third party timber
purchases, which are needed to supplement total requirements. The groups main
objective is the optimization of the flow of timber into various manufacturing
units. As the Companys forest activity in Canada is conducted primarily on
Crown lands, the Forest Resource Management group works closely with provincial
governments to ensure harvesting plans and operations comply with established
regulations and that stumpage charged by the provinces is reasonable and
reflects the fair value of the timber being harvested. During fiscal 2012, the
Companys operations harvested and delivered 3.9 million cubic metres of timber,
unchanged from the prior year. Additional supply of approximately 0.8 million
cubic metres was secured mainly through purchases and exchanges with third
parties, compared to 0.9 million cubic metres in the prior year.

The Forest Products segment includes operations located in
Quebec and Ontario. At the end of the March 2012 quarter, the Company sold its
two BC sawmills. The sawmills had a capacity of 450 million board feet of
lumber, which represented approximately 29% of the Companys total SPF lumber
capacity at that time. The SPF lumber operations can produce approximately 930
million board feet of lumber. The specialty wood operations can annually produce
30 million board feet of hardwood lumber. During the December 2011 quarter, the
Company sold its Toronto, Ontario, hardwood flooring plant and announced the
closure of its Huntsville, Ontario, hardwood flooring plant. The two operations
had a combined capacity of 20 million square feet of hardwood flooring. The
Companys engineered wood operations consist of two finger joint lumber
operations, which were idle for all of fiscal 2011 and fiscal 2012.

Tembec Financial Report 2012 9

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Managements Discussion and Analysis

The following summarizes the current annual capacity of each
facility by product group:

|SPF LUMBER                                |  | mbf     | 
|----------------------------------------- |  | ------- | 
|Stud lumber - La Sarre, QC                |  | 135,000 | 
|Stud lumber - Senneterre, QC              |  | 150,000 | 
|Stud lumber - Cochrane, ON                |  | 110,000 | 
|Stud lumber - Kapuskasing, ON             |  | 105,000 | 
|Random lumber - Béarn, QC                 |  | 110,000 | 
|Random lumber - Chapleau, ON              |  | 135,000 | 
|Random lumber - Hearst, ON                |  | 160,000 | 
|Finger joint
      lumber - Cranbrook, BC |  | 25,000  | 
|                                          |  | 930,000 | 

|SPECIALTY WOOD                         |  | mbf    | 
|-------------------------------------- |  | ------ | 
|Hardwood lumber -
      Huntsville, ON |  | 30,000 | 

|ENGINEERED WOOD                                          |  | mbf    | 
|-------------------------------------------------------- |  | ------ | 
|Engineered finger joint lumber - La Sarre, QC            |  | 60,000 | 
|Engineered finger
      joint lumber - Kirkland Lake, ON |  | 30,000 | 
|                                                         |  | 90,000 | 

The segment is dominated by SPF lumber, which represented 94%
of building material sales in fiscal 2012, compared to 85% in the prior year.
The volume of SPF lumber sold in fiscal 2012 decreased by 72 million board feet
or 8%. The sale of the Companys two BC sawmills at the end of the March 2012
quarter had a significant impact on shipments and volumes. Shipments of lumber
from the two sawmills during the first two quarters of fiscal 2012 totalled 172
million board feet as compared to 343 million board feet in the full 12-month
period of fiscal 2011, a decrease of 171 million board feet. Shipments from the
Companys Eastern sawmills increased by 99 million board feet, partially
offsetting the previously noted decrease. Shipments were equal to 62% of
capacity, up from 57% in fiscal 2011. In response to relatively low lumber
demand, the Company continued to reduce production by curtailing operations at
several facilities for either indefinite or temporary periods. The split between
Eastern/Western shipments was 79/21 as compared to 62/38 a year ago. US $
reference prices for random lumber were up by US $16 per mbf on average while
stud lumber increased by US $39 per mbf. Currency was favourable as the Canadian
dollar averaged US $0.992, a 2.1% decrease from US $1.013 in the prior year. The
combined result was a $35 per mbf price increase from a year ago.

10Tembec Financial Report 2012

---

Managements Discussion and Analysis

Specialty wood represented 6% of building material sales in
fiscal 2012, down from 15% in the prior year. The decline was due to the sale of
the Toronto, Ontario, hardwood flooring plant and the closure of the Huntsville,
Ontario, hardwood flooring plant.

There were no engineered wood sales in fiscal 2011 and 2012.
The two finger joint facilities were idle for all of fiscal 2011 and fiscal
2012.

The Forest Products segment produced and shipped approximately
1.0 million tonnes of wood chips in fiscal 2012, 80% of which were directed to
the Companys pulp and paper operations. In 2011, the segment produced 1.1
million tonnes and shipped 85% of this volume to the pulp and paper mills. The
internal transfer price of wood chips is based on current and expected market
transaction prices.

Total sales for this segment reached $432 million, a decrease
of $39 million over the prior year. After eliminating internal sales, the Forest
Products segment generated 21% of Company consolidated sales, down from 22% in
the prior year. The segments main market is North America, which represented
97% of consolidated sales in fiscal 2012, compared to 94% in the prior year.

Sales
    
    
    
    
    
    Shipments
    
    
    
    
    
    Selling prices($ millions)
    
    
    
    
    
    (000 units
    )
    
    
    
    
    ($ / unit)2011
    
    
    2012
    
    
    2011
    
    
    2012
    
    
    2011
    
    
    2012SPF lumber
      (mbf)
    
    283
    
    
    282
    
    
    907.9
    
    
    835.7
    
    
    312
    
    
    337Specialty woodHardwood (mbf)
    
    6
    
    
    8
    
    
    9.5
    
    
    12.7
    
    
    632
    
    
    629Hardwood
      flooring (000 square ft)
    
    45
    
    
    10
    
    
    9.1
    
    
    2.2
    
    
    4,945
    
    
    4,54551
    
    
    18Engineered woodEngineered
      finger joint lumber (mbf)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total building
      materials
    
    334
    
    
    300Wood chips,
      logs and by-products
    
    137
    
    
    132Total sales
    
    471
    
    
    432Internal
      wood chips and other sales
    
    (96
    )
    
    (84
    )Consolidated
      sales
    
    375
    
    
    348


Tembec Financial Report 2012 11

---

Managements Discussion and Analysis

|QUARTERLY PRICES  WESTERN SPF MILL NET | QUARTERLY PRICES  EASTERN SPF DELIVERED
|--------------------------------------- | ----------------------------------------
|(US $ per mbf)                          | (US $ per mbf)                          
|                                        |                                         

MARKETS

The Company markets its lumber with its own internal sales
force.

The benchmark random length Western SPF (#2 and better) lumber
net price averaged US $275 per mbf in 2012, an increase from US $263 per mbf in
2011. In the East, the random length Eastern SPF average lumber price (delivered
Great Lakes) increased from US $350 per mbf to US $370 per mbf in 2012. The
Company considers these to be relatively low levels, approximately US $30 to US
$40 below normal trend line prices for random lumber. The reference price for
stud lumber increased with the Eastern average lumber price (delivered Great
Lakes) up from US $314 per mbf to US $353 per mbf, a level approximately US $30
to US $40 per mbf below trend line prices. The prices were driven by a
relatively weak U.S. housing market. Housing starts in the U.S. on a seasonally
adjusted basis averaged 729,000 units in fiscal 2012, an increase over the
578,000 units in fiscal 2011. However, these remain well below the 2 million
unit mark experienced in the 2004-2006 period and the +1.2 million average that
would be indicative of normal market conditions. While the Company recognized
several years ago that U.S. housing starts could not maintain the 2 million unit
per year run rate, and that a degree of market correction would likely occur at
some point, the severity and extent of the correction had not been anticipated.
The negative effects of the sub-prime mortgage difficulties, the latter having
fuelled the strong demand in 2004-2006, have been much greater in terms of
impact and duration than originally foreseen.

12Tembec Financial Report 2012

---

Managements Discussion and Analysis

In addition to difficult market conditions, the Companys
financial performance continued to be impacted by export taxes on lumber shipped
to the U.S. Effective October 12, 2006, the governments of Canada and the United
States implemented an agreement for the settlement of the softwood lumber
dispute. The Softwood Lumber Agreement (SLA) requires that an export tax be
collected by the Government of Canada, which is based on the price and volume of
lumber shipped. Since that date, the Companys Eastern Canadian sawmills,
located in Quebec and Ontario, have been subject to export quota limitations and
5% export tax on lumber shipped to the U.S. In April 2009, the effective tax on
Eastern lumber shipments increased from 5% to 15% as a result of an arbitration
decision relating to alleged over-shipments of lumber between January 2007 and
June 2007. The SLA provides that during periods of relatively high prices, as
was the case during the early summer months, the export tax rate declines.
During fiscal 2011, a second arbitration penalty of approximately 1% was imposed
on Eastern lumber shipments beginning in March 2011. However, the first
arbitration penalty of 10% expired in June 2011. Overall, the average rate on
all Eastern lumber shipments to the U.S. was 11.7% and the total cost was $6
million in the prior year. In fiscal 2012, the average tax rate on Eastern
lumber shipments to the U.S. was 4.8% and the total cost was $4 million. The
decrease in rate was caused by the previously noted expiration of the 10%
arbitration penalty. The decrease in rate was partially offset by an increase in
the volume and price of lumber shipped to the U.S.

During fiscal 2012, the Company sold its two British Columbia
sawmills in March 2012. As such, the MD&A data reflects the mills financial
results for six months in fiscal 2012 as compared to 12 months in fiscal 2011.
The BC sawmills were subject to a 15% export tax, but shipments were not quota
limited. Under certain circumstances, the tax could be increased to 22.5%, which
was not the case in either fiscal 2011 or the first six months of fiscal 2012.
During fiscal 2011, the average rate on shipments to the U.S was 15% and the
total cost was $7 million. In fiscal 2012, the average rate on shipments was
also 15% and the total cost was $3 million. The reduction in cost relates to the
shorter period of ownership.

Tembec Financial Report 2012 13

---

Managements Discussion and Analysis

OPERATING RESULTS

The following summarizes adjusted EBITDA variances by major
element:

Variance - favourable (unfavourable)Export
    
    
    Mill
    
    
    Inventory NRV(in millions of
      dollars)
    
    Price
    
    
    taxes
    
    
    costs
    
    
    adjustments
    
    
    Other
    
    
    TOTALSPF lumber
    
    27
    
    
    6
    
    
    2
    
    
    1
    
    
    (5
    )
    
    31Specialty wood
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    1
    
    
    Engineered wood
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other segment
      items
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26
    
    
    6
    
    
    2
    
    
    1
    
    
    (4
    )
    
    31


In fiscal 2012, adjusted EBITDA was negative $16 million
compared to negative adjusted EBITDA of $47 million in the prior year. SPF
lumber adjusted EBITDA improved by $31 million. The previously noted higher
selling prices for lumber increased adjusted EBITDA by $27 million. The higher
prices were assisted by currency as the Canadian dollar averaged US $0.992, a
2.1% decrease from US $1.013 in the prior year. The previously noted decline in
export taxes on lumber shipped to the U.S. increased adjusted EBITDA by a
further $6 million. Sawmill manufacturing costs declined by $2 million,
primarily in the Eastern sawmills, which produced 16% more lumber versus 2011.
In the prior year, the segment had benefited from a $1 million favourable
adjustment to the carrying values of logs and lumber inventories compared to a
favourable adjustment of $2 million in the current year. The $5 million negative
variance in Other includes a $4 million negative volume variance due to
selling a higher volume of lumber at negative margins as well as a negative
variance of $1 million related to freight costs. Specialty wood adjusted EBITDA
was unchanged year-over-year. Engineered wood results were also unchanged as
both plants remained idle for both years. The adjusted EBITDA margin to total
sales was negative 3.7% compared to negative 10.0% in the prior year.

The following summarizes operating results variances by major
element:

|                               |  |      |   |  |      |   |  | Variance       | 
|------------------------------ |  | ---- | - |  | ---- | - |  | -------------- | 
|                               |  |      |   |  |      |   |  | favourable     | 
|(in millions of
      dollars) |  | 2011 |   |  | 2012 |   |  | (unfavourable) | 
|Adjusted EBITDA                |  | (47  | ) |  | (16  | ) |  | 31             | 
|Depreciation and amortization  |  | 14   |   |  | 10   |   |  | 4              | 
|Other items (gain)             |  | 3    |   |  | (22  | ) |  | 25             | 
|Operating loss                 |  | (64  | ) |  | (4   | ) |  | 60             | 

The Forest Products segment generated an operating loss of $4
million, as compared to an operating loss of $64 million in fiscal 2011. In
addition to the previously noted improvement in adjusted EBITDA, the sale of the
BC sawmills and the hardwood flooring operations led to lower depreciation
expense. During the most recent fiscal year, the Company recorded a gain of $24
million related to the sale of the BC sawmills. The Company sold its Toronto,
Ontario, hardwood flooring plant and concurrently closed its Huntsville,
Ontario, hardwood flooring plant. The combined effect was a charge of $2
million. In the prior year period, the segment recorded a charge of $2 million
relating to the permanent closure of the Taschereau, Quebec, sawmill. The charge
was for severance and other closure costs. The Company also absorbed a charge of
$1 million related to severance payments at an idled planer mill in Cranbrook,
BC.

14Tembec Financial Report 2012

---

Managements Discussion and Analysis

|SPECIALTY
      CELLULOSE AND CHEMICAL PULP |  |      |   |  |      |      
|------------------------------------------- |  | ---- | - |  | ---- | -----
|(in millions of dollars)                    |  |      |   |  |      |      
|                                            |  | 2011 |   |  | 2012 |      
|Sales - Pulp (1)                            |  | 600  |   |  | 562  |      
|Sales - Chemicals                           |  | 93   |   |  | 100  |      
|                                            |  | 693  |   |  | 662  |      
|Freight and other deductions                |  | 66   |   |  | 68   |      
|Cost of sales (1)                           |  | 464  |   |  | 481  |      
|SG&A                                        |  | 23   |   |  | 21   |      
|Adjusted EBITDA                             |  | 140  |   |  | 92   |      
|Adjusted EBITDA
      margin on sales       |  | 20.2 | % |  | 13.9 | **%**
|Depreciation and
      amortization         |  | 19   |   |  | 21   |      
|Operating earnings                          |  | 121  |   |  | 71   |      
|                                            |  |      |   |  |      |      
|Identifiable
      assets (excluding cash)  |  | 491  |   |  | 544  |      

(1) Includes intersegment sales eliminated on
consolidation

The Specialty Cellulose and Chemical Pulp segment consists of
three market pulp manufacturing facilities. The facilities are divided into two
main types. Two pulp mills produce specialty cellulose pulps. The remaining
facility produces chemical softwood kraft paper pulp (NBSK).

The two specialty cellulose pulp mills have an annual capacity
of 310,000 tonnes per year. The softwood kraft mill has an annual capacity of
270,000 tonnes. The specialty cellulose pulp produced at the two pulp mills is a
high purity cellulose utilized in a wide variety of specialized products such as
pharmaceuticals, food additives, and industrial chemicals. The Temiscaming mill
also produces viscose grade pulp, which is utilized in the production of
viscose staple fibre, which in turn is used to produce rayon for the textile
industry. The Tartas mill also produced specialized fluff pulp, which is
utilized in the production of sanitary products. The production of specialized
fluff pulp was discontinued in September 2011 as the mill transitioned to 100%
specialty cellulose grades.

The two specialty cellulose mills generate lignin as a
by-product of the sulphite process, which is sold to third parties. The
Temiscaming mill also includes a facility that produces ethanol as a by-product
that is also sold to third parties.

The segment also includes a stand-alone resin business, which
produces powder and liquid phenolic resins at three operating sites in Quebec:
Temiscaming, Longueuil, and Trois-Pistoles. The Company also operates a fourth
facility located in Toledo, Ohio, which manufactures powder and liquid
amino-resins. The chemical business periodically purchases and re-sells third
party pulp mill by-product chemicals.

The following summarizes the annual operating capacity of each
facility:

|SPECIALTY CELLULOSE                                                       |  | tonnes  | 
|------------------------------------------------------------------------- |  | ------- | 
|Specialty cellulose and commodity dissolving pulp -
      Temiscaming, QC |  | 160,000 | 
|Specialty
      cellulose - Tartas, France                                |  | 150,000 | 
|                                                                          |  | 310,000 | 

|CHEMICAL PULP                 |  |         | 
|----------------------------- |  | ------- | 
|NBSK -
      Skookumchuck, BC |  | 270,000 | 

|CHEMICALS                                                                      |  |         | 
|------------------------------------------------------------------------------ |  | ------- | 
|Resin and related products - Temiscaming and Longueuil, QC;
      Toledo, Ohio |  | 170,000 | 
|Lignin - Temiscaming, QC; Tartas, France                                       |  | 190,000 | 
|Ethanol -
      Temiscaming, QC (million litres)                               |  | 12.1    | 

Tembec Financial Report 2012 15

---

Managements Discussion and Analysis

Specialty cellulose shipments represented 54% of segment
shipments in fiscal 2012, compared to 53% in the prior year. Specialty cellulose
sales as a percentage of total segment pulp sales increased from 68% to 72% due
to lower prices for NBSK pulp.

Chemical pulp NBSK represented 46% of segment pulp shipments in
fiscal 2012, compared to 47% in the prior year. Based on sales dollars, NBSK
pulp sales as a percentage of total segment pulp sales decreased from 32% to 28%
due to a decline in selling prices.

Total 2012 pulp shipments of 479,900 tonnes include 17,300
tonnes of NBSK pulp consumed by the Companys paperboard operations as compared
to 15,300 tonnes in the prior year.

Total sales for the Specialty Cellulose and Chemical Pulp
segment were $662 million, a decrease of $31 million from the prior year. After
eliminating internal sales, the Specialty Cellulose and Chemical Pulp segment
generated 39% of Company consolidated sales, unchanged from the prior year. The
Specialty Cellulose and Chemical Pulp segment is a global business. In 2012, 61%
of consolidated pulp sales were generated outside of Canada and the U.S., as
compared to 64% in the prior year.

Sales
    
    
    
    
    
    Shipments
    
    
    
    
    
    Selling prices($ millions)
    
    
    
    
    
    (000 units
    )
    
    
    
    
    ($ / unit)2011
    
    
    2012
    
    
    2011
    
    
    2012
    
    
    2011
    
    
    2012Specialty pulpSpecialty cellulose (tonnes)
    
    311
    
    
    353
    
    
    209.5
    
    
    215.1
    
    
    1,484
    
    
    1,641Viscose grade (tonnes)
    
    85
    
    
    54
    
    
    52.4
    
    
    42.3
    
    
    1,622
    
    
    1,253Specialty fluff (tonnes)
    
    9
    
    
    
    
    
    8.1
    
    
    
    
    
    1,111
    
    
    405
    
    
    407
    
    
    270.0
    
    
    257.4Chemical paper pulps (tonnes)
    
    195
    
    
    155
    
    
    237.3
    
    
    222.5
    
    
    822
    
    
    697Total specialty cellulose and chemical pulp
      sales
    
    600
    
    
    562
    
    
    507.3
    
    
    479.9ChemicalsResin and related products (tonnes)
    
    55
    
    
    55
    
    
    55.2
    
    
    55.7
    
    
    996
    
    
    987Lignin (tonnes)
    
    29
    
    
    29
    
    
    131.5
    
    
    132.4
    
    
    221
    
    
    219Ethanol (000 litres)
    
    7
    
    
    9
    
    
    8.9
    
    
    10.0
    
    
    787
    
    
    90091
    
    
    93Other sales
    
    2
    
    
    7Total sales
    
    693
    
    
    662Internal pulp sales
    
    (12
    )
    
    (12
    )
    
    (15.3
    )
    
    (17.3
    )Consolidated sales
    
    681
    
    
    650


16Tembec Financial Report 2012

---

Managements Discussion and Analysis

MARKETS

The Company markets its pulp on a world-wide basis, primarily
through its own sales force. Permanent sales offices are maintained in Toronto,
Canada; Dax, France; and Beijing, China. Contractual arrangements with third
party representatives are also utilized.

The shipments to capacity ratio for specialty pulp was 83% in
fiscal 2012 versus 87% in the prior year. The decrease in shipment ratio was due
to a decrease of 10,100 tonnes in viscose grade pulp shipments and 8,100 tonnes
in specialty fluff shipments, which the Company no longer manufactures. This was
due to the Companys objective of focusing on specialty or higher purity
grades and reducing its exposure to viscose and fluff grades. Specialty
cellulose pulps have a lesser yield, which in turn reduces the productivity of
the two mills. During fiscal 2011 and 2012, both mills operated at full rates
and no downtime was taken for market conditions. The strong market conditions
for specialty grades led to higher US dollar and euro prices. Pricing for
specialty cellulose increased by $157 per tonne. The increase in Canadian dollar
selling prices would have been higher if not for the weaker euro, which averaged
5.1% lower and reduced average prices by $37 per tonne. Market conditions in the
viscose grade weakened from the record levels reached in 2011 and prices
declined by $369 per tonne. The favourable specialty cellulose market conditions
also led to low inventory levels of finished pulp, ending fiscal 2012 at 27 days
of supply compared to 22 days at the end of 2011.

The shipments to capacity ratio for chemical paper pulp or NBSK
was 82% in fiscal 2012 versus 88% in the prior year. The decline in shipment
ratio was due to a combination of lower productivity and inventory movement.
Market conditions for NBSK pulp were significantly weaker during the most recent
year. The benchmark price (delivered China) declined by US $183 per tonne. With
a weaker Canadian dollar and a higher sales mix factor providing a partial
offset, the net effect was a reduction of $125 per tonne. Fiscal 2012 inventory
of NBSK ended the year at only nine days, as year-end coincided with the annual
maintenance shutdown. This level does not allow for effective customer service
and will be increased in the first quarter of fiscal 2013.

QUARTERLY PRICES  SPECIALTY CELLULOSE

QUARTERLY PRICES  VISCOSE GRADE(US $ per tonne)

QUARTERLY PRICES  NBSK(US $ per tonne)

Tembec Financial Report 2012 17

---

Managements Discussion and Analysis

OPERATING RESULTS

The following summarizes adjusted EBITDA variances by major
element:

Variance - favourable (unfavourable)ForeignInventory
    
    
    exchangeMill
    
    
    NRV
    
    
    impact(in millions of
      dollars)
    
    Price
    
    
    costs
    
    
    adjustments
    
    
    on costs
    
    
    Other
    
    
    TOTALSpecialty cellulose
    
    18
    
    
    (28
    )
    
    
    
    
    7
    
    
    (5
    )
    
    (8
    )Chemical paper pulp (NBSK)
    
    (28
    )
    
    (6
    )
    
    (1
    )
    
    
    
    
    
    
    
    (35
    )Chemicals
    
    4
    
    
    (7
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Other segment
      items
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2
    )
    
    (2
    )(6
    )
    
    (41
    )
    
    (1
    )
    
    7
    
    
    (7
    )
    
    (48
    )


Fiscal 2012 adjusted EBITDA was $92 million compared to $140
million in the prior year. Specialty grades of cellulose pulp increased in price
and more than offset declines in viscose grades, increasing adjusted EBITDA by
$18 million. Manufacturing costs at the two specialty pulp mills increased by
$28 million, primarily for chemicals, supplies and fiber. The mills produced
more specialty grades of cellulose pulp, which have lower yields and are more
costly to produce than viscose grades. The weaker euro versus the Canadian
dollar, which reduced the Tartas mill selling prices by $10 million, also
reduced their Canadian dollar equivalent costs by $7 million leaving a net
adjusted EBITDA impact of $3 million. The remaining $5 million negative variance
is primarily related to volume as shipments declined by 4.7% year-over-year.

As noted previously, market conditions for NBSK were
significantly weaker during 2012. The decline in prices reduced adjusted EBITDA
by $28 million. Mill manufacturing costs increased by $6 million, primarily for
fiber and chemicals.

The $4 million favourable chemicals price variance was due to
higher resin prices. However, raw material costs increased by a similar amount
and resin profitability was relatively unchanged. The decline of $3 million in
chemicals adjusted EBITDA was due to the Canadian lignin business, which
experienced lower prices and higher costs.

The two North American mills purchased approximately 852,000
bone dry tonnes of wood chips in fiscal 2012, up from 845,000 in the prior year.
Of this amount, approximately 49% was supplied by the Forest Products segment,
compared to 67% in the prior year. The decline in internal fiber percentage was
due to the sale of the two BC sawmills in March 2012. While the Skookumchuck
NBSK mill continues to utilize the wood chip output of the two sawmills from the
new owner, they are now classified as external supply. The remaining
requirements were purchased from third parties under contracts and agreements of
various durations. The pulp mill located in Southern France purchased 287,000
bone dry tonnes of wood in fiscal 2012 as compared to 308,000 bone dry tonnes in
the prior year. The fibre is sourced from many private landowners.

Overall, lower NBSK prices and higher manufacturing costs
reduced adjusted EBITDA margins from 20.2% in 2011 to 13.9% in 2012.

The following summarizes operating results variances by major
element:

|                                    |  |      |  |  |      |  |  | Variance       |  
|----------------------------------- |  | ---- |  |  | ---- |  |  | -------------- | -
|                                    |  |      |  |  |      |  |  | favourable     |  
|(in millions of
      dollars)      |  | 2011 |  |  | 2012 |  |  | (unfavourable) |  
|Adjusted EBITDA                     |  | 140  |  |  | 92   |  |  | (48            | )
|Depreciation and
      amortization |  | 19   |  |  | 21   |  |  | (2             | )
|Operating earnings                  |  | 121  |  |  | 71   |  |  | (50            | )

The Specialty Cellulose and Chemical Pulp segment generated
operating earnings of $71 million during the most recently completed fiscal
year, compared to operating earnings of $121 million in the prior year. The
previously noted decline in adjusted EBITDA led to the lower operating
earnings.

18Tembec Financial Report 2012

---

Managements Discussion and Analysis

|HIGH-YIELD
      PULP                      |  |      |    |  |      |   
|------------------------------------------ |  | ---- | -- |  | ---- | --
|(in millions of dollars)                   |  |      |    |  |      |   
|                                           |  | 2011 |    |  | 2012 |   
|Sales (1)                                  |  | 378  |    |  | 352  |   
|Freight and other deductions               |  | 79   |    |  | 77   |   
|Cost of sales (1)                          |  | 299  |    |  | 298  |   
|SG&A                                       |  | 3    |    |  | 6    |   
|Adjusted EBITDA                            |  | (3   | )  |  | (29  | ) 
|Adjusted EBITDA
      margin on sales      |  | (0.8 | )% |  | (8.2 | )%
|Depreciation and amortization              |  | 11   |    |  | 13   |   
|Other item:                                |  |      |    |  |      |   
|Chetwynd impairment charge                 |  | -    |    |  | 50   |   
|Operating loss                             |  | (14  | )  |  | (92  | ) 
|                                           |  |      |    |  |      |   
|Identifiable
      assets (excluding cash) |  | 173  |    |  | 156  |   

(1) Includes intersegment sales eliminated on
consolidation

The High-Yield Pulp segment consists of three market pulp
manufacturing facilities. High-yield pulps are produced with a combination of
mechanical and chemical processes. The Company produces hardwood grades made
from maple, aspen and birch. High-yield pulps have a lower tensile and tear
strength than kraft pulps but they offer advantages on bulk and opacity. They
compete against other hardwood or short fibre grades, with Bleached Eucalyptus
Kraft (BEK) being the most prominent.

The following summarizes the annual capacity of each
facility:

|HIGH-YIELD PULP                          |  | tonnes  | 
|---------------------------------------- |  | ------- | 
|Hardwood high-yield - Temiscaming, QC    |  | 315,000 | 
|Hardwood high-yield - Matane, QC         |  | 250,000 | 
|Hardwood
      high-yield - Chetwynd, BC |  | 240,000 | 
|                                         |  | 805,000 | 

Total 2012 shipments of 640,700 tonnes include 60,000 tonnes of
high-yield pulp consumed by the Companys paperboard operations as compared to
57,500 tonnes in the prior year.

Total sales for the High-Yield Pulp segment were $352 million,
a decrease of $26 million from the prior year. After eliminating internal sales,
the High-Yield Pulp segment generated 19% of Company consolidated sales, as
compared to 20% in the prior year. The High-Yield Pulp segment is more export
oriented than the other business segments within the Company. In 2012, 99% of
consolidated pulp sales were generated outside of Canada and the U.S., unchanged
from the prior year. China alone accounted for 36% of sales compared to 49% in
the prior year.

Tembec Financial Report 2012 19

---

Managements Discussion and Analysis

Sales
    
    
    
    
    
    Shipments
    
    
    
    
    
    Selling prices($ millions)
    
    
    
    
    
    (000 tonnes
    )
    
    
    
    
    ($/tonne)2011
    
    
    2012
    
    
    2011
    
    
    2012
    
    
    2011
    
    
    2012Hardwood high-yield
    
    378
    
    
    352
    
    
    664.3
    
    
    640.7
    
    
    569
    
    
    549Internal sales
    
    (30
    )
    
    (30
    )
    
    (57.5
    )
    
    (60.0
    )
    
    522
    
    
    500Consolidated
      sales
    
    348
    
    
    322
    
    
    606.8
    
    
    580.7
    
    
    573
    
    
    555


MARKETS

The Company markets its pulp on a world-wide basis, primarily
through its own sales force. Sales offices are maintained in Toronto, Canada;
Dax, France; and Beijing, China. Contractual arrangements with third party
representatives are also utilized.

The shipments to capacity ratio for high-yield pulp was at 80%
versus 83% in the prior year. These are relatively low percentages, which are
not indicative of a strong market. The US $ reference price for BEK decreased by
US $120 per tonne compared to the prior year period. However, the drop in US $
pricing for high-yield pulp was less pronounced. Currency was slightly
favourable as the Canadian dollar averaged US $0.992, a 2.1% decrease from US
$1.013 in the prior year. The net effect reduced prices by approximately $20 per
tonne during the fiscal year. The average selling price for third party sales
was $555 per tonne, a decrease of $18 per tonne from the prior year average. In
response to the weak market conditions, the Company indefinitely curtailed
production at the Chetwynd pulp mill in September 2012. Inventory levels ended
the year at 35 days of supply as compared to 15 days at the end of 2011. The
abnormally low level of inventory at the end of the prior year was related to a
labour strike that occurred at the Matane mill.

QUARTERLY PRICES  HIGH-YIELD(US $ per
tonne)

20Tembec Financial Report 2012

---

Managements Discussion and Analysis

OPERATING RESULTS

The following summarizes adjusted EBITDA variances by major
element:

Variance - favourable (unfavourable)InventoryMill
    
    
    Freight
    
    
    NRV(in millions of
      dollars)
    
    Price
    
    
    costs
    
    
    and SG&A
    
    
    adjustments
    
    
    Other
    
    
    TOTALHigh-yield pulps
    
    (12
    )
    
    (6
    )
    
    (3
    )
    
    (2
    )
    
    (3
    )
    
    (26
    )


Fiscal 2012 adjusted EBITDA was negative $29 million compared
to negative $3 million in the prior year. The previously noted decrease in pulp
selling prices decreased adjusted EBITDA by $12 million. Mill costs increased by
$6 million, primarily for fiber and chemicals. This was partially offset by
improved fixed cost absorption as the mills produced 6.9% more tonnes in 2012.
Freight and SG&A costs increased by $3 million. The current year costs
include a charge of $3 million relating to the decrease in the carrying values
of finished goods raw material inventory as compared to a charge of $1 million
in the prior year.

The three pulp mills purchased approximately 707,600 bone dry
tonnes of wood chips in fiscal 2012, up from 682,800 in the prior year. Of this
amount, approximately 24% was supplied by the Forest Products segment, compared
to 19% in the prior year. The remaining requirements were purchased from third
parties under contracts and agreements of various durations.

Overall, lower prices and higher costs reduced profitability
with a negative adjusted EBITDA margin of 8.2% compared to negative 0.8% in the
prior year.

The following summarizes operating results variances by major
element:

|                               |  |      |   |  |      |   |  | Variance       |  
|------------------------------ |  | ---- | - |  | ---- | - |  | -------------- | -
|                               |  |      |   |  |      |   |  | favourable     |  
|(in millions of
      dollars) |  | 2011 |   |  | 2012 |   |  | (unfavourable) |  
|Adjusted EBITDA                |  | (3   | ) |  | (29  | ) |  | (26            | )
|Depreciation and amortization  |  | 11   |   |  | 13   |   |  | (2             | )
|Other items                    |  |     |   |  | 50   |   |  | (50            | )
|Operating loss                 |  | (14  | ) |  | (92  | ) |  | (78            | )

The High-Yield Pulp segment generated an operating loss of $92
million during the most recently completed fiscal year, compared to an operating
loss of $14 million in the prior year. In addition to the previously noted
decline in adjusted EBITDA, the segment absorbed an impairment charge of $50
million relating to the property, plant and equipment, including supplies and
materials, of the Chetwynd, BC, pulp mill.

Tembec Financial Report 2012 21

---

Managements Discussion and Analysis

|PAPER                                      |  |      |   |  |      |      
|------------------------------------------ |  | ---- | - |  | ---- | -----
|(in millions of dollars)                   |  |      |   |  |      |      
|                                           |  | 2011 |   |  | 2012 |      
|Sales                                      |  | 339  |   |  | 346  |      
|Freight and other deductions               |  | 45   |   |  | 46   |      
|Cost of sales                              |  | 255  |   |  | 252  |      
|SG&A                                       |  | 10   |   |  | 11   |      
|Adjusted EBITDA                            |  | 29   |   |  | 37   |      
|Adjusted EBITDA
      margin on sales      |  | 8.6  | % |  | 10.7 | **%**
|Depreciation and
      amortization        |  | 3    |   |  | 2    |      
|Operating earnings                         |  | 26   |   |  | 35   |      
|                                           |  |      |   |  |      |      
|Identifiable
      assets (excluding cash) |  | 122  |   |  | 120  |      

The Paper segment currently includes two paper manufacturing
facilities with a total of three paper machines. The mill located in
Kapuskasing, Ontario, produces newsprint on two machines. The facility located
in Temiscaming, Quebec, produces multiply coated bleached board on one machine.
The board mill is partially integrated with a high-yield pulp mill and also
consumes pulp manufactured by the Company at its British Columbia NBSK pulp
mill. The total capacity of the Paper segment is 420,000 tonnes. Prior to April
2011, the Paper segment also included the financial results of a hydro-electric
dam located in Smooth Rock Falls, Ontario. The dam was sold on March 29,
2011.

The following summarizes the products and capacity of each
facility:

|COATED BLEACHED BOARD |  | tonnes  | 
|--------------------- |  | ------- | 
|Temiscaming, QC       |  | 180,000 | 

|NEWSPRINT       |  |         | 
|--------------- |  | ------- | 
|Kapuskasing, ON |  | 240,000 | 
|                |  |         | 
|                |  | 420,000 | 

Coated bleached board shipments represented 44% of Paper
segment shipments in fiscal 2012, as compared to 42% in the prior year. As a
percentage of total segment sales, coated bleached board represented 59% of
sales compared to 57% in the prior year.

Newsprint shipments represented 56% of Paper segment shipments
in fiscal 2012, as compared to 58% in the prior year. In terms of total segment
sales, newsprint represented 41% of sales compared to 42% in the prior year.

Sales for the Paper segment totalled $346 million, as compared
to $339 million in the prior year. The segment generated 21% of Company
consolidated sales, as compared to 19% in fiscal 2011. The focus of the paper
business is North America, which accounted for 94% of consolidated sales in
2012, compared to 92% in the prior year. The U.S. alone accounted for 77% of
sales in fiscal 2012, up from 74% the prior year.

22Tembec Financial Report 2012

---

Managements Discussion and Analysis

Sales
    
    
    
    
    
    Shipments
    
    
    
    
    
    Selling prices($ millions)
    
    
    
    
    
    (000 tonnes
    )
    
    
    
    
    ($/tonne)2011
    
    
    2012
    
    
    2011
    
    
    2012
    
    
    2011
    
    
    2012Coated bleached board (rolls and sheets)
    
    194
    
    
    204
    
    
    165.2
    
    
    171.2
    
    
    1,174
    
    
    1,192Newsprint
    
    143
    
    
    142
    
    
    228.5
    
    
    221.8
    
    
    626
    
    
    640Electricity sales
    
    2
    
    
    Consolidated
      sales
    
    339
    
    
    346
    
    
    393.7
    
    
    393.0


MARKETS

The benchmark price for coated bleached board (16 point)
averaged US $1,132 per short ton in fiscal 2012, an US $18 per short ton
decrease over the prior year. Relatively stable pricing was supported by good
market demand. The shipments to capacity ratio for coated bleached board was 95%
in fiscal 2012 compared to 92% in the prior year. These percentages reflect the
good market fundamentals of the North American coated bleached board market over
the last two years. The board mill operated at full capacity in both fiscal
2011 and fiscal 2012, with no market downtime taken in either year. The small
decline in US $ prices was offset by favourable currency as the Canadian dollar
averaged $0.992, a 2.1% decrease from US $1.013 in the prior year. The inventory
level at year-end was at 50 days, compared to 52 days at the end of the prior
year. These are normal levels given the product sales mix, which includes both
rolls and sheets.

The benchmark newsprint price (48.8 gram  East Coast) averaged
US $640 per tonne in fiscal 2012, unchanged from the prior year. The shipments
to capacity ratio for newsprint was 92% as compared to 95% in the prior year,
while these ratios would normally be indicative of a stable market, that was not
the case for North American newsprint, as demand continued to decline. Despite
flat US $ prices, the Companys average selling price increased by $14 due to
the previously noted weaker Canadian dollar. Inventory levels at year-end were
at 14 days, unchanged from the prior year, which is a normal level for the
newsprint mill.

|QUARTERLY PRICES  COATED BLEACHED BOARD | QUARTERLY PRICES  NEWSPRINT
|---------------------------------------- | ----------------------------
|(US $ per short ton)                     | (US $ per tonne)            
|                                         |                             

Tembec Financial Report 2012 23

---

Managements Discussion and Analysis

OPERATING RESULTS

The following summarizes adjusted EBITDA variances by major
element:

Variance - favourable (unfavourable)Mill
    
    
    Freight(in millions of
      dollars)
    
    Price
    
    
    costs
    
    
    SGA
    
    
    Other
    
    
    TOTALCoated bleached board
    
    3
    
    
    2
    
    
    (1
    )
    
    
    
    
    4Newsprint
    
    3
    
    
    5
    
    
    (2
    )
    
    (1
    )
    
    5Other segment
      items
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    (1
    )6
    
    
    7
    
    
    (3
    )
    
    (2
    )
    
    8


Fiscal 2012 adjusted EBITDA was $37 million compared to $29
million in the prior year. Higher coated bleached board prices added $3 million
to adjusted EBITDA. Costs at the mill declined by $2 million with lower fiber
costs offsetting increases in other areas. Higher newsprint prices increased
adjusted EBITDA by $3 million. Manufacturing costs at the newsprint mill also
declined by $5 million, primarily as a result of lower energy costs.

The coated bleached board mill utilizes a combination of
chemical kraft and high-yield pulps to produce a three-ply sheet. During fiscal
2012, the mill utilized 17,300 tonnes of NBSK supplied by the Companys
Skookumchuck NBSK pulp mill as compared to 15,300 tonnes in the prior year. The
mill also consumed 60,000 tonnes of high-yield pulp supplied by the Temiscaming
mill versus 57,500 tonnes in fiscal 2011. The balance of pulp requirements is
purchased from third parties.

The newsprint mill utilizes virgin fibre, primarily in the form
of wood chips. During fiscal 2012, the operations purchased 238,500 bone dry
tonnes of virgin fibre, of which approximately 80% was internally sourced. In
the prior year, 257,400 bone dry tonnes of virgin fibre were purchased, with 81%
being sourced internally.

Overall, the higher prices and the lower costs increased
adjusted EBITDA margins from 8.6% to 10.7% .

The following summarizes operating results variances by major
element:

|                                    |  |      |  |  |      |  |  | Variance       | 
|----------------------------------- |  | ---- |  |  | ---- |  |  | -------------- | 
|                                    |  |      |  |  |      |  |  | favourable     | 
|(in millions of
      dollars)      |  | 2011 |  |  | 2012 |  |  | (unfavourable) | 
|Adjusted EBITDA                     |  | 29   |  |  | 37   |  |  | 8              | 
|Depreciation and
      amortization |  | 3    |  |  | 2    |  |  | 1              | 
|Operating earnings                  |  | 26   |  |  | 35   |  |  | 9              | 

The Paper segment generated operating earnings of $35 million
compared to operating earnings of $26 million in the prior year. The previously
noted improvement in adjusted EBITDA led to the higher operating earnings.

24Tembec Financial Report 2012

---

Managements Discussion and Analysis

|CORPORATE                                         |  |      |   |  |      |  
|------------------------------------------------- |  | ---- | - |  | ---- | -
|(in millions of dollars)                          |  |      |   |  |      |  
|                                                  |  | 2011 |   |  | 2012 |  
|General and administrative expenses               |  | 19   |   |  | 21   |  
|Share-based compensation                          |  | 2    |   |  | (1   | )
|Depreciation                                      |  | 1    |   |  |     |  
|Other items:                                      |  |      |   |  |      |  
|Custodial - idled facilities                      |  | 7    |   |  | 10   |  
|Write-down of Temlam loan receivable              |  |     |   |  | 16   |  
|Gain on sale of minority equity interest          |  |     |   |  | (4   | )
|Gain on Tembec USA LLC filing                     |  | (4   | ) |  |     |  
|Gain on sale
      of Smooth Rock Falls hydro dam |  | (3   | ) |  |     |  
|Operating expenses                                |  | 22   |   |  | 42   |  

The Company recorded a $1 million credit for share-based
compensation in the current year, compared to a $2 million charge last year.
Senior executives currently participate in a long-term incentive plan which
entitles participants to potentially receive units that are equal in value to
one common share. The units have a defined vesting period and are subject to
performance conditions that ultimately determine the amount of units that vest
and are earned by plan participants. Non-executive members of the Board of
Directors receive a portion of their fees in the form of Deferred Share Units
(DSU). The DSUs vest at specified dates. The period credit/expense consists of
normal periodic variation in the number of units based on anticipated or normal
vesting and the changes in the value of the Companys share price.

The Corporate segments other items include expenses relating
to several permanently idled facilities. The costs relate to custodial, site
security, legal and remediation activities. These legacy costs totalled $10
million in the most recent year, as compared to $7 million in the prior year.

The current year includes a $16 million charge relating to the
write-down of the loan receivable from Temlam Inc. The latter is currently under
creditor protection and owns an idled laminated veneer lumber (LVL) facility
located in Amos, Quebec. The Company has a 50% secured interest in the facility.
The cutting rights that were previously attached to the LVL facility were
granted to another company. In the absence of a guaranteed fibre supply, the
Company concluded that the re-start of the facility is unlikely and has adjusted
its carrying value to the amount anticipated to be realized upon liquidation or
sale. The current year also includes a gain of $4 million relating to the sale
of a minority equity interest in two dissolving pulp mills.

The prior year includes a gain of $4 million related to the
filing of Tembec USA LLC under Chapter 7 of the Bankruptcy Code of the United
States. The gain was generated by a reduction in the Companys accrued benefit
obligation. The period also included a gain of $3 million related to the sale of
hydro-electric generating assets located in Smooth Rock Falls, Ontario.

Tembec Financial Report 2012 25

---

Managements Discussion and Analysis

NON-OPERATING ITEMS

|INTEREST, FOREIGN
      EXCHANGE AND OTHER |  |      |   |  |      |  
|------------------------------------------ |  | ---- | - |  | ---- | -
|(in millions of dollars)                   |  |      |   |  |      |  
|                                           |  | 2011 |   |  | 2012 |  
|Interest on debt                           |  | 32   |   |  | 38   |  
|Interest income                            |  | (1   | ) |  | (1   | )
|Capitalized interest                       |  |     |   |  | (2   | )
|Fees - new working capital facility        |  | 2    |   |  |     |  
|Foreign exchange items                     |  |     |   |  | 4    |  
|Change in fair value of warrants (gain)    |  | (5   | ) |  |     |  
|Bank charges and
      other               |  | 3    |   |  | 2    |  
|                                           |  | 31   |   |  | 41   |  

The increase in the interest expense relates primarily to the
issue of a US $50 million additional tranche of 11.25% senior secured notes in
February 2012. This brought the total amount outstanding of 11.25% senior
secured notes to US $305 million, which constitutes the bulk of the Companys
annual interest expense. Foreign exchange items relate primarily to gains or
losses on the translation of US $ net monetary assets. When the Canadian dollar
strengthens versus the US dollar, losses are generated. This was the case in the
current year. Prior to February 29, 2012, there were 11,093,943 outstanding
warrants convertible into common shares of the Company. They expired on that
date and were not converted into common shares of the Company.

|TRANSLATION OF FOREIGN DEBT
|---------------------------

During fiscal 2012, the Company recorded a gain of $13 million
on the translation of its US $ denominated debt as the relative value of the
Canadian dollar increased from US $0.971 to US $1.017.

During fiscal 2011, the Company recorded a loss of $1 million
on the translation of its US $ denominated debt as the relative value of the
Canadian dollar decreased from US $0.975 to US $0.971.

|INCOME TAXES
|------------

During fiscal 2012, the Company recorded an income tax expense
of $22 million on a loss before income taxes of $60 million. The income tax
expense reflected a $38 million unfavourable variance versus an anticipated
income tax recovery of $16 million based on the Companys effective tax rate of
26.3% . The current year absorbed $32 million unfavourable variance related to
period losses for which no deferred tax asset was recognized. Based on past
financial performance, deferred income tax assets of the Companys Canadian
operations have not been recognized as it has not been determined that future
realization of these assets is probable. The expense was also increased by $6
million due to higher statutory income tax rates in France.

During fiscal 2011, the Company recorded an income tax expense
of $20 million on earnings before income taxes of $15 million. The income tax
expense reflected a $16 million unfavourable variance versus an anticipated tax
expense of $4 million based on the Companys effective tax rate of 27.8% . The
prior year absorbed a $10 million unfavourable variance related to period losses
for which no deferred tax asset was recognized. The expense was also increased
by $6 million due to higher statutory income tax rates in France.

26Tembec Financial Report 2012

---

Managements Discussion and Analysis

NET LOSS

The Company generated a net loss of $82 million or $0.82 per
share for the year ended September 29, 2012, compared to a net loss of $5
million or $0.05 per share for the year ended September 24, 2011. As noted
previously, the Companys financial results were impacted by certain specific
items. The following table summarizes the impact of these items on the reported
financial results. The Company believes it is useful supplemental information as
it provides an indication of results excluding the specific items. This
supplemental information is not intended as an alternative measure for net earnings as
determined by IFRS. The table below contains the gain or loss on translation of
foreign debt, which is a recurring item. Because the Company has a substantial
amount of US $ denominated debt, relatively minor changes in the value of the
Canadian dollar versus the US dollar can lead to large unrealized periodic gains
or losses. As well, this item receives capital gain/loss tax treatment and is
not tax-affected at regular business income rates.

|                                                      |  | Year ended         |   |  | Year ended         |  
|----------------------------------------------------- |  | ------------------ | - |  | ------------------ | -
|                                                      |  | September 24, 2011 |   |  | September 29, 2012 |  
|                                                      |  | $ millions         |   |  | $ per share        |  
|Net loss as reported                                  |  |                    |   |  |                    |  
|- in accordance with IFRS                             |  | (5                 | ) |  | (0.05              | )
|Specific items (after-tax):                           |  |                    |   |  |                    |  
|Loss (gain) on translation of foreign debt            |  | 1                  |   |  | 0.01               |  
|Gain on derivative financial instruments              |  | (1                 | ) |  | (0.01              | )
|Gain on sale of BC sawmills                           |  |                   |   |  |                   |  
|Loss on sale/closure of flooring assets               |  |                   |   |  |                   |  
|Write-down of Temlam loan receivable                  |  |                   |   |  |                   |  
|Gain on sale of minority interest                     |  |                   |   |  |                   |  
|Asset impairment - Chetwynd pulp mill                 |  |                   |   |  |                   |  
|Taschereau sawmill closure charge                     |  | 2                  |   |  | 0.02               |  
|Cranbrook planer mill severance charge                |  | 1                  |   |  | 0.01               |  
|Gain on Tembec USA LLC filing                         |  | (4                 | ) |  | (0.04              | )
|Gain on sale of Smooth Rock Falls hydro dam           |  | (2                 | ) |  | (0.02              | )
|Costs for permanently idled facilities                |  | 5                  |   |  | 0.05               |  
|Unrecognized
      deferred tax assets on above items |  | 1                  |   |  | 0.01               |  
|Net loss excluding specific items                     |  |                    |   |  |                    |  
|- not in
      accordance with IFRS                   |  | (2                 | ) |  | (0.02              | )

Tembec Financial Report 2012 27

---

Managements Discussion and Analysis

COMPREHENSIVE LOSS

The following table summarizes the impact of items affecting
the reported total comprehensive loss during the last two fiscal years:

|                                                                     |  | September |   |  | September |  
|-------------------------------------------------------------------- |  | --------- | - |  | --------- | -
|(in millions of
      dollars)                                       |  | 2011      |   |  | 2012      |  
|Net loss                                                             |  | (5        | ) |  | (82       | )
|Defined benefit pension plans loss                                   |  | (64       | ) |  | (42       | )
|Other benefit plans gain                                             |  |          |   |  | 4         |  
|Foreign
      currency translation gain (loss) on foreign operations |  | 2         |   |  | (11       | )
|Total
      comprehensive loss                                       |  | (67       | ) |  | (131      | )

During fiscal 2012, the Company recognized a charge of $42
million relating to the net increase in defined pension plan liabilities. This
was the result of several items. A decline in the discount rate used to
calculate the pension obligation generated an actuarial loss of $77 million.
This unfavourable item was partially offset by a higher than expected return on
plan assets, which generated a gain of $31 million. The Company also generated
an experience gain of $4 million on its defined benefit pension plans. In the
prior year, the Company had recognized a charge of $64 million relating to the
net increase in defined benefit plan liabilities. A decline in the discount rate
used to calculate the pension obligation generated an actuarial loss of $44
million. A lower than expected return on plan assets added a further $27 million
to net liability. Several other favourable items totalling $7 million provided a
partial offset. During the most recent year, the Company generated an experience
gain of $6 million, partially offset by a $2 million increase in obligations due
to a decline in discount rate, on its other benefit plans obligations. There was
no comparable gain or loss in the prior year.

Comprehensive items also include gains or losses related to the
currency translation of the assets and liabilities of the Companys French and
U.S. operations. The gains or losses are generated by the changes in the end of
period exchange rates. During fiscal 2012, the currency translation of the
French operations generated a loss of $12 million, partially offset by a gain of
$1 million relating to the U.S. operations. In the prior year, the currency
translation of the French and U.S. operations generated a gain of $1 million
each.

28Tembec Financial Report 2012

---

Managements Discussion and
Analysis

QUARTERLY FINANCIAL
INFORMATION(in millions of dollars, except per share amounts)

2011
    
    
    
    
    
    
    
    
    
    
    
    2012Dec. 10
    
    
    March 11
    
    
    June 11
    
    
    Sept. 11
    
    
    Dec. 11
    
    
    March 12
    
    
    June 12
    
    
    Sept. 12Sales
    
    422
    
    
    452
    
    
    448
    
    
    421
    
    
    401
    
    
    407
    
    
    415
    
    
    443Adjusted EBITDA
    
    12
    
    
    34
    
    
    33
    
    
    19
    
    
    12
    
    
    2
    
    
    27
    
    
    23Depreciation and amortization
    
    13
    
    
    11
    
    
    12
    
    
    12
    
    
    12
    
    
    10
    
    
    11
    
    
    13Other items
    
    2
    
    
    6
    
    
    (7
    )
    
    2
    
    
    2
    
    
    (5
    )
    
    2
    
    
    51Operating earnings (loss)
    
    (3
    )
    
    17
    
    
    28
    
    
    5
    
    
    (2
    )
    
    (3
    )
    
    14
    
    
    (41
    )Net
      earnings (loss)
    
    (11
    )
    
    6
    
    
    17
    
    
    (17
    )
    
    (16
    )
    
    (14
    )
    
    (5
    )
    
    (47
    )Basic and fully diluted net earnings (loss) in dollars per
      share
    
    (0.11
    )
    
    0.06
    
    
    0.17
    
    
    (0.17
    )
    
    (0.16
    )
    
    (0.14
    )
    
    (0.05
    )
    
    (0.47
    )Comprehensive earnings (loss)
    
    (13
    )
    
    10
    
    
    19
    
    
    (83
    )
    
    (21
    )
    
    (14
    )
    
    (10
    )
    
    (86
    )


|FOURTH QUARTER ANALYSIS
|-----------------------

The Company reported a net loss of $47 million or $0.47 per
share in the fourth quarter ended September 29, 2012, compared to a net loss of
$17 million or $0.17 per share in the same quarter of fiscal 2011. The weighted
average number of common shares outstanding was 100 million, unchanged from the
prior year.

Sales increased by $22 million as compared to the same quarter
a year ago. Currency was favourable as the Canadian dollar averaged US $1.003, a
2.0% decrease from US $1.023 in the prior year quarter. Forest Products segment
sales decreased by $13 million as a result of lower shipments, partially offset
by higher prices. Specialty Cellulose and Chemical Pulp segment sales decreased
by $13 million due to lower prices. High-Yield Pulp segment sales increased by
$24 million due to higher shipments. Paper segment sales increased by $12
million due to higher shipments.

Adjusted EBITDA increased by $4 million from the prior year
quarter. Forest Products segment adjusted EBITDA improved by $18 million from
the prior year quarter due to higher prices and lower costs. Specialty Cellulose
and Chemical Pulp segment adjusted EBITDA decreased by $14 million due primarily
to lower prices. High-Yield Pulp segment adjusted EBITDA decreased by $1 million
due to lower prices, partially offset by lower costs. Paper segment adjusted
EBITDA increased by $8 million because of lower costs.

The Company generated an operating loss of $41 million compared
to operating earnings of $5 million in the same quarter a year ago. The
previously noted improvement in adjusted EBITDA was more than offset by the
impact of other items. During the September 2012 quarter, the Company absorbed
an impairment charge of $50 million relating to the property, plant and
equipment, including supplies and materials, of the Chetwynd, BC, pulp mill.

The interest expense relates primarily to interest on the
11.25% senior secured notes maturing in December 2018. In the prior year
quarter, the amount of outstanding notes was US $255 million as compared to US
$305 million during the most recent quarter. Foreign exchange items relate
primarily to gains or losses on the translation of US $ net monetary assets.
When the Canadian dollar weakens versus the US dollar, as was the case in the
prior year quarter, gains are generated. When the Canadian dollar strengthens
versus the US dollar, as was the case in the most recent quarter, losses are
generated.

During the September 2012 quarter, the Company recorded a gain
of $13 million on the translation of its US $ denominated debt as the relative
value of the Canadian dollar increased from US $0.976 to US $1.017.

Tembec Financial Report 2012 29

---

Managements Discussion and Analysis

During the September 2011 quarter, the Company recorded a loss
of $11 million on the translation of its US $ denominated debt as the relative
value of the Canadian dollar decreased from US $1.013 to US $0.971.

During the September 2012 quarter, the Company recorded an
income tax expense of $5 million on a loss before income taxes of $42 million.
The income tax expense reflected a $16 million unfavourable variance versus an
anticipated income tax recovery of $11 million based on the Companys effective
tax rate of 26.3% . The September 2012 quarter absorbed a $16 million
unfavourable variance related to period losses for which no deferred tax asset
was recognized. Based on past financial performance, deferred income tax assets
of the Companys Canadian operations have not been recognized as it has not been
determined that future realization of these assets is probable.

During the September 2011 quarter, the Company recorded an
income tax expense of $8 million on a loss before income taxes of $9 million.
The income tax expense reflected an $11 million unfavourable variance versus an
anticipated income tax recovery of $3 million based on the Companys effective
tax rate of 27.8% . The September 2011 quarter absorbed a $7 million
unfavourable variance related to period losses for which no deferred tax asset
was recognized.

During the September 2012 quarter, the Company recognized a
charge of $42 million in comprehensive loss relating to the net increase in
defined pension plan liabilities. This was the result of several items. A
decline in the discount rate used to calculate the pension obligation generated
an actuarial loss of $77 million. This unfavourable item was partially offset by
a higher than expected return on plan assets, which generated a gain of $31
million. The Company also generated an experience gain of $4 million on its
defined benefit pension plans. In the prior year quarter, the Company had
recognized a charge of $64 million relating to the net increase in defined
benefit pension plan liabilities. A decline in the discount rate used to
calculate the pension obligation generated an actuarial loss of $44 million. A
lower than expected return on plan assets added a further $27 million to net
liability. Several other favourable items totalling $7 million provided a
partial offset. During the most recent quarter, the Company generated an
experience gain of $6 million, partially offset by a $2 million increase in
obligations due to a decline in discount rate, on its other benefit plan
obligations. There was no comparable gain or loss in the year ago period.

Comprehensive earnings (loss) also include gains or losses
related to the currency translation of the assets and liabilities of the
Companys French and U.S. operations. The gains or losses are generated by the
changes in the end of period exchange rates. During the September 2012 quarter,
the currency translation of the French operations generated a loss of $2
million, partially offset by a gain of $1 million relating to the U.S.
operations. In the prior year quarter, the currency translation of the U.S.
operations generated a loss of $2 million.

The fourth quarter 2012 interim MD&A issued on November 15,
2012, provides a more extensive analysis of items having impacted the Companys
fourth quarter financial results.

|SUMMARY OF QUARTERLY RESULTS
|----------------------------

On a quarterly basis, sales and margins were negatively
impacted by relatively low lumber and paper pulp prices. Currency did not impact
Canadian operations significantly as the Canadian dollar was close to parity
over the last eight quarters, averaging US $1.003 with a quarterly average high
of US $1.033 and a low of US $0.977. However, the weakening of the relative
value of the euro versus the Canadian dollar that occurred over the last three
quarters did reduce the adjusted EBITDA of the French specialty cellulose mill.
The euro ended fiscal 2012 at C $1.263, a 9.3% decrease versus C $1.392 at the
end of fiscal 2011.

The Forest Products segment generated negative adjusted EBITDA
of $63 million during the last eight quarters. This represents an average
negative margin of 7.0% on sales of $903 million. The U.S. lumber and housing
market was very weak during the last two years and the Companys lumber
shipments to capacity ratio ranged from 54% to 70%. The U.S. market has recently
improved and lumber prices have followed this trend. In the September 2012 quarter, the
Forest Products segment generated adjusted EBITDA of $8 million and a positive
margin of 7.4%, the first positive quarterly results of the last two years. The
financial performance was negatively impacted by export taxes on lumber shipped
to the United States. The total amount incurred over the last two years was $20
million.

30Tembec Financial Report 2012

---

Managements Discussion and Analysis

The Specialty Cellulose and Chemical Pulp segment generated
adjusted EBITDA of $232 million during the last eight quarters. This represents
an average margin of 17.1% on sales of $1,355 million. The margins averaged
20.2% in fiscal 2011 when both specialty cellulose and NBSK pulp prices were
relatively high. A weakening of NBSK pulp prices in fiscal 2012 resulted in
weaker results and average margins declined to 13.9% .

The High-Yield Pulp segment generated negative adjusted EBITDA
of $32 million during the last eight quarters. This represents a negative margin
of 4.4% on sales of $730 million. The market for high-yield pulp has been
relatively weak over the last two years, and like NBSK pulp, was weaker in
fiscal 2012 versus fiscal 2011, and margins dropped to negative 8.2% .

The Paper segment generated adjusted EB ITDA of $66 million
over the last eight quarters. This represents an average margin of 9.6% on sales
of $685 million. Prices for coated bleached board and newsprint have not
fluctuated significantly over the last two years and segment financial results
have been relatively stable.

Corporate general and administrative expenses of the Company
have averaged approximately $5 million per quarter over the last two years and
there has been no significant changes in the composition of those expenses.

Overall, the Company generated adjusted EBITDA of $162 million
in the last eight quarters. This represents an average margin of approximately
4.8% on sales of $3.4 billion.

Other items reduced the Companys operating earnings by $53
million during the last eight quarters. While there were several offsetting
favourable and unfavourable items, the most significant unfavourable item was a
$50 million asset impairment charge taken in the September 2012 quarter.

Due to the strengthening Canadian dollar versus the US dollar,
the Company recorded a gain of $12 million on the translation of its
foreign-denominated debt over the last two years. However, the impact of the
quarterly US debt translation gains and losses added considerable volatility to
the financial results, with the impact ranging from a gain of $13 million in the
September 2012 quarter to a loss of $11 million in the September 2011 quarter.

During the last two years, the Company has recorded an income
tax expense of $42 million. The expense relates primarily to its French
operations as the Canadian operations have significant amounts of unrecognized
tax losses.

Tembec Financial Report 2012 31

---

Managements Discussion and Analysis

FINANCIAL POSITION AND LIQUIDITY

|FREE CASH FLOW                                           |  |      |   |  |      |  
|-------------------------------------------------------- |  | ---- | - |  | ---- | -
|(in millions of dollars)                                 |  |      |   |  |      |  
|                                                         |  | 2011 |   |  | 2012 |  
|Cash flow from operations before working capital changes |  | 64   |   |  | 13   |  
|Less:                                                    |  |      |   |  |      |  
|Additions to property, plant and equipment               |  | 58   |   |  | 120  |  
|Interest on
      debt                                   |  | 32   |   |  | 38   |  
|Free cash flow
      (negative)                          |  | (26  | ) |  | (145 | )

Cash flow from operations before working capital changes in
fiscal 2012 was $13 million, compared to $64 million in the prior year. The
decline in cash flow was due to lower adjusted EBITDA, income taxes paid
relating to the French operations and an increase in excess cash contributions
for employee future benefit plans. After allowing for capital expenditures of
$120 million and interest on debt of $38 million, free cash flow in fiscal 2012
was negative $145 million compared to negative $26 million in the prior year. In
fiscal 2012, non-cash working capital items used $85 million. The majority of
the increase in working capital was related to increased trade receivables in
the Forest Products and High-Yield Pulp segments as well as higher inventories
in the Specialty Cellulose and Chemical Pulp and the High-Yield Pulp segments.
As a result, cash flow from operations declined from positive $99 million in
fiscal 2011 to negative $72 million in fiscal 2012.

|CAPITAL SPENDING                      |  |      |  |  |      | 
|------------------------------------- |  | ---- |  |  | ---- | 
|(in millions of dollars)              |  |      |  |  |      | 
|                                      |  | 2011 |  |  | 2012 | 
|Forest Products                       |  | 10   |  |  | 12   | 
|Specialty Cellulose and Chemical Pulp |  | 38   |  |  | 91   | 
|High-Yield Pulp                       |  | 5    |  |  | 8    | 
|Paper                                 |  | 5    |  |  | 7    | 
|Corporate                             |  |     |  |  | 2    | 
|Net capital
      expenditures        |  | 58   |  |  | 120  | 
|As a % of consolidated sales          |  | 3.3% |  |  | 7.2% | 
|As a % of
      depreciation          |  | 121% |  |  | 261% | 

32Tembec Financial Report 2012

---

Managements Discussion and Analysis

During fiscal 2012, capital expenditures totalled $120 million
compared to $58 million in the prior year. The Company estimates that annual
capital expenditures of $35 million to $40 million are required to adequately
maintain its facilities. The increase in capital expenditures in fiscal 2012
relates to one relatively large capital project. In March 2012, the Company
announced a $190 million capital investment to upgrade its specialty cellulose
mill in Temiscaming, Quebec. The project involves the replacement of three
low-pressure boilers with a single new high-pressure boiler designed to burn
waste sulphite liquor generated by the specialty cellulose manufacturing
process. The project also includes the installation of a new 50-megawatt
electrical turbine. During the year, $56 million was spent on the project,
bringing total cumulative project expenditures to $59 million. It is currently
estimated that the project will increase annual adjusted EBITDA by $40 million
to $45 million once it becomes fully operational in the spring of 2014.

While the cost of major equipment purchases related to the
Temiscaming specialty cellulose project have been in line with expectations,
recent quotes provided by potential vendors for construction labour have
significantly exceeded the budgeted amounts. The Company is currently reviewing
quotes to assess the underlying causes of these discrepancies. Preliminary
indications are that the high quotes are due in large part to the overheated
construction market in the Province of Quebec and the resulting scarcity of
qualified contractors and related labour. The Companys desire to complete
certain elements prior to the onset of the winter months is likely contributing
to the cost pressures. Given these circumstances, the Company has decided to
reduce construction activity over the winter months.

As a result, the boiler start-up, initially scheduled for
December 2013, will likely be delayed by approximately three months. The impact
on the start-up of the turbine, scheduled for May 2014, is still under review.
The Companys view is that these actions are necessary and prudent under the
circumstances.

The Company completed the installation of a new electrical
turbine at the Tartas specialty cellulose mill at a total estimated cost of $21
million. During the year, $11 million was spent to complete the project. The
turbine was commissioned in June 2012 and became operational in the September
2012 quarter. Current forecasts are that the turbine will increase mill adjusted
EBITDA by $8 million per year.

On October 9, 2009, the Company was advised that it had
qualified for $24 million of credits under the federal governments Pulp and
Paper Green Transformation Program. The credits were used to finance capital
projects that generate environmental benefits, including investments in energy
efficiency or the production of renewable energy from forest biomass. The
Company has utilized its full allotment of credits.

|ACQUISITIONS, INVESTMENTS AND DIVESTITURES
|------------------------------------------

On February 21, 2011, the Company announced the permanent
closure of its Taschereau, Quebec, SPF sawmill. As a result, a charge of $2
million was recorded in the fiscal 2011 financial results.

On March 29, 2011, the Company announced the sale of its
hydro-electric generating assets located in Smooth Rock Falls, Ontario. The
purchaser paid $16 million in cash for the assets. As a result, the Company
recorded a gain of $3 million in the fiscal 2011 financial results.

On November 25, 2011, the Company sold its Toronto, Ontario,
hardwood flooring plant for proceeds of $13 million. Concurrently, the Company
also announced the closure of its Huntsville, Ontario, hardwood flooring plant.
The sale of the Toronto plant and the closure of the Huntsville plant resulted
in a charge of $2 million that was recorded in the Companys fiscal 2012
financial results.

On March 23, 2012, the Company sold its British Columbia
Southern Interior wood products assets for proceeds of $66 million. The sale
included the Elko and Canal Flats sawmills and approximately 1.1 million cubic
meters of combined Crown tenures, private land and contract annual allowable
cut. As a result of the sale, the Company recorded a gain of $24 million in the
fiscal 2012 financial results.

Tembec Financial Report 2012 33

---

Managements Discussion and Analysis

|FINANCING ACTIVITIES
|--------------------

NET DEBT TO TOTAL CAPITALIZATION

The Companys strategy is to maintain the net debt to total
capitalization ratio at 40% or less. The objective is to keep a relatively
strong balance sheet and maintain the ability of the Company to access capital
markets at favourable rates. The net debt to total capitalization ratio of the
Company was 45% as at September 29, 2012, as compared to 27% at the end of the
prior fiscal year. The increase was due to fiscal 2012 losses, which reduced
shareholders equity, combined with higher net debt due primarily to finance the
previously noted Temiscaming specialty cellulose project. The Company
anticipates that the net debt to total capitalization ratio will remain in
excess of its target until the Temiscaming project is completed and begins to
generate the projected incremental adjusted EBITDA.

|LONG-TERM DEBT                                                                                                   |  |      |  |  |      | 
|---------------------------------------------------------------------------------------------------------------- |  | ---- |  |  | ---- | 
|(in millions of dollars)                                                                                         |  |      |  |  |      | 
|                                                                                                                 |  | 2011 |  |  | 2012 | 
|Tembec Industries - US $305 million (2011 - US $255
      million) 11.25% senior secured notes due December 2018 |  | 262  |  |  | 300  | 
|Tembec Inc. - 6% unsecured notes due September 2012                                                              |  | 5    |  |  |     | 
|Tembec Energy LP - 6.35% secured term loan                                                                       |  |     |  |  | 20   | 
|Tembec French operations                                                                                         |  | 25   |  |  | 22   | 
|Kirkland Lake Engineered Wood Products Inc.                                                                      |  | 8    |  |  | 8    | 
|Other debt                                                                                                       |  | 2    |  |  | 2    | 
|Total long-term debt                                                                                             |  | 302  |  |  | 352  | 
|Less net
      unamortized financing costs                                                                       |  | 13   |  |  | 13   | 
|                                                                                                                 |  | 289  |  |  | 339  | 
|Current portion
      included in above                                                                          |  | 18   |  |  | 16   | 

34Tembec Financial Report 2012

---

Managements Discussion and Analysis

In August 2010, the Company completed a private offering of US
$255 million of 11.25% senior secured notes maturing in December 2018. In
February 2012, the Company issued a further US $50 million of senior secured
notes with the same terms and conditions as the original US $255 million notes.
The notes are senior secured obligations of the Company, secured by a first
priority lien on the majority of the property and assets of the Company. They
are secured by a second priority lien on accounts receivable, inventories and
certain intangibles.

During the March 2012 quarter, the Company entered into a $75
million term loan facility to assist with the financing of the previously
mentioned Temiscaming, Quebec, specialty cellulose project. The interest rate on
the facility is 5.5% . The loan has a 15-year term consisting of a three-year
construction or drawdown period followed by a 12-year amortization period. The
term of the loan will be shortened by three years if the Company does not
complete certain future capital expenditures at the Temiscaming specialty
cellulose mill. The loan is secured by a second ranking charge on the project
assets. The Company has also granted the lender a five-year option starting on
the first loan disbursement date to acquire 3 million common shares of Tembec at
a price of $7 per share. As at the end of September 2012, the Company had not
drawn on the facility. On October 19, 2012 and on November 14, 2012, the Company
received $9 million and $6 million respectively on the term loan.

On June 29, 2012, the Company entered into a $30 million term
loan facility to assist with the financing of the previously noted specialty
cellulose project in Temiscaming, Quebec. The interest rate on this loan will be
the greater of 6.35% and the yield on equivalent terms Government of Canada
bonds plus 4.25% at the date the funds are advanced. The loan will be reimbursed
in blended monthly instalments over a period of eight years beginning
approximately 24 months after the initial advance, with a balloon payment of
$18 million to be repaid at the end of the ten-year term period. The loan is
secured by a first ranking charge on the project assets. On July 12, 2012, the
Company received $20 million representing the first tranche advanced under the
facility. The interest rate on this tranche was set at 6.35% . The final $10
million tranche will be advanced by June 2013 at the latest.

The two previously noted facilities will fund $105 million of
the $190 million required to complete the Temiscaming, Quebec, specialty
cellulose project. The Company intends to fund the remaining amount from
available cash resources and cash flows from operations.

As part of a financial recapitalization that occurred in 2008,
the Company issued $18 million of 6% unsecured notes having a maturity of
September 30, 2012. These notes were subject to an amortization schedule and an
amount of $5 million was repaid in fiscal 2012, compared to $4 million in the
prior year. The notes were fully repaid in fiscal 2012.

The debt of the French operations relates to the Companys
specialty cellulose pulp mill. The decrease in debt relates to scheduled
amortization payments.

Tembec Financial Report 2012 35

---

Managements Discussion and Analysis

The current portion of long-term debt includes $8 million
related to the Kirkland Lake Engineered Wood Products facility. This operation
has been idle for several years and the loan has been subject to a standstill
agreement between the Company and the lender. This is a non-recourse facility
and while it is classified as a current item, the Company considers it highly
unlikely that it will repay this facility in the next 12 months.

Pursuant to the previously noted issuance of the 2018 senior
secured notes, Moodys Investors Service (Moodys) assigned a B3 rating to the
new long-term debt and the same level for the Companys corporate credit rating.
Standard and Poors (S&P) assigned a B- rating to the senior secured notes
as well as the Companys corporate credit rating. Moodys has a stable outlook
with respect to its ratings. S&P has a negative outlook with respect to
its rating.

At the end of September 2012, the Company had total cash of $92
million (including cash held in trust) plus unused operating lines of $48
million. At the end of September 2011, the Company had total cash of $105
million and unused operating lines of $124 million. The Company has set an
objective of maintaining a minimum liquidity of $135 million to $150 million.
The Company defines operating lines to include loans of various durations
which are secured by charges on accounts receivable and/or inventories.
Operating lines are used primarily to fund short-term requirements associated
with both seasonal and cyclical inventory increases which can occur in the
Companys business segments. The Company would not normally draw on the
operating lines to fund capital expenditures or normal average working capital
requirements. The operating lines are established across several entities and
jurisdictions to ensure they meet the needs of the various operating units.

The following table summarizes the unused operating lines at
the end of the last two fiscal years:

|OPERATING
      LINES            |  |      |   |  |      |  
|-------------------------------- |  | ---- | - |  | ---- | -
|(in millions of dollars)         |  |      |   |  |      |  
|                                 |  | 2011 |   |  | 2012 |  
|Borrowing base                   |  | 186  |   |  | 187  |  
|Less: availability
      reserve |  | (22  | ) |  | (23  | )
|Net availability                 |  | 164  |   |  | 164  |  
|Outstanding letters of credit    |  | (34  | ) |  | (48  | )
|Amount drawn                     |  | (6   | ) |  | (68  | )
|Unused amount                    |  | 124  |   |  | 48   |  

In March 2011, the Company entered into a five-year $200
million ABL (asset-based loan) facility expiring in February 2016. The ABL has a
first priority charge over the receivables and inventories of the Companys
Canadian operations. The facility is subject to a permanent availability reserve
of $15 million. This amount is increased to $25 million if the Companys
trailing 12-month adjusted EBITDA falls below $60 million. There is also a
variable reserve, which totalled $8 million at the end of fiscal 2012 as
compared to $7 million at the end of the prior year.

In April 2011, the Ontario Court of Appeal rendered a decision
in the restructuring proceedings involving Indalex Limited under the
Companies Creditors Arrangement Act (CCAA). The Court of Appeal held
that defined benefit pension plan deficiency claims had priority over security
held by debtor-in-possession (DIP) lenders in the context of a sale made under a
CCAA proceeding. This decision is currently being appealed to the Supreme Court
of Canada. The agent for the ABL lenders syndicate recently expressed concern
regarding the solvency deficits of the Companys Ontario defined benefit pension
plans. In light of the uncertainty surrounding the Ontario Court of Appeal
decision, the ABL agent requested that the Company refrain from making any
further draws or utilization of the ABL facility until such priority issue is
dealt with by the Supreme Court of Canada.

36Tembec Financial Report 2012

---

Managements Discussion and Analysis

The Company is currently under discussions with the ABL agent
regarding this request as it considers the risk to be minimal and the position
of the ABL agent to be unwarranted. The ruling of the Supreme Court of Canada is
expected in the near term and the Company anticipates it will resolve the
situation. However, there can be no assurance at this time that the decision of
the Ontario Court of Appeal will not be maintained by the Supreme Court of
Canada, nor that a decision will be rendered in a timely manner. The Companys
liquidity position at September 29, 2012, was $140 million, including $31
million related to the unutilized portion of the ABL. If the unutilized ABL
portion was to remain unavailable for an extended period of time, the Companys
liquidity would fall below its stated objective of $135 million to $150 million.
In order to address this risk, the Company is assessing other liquidity
enhancing alternatives such as limiting capital expenditures and seeking other
sources of financing or funding.

The outstanding letters of credit constitute security for
various operating items, principally the unfunded portion of supplementary
retirement plans, future landfill closure liabilities and performance guarantees
related to electricity generation agreements. The Company does not have any
other significant off-balance sheet arrangements.

The French operations are supported by receivable factoring
agreements. As such, the borrowing base fluctuates periodically, depending on
shipments and cash receipts.

|COMMON SHARES                      |  |      |  |  |      | 
|---------------------------------- |  | ---- |  |  | ---- | 
|(in millions)                      |  |      |  |  |      | 
|                                   |  | 2011 |  |  | 2012 | 
|Shares outstanding
      - opening |  | 100  |  |  | 100  | 
|Shares outstanding
      - ending  |  | 100  |  |  | 100  | 

There were no shares issued in fiscal 2011 and fiscal 2012.

Prior to February 29, 2012, there were 11,093,943 outstanding
warrants (unchanged from the prior year). The warrants were convertible into an
equal amount of common shares. They would have been deemed to be exercised and
automatically converted into common shares of the Company if the 20-day
volume-weighted average trading price of a single common share reached or
exceeded $12.00 or immediately prior to any transaction that would have
constituted a change of control at a purchase price per common share equal to at
least $12.00. The warrants expired unexercised on February 29, 2012.

Pursuant to options granted under the prior Long-Term Incentive
Plan (LTIP), an additional 104,987 shares may be issued. The weighted average
exercise price of the options was $66.13 per share with expiry dates up to 2016.
As at September 29, 2012, all of the options were exercisable.

Tembec Financial Report 2012 37

---

Managements Discussion and Analysis

FINANCIAL INSTRUMENTS AND CONTRACTUAL
OBLIGATIONS

|FINANCIAL ASSETS
      AND LIABILITIES           |  |                    |  |  |            | 
|------------------------------------------------ |  | ------------------ |  |  | ---------- | 
|(in millions of dollars)                         |  |                    |  |  |            | 
|                                                 |  | September 29, 2012 | 
|                                                 |  | Carrying value     |  |  | Fair value | 
|Financial assets                                 |  |                    |  |  |            | 
|Cash and cash equivalents                        |  | 87                 |  |  | 87         | 
|Cash held in trust                               |  | 5                  |  |  | 5          | 
|Accounts receivable                              |  | 200                |  |  | 200        | 
|Loans receivable                                 |  | 12                 |  |  | 12         | 
|Financial liabilities                            |  |                    |  |  |            | 
|Operating bank loans                             |  | 68                 |  |  | 68         | 
|Accounts payable and accrued charges             |  | 230                |  |  | 230        | 
|Interest payable                                 |  | 10                 |  |  | 10         | 
|Long-term
      debt (including current portion) |  | 339                |  |  | 369        | 

The carrying values for cash and cash equivalents, cash held in
trust, accounts receivable, loans receivable, operating bank loans, accounts
payable and accrued charges, and interest payable approximate their fair values
due to the near-term maturity of these instruments.

The fair value of the long-term debt is $30 million higher than
its carrying value. Unamortized financing costs increased the fair value by $13
million. The fair value was increased by a further $17 million as the Companys
US $305 million senior secured notes were trading above par at year-end.

|FINANCIAL RISKS
|---------------

Credit riskCredit risk arises from the possibility
that entities to which the Company sells products may experience financial
difficulty and be unable to fulfill their contractual obligations. The Company
does not have a significant exposure to any individual customer or counterparty.
The Company reviews a new customers credit history before extending credit and
conducts regular reviews of its existing customers credit performance. All
credit limits are subject to evaluation and revision at any time based on
changes in levels of creditworthiness and must be reviewed at least once per
year. Sales orders cannot be processed unless a credit limit has been properly
approved. Bad debt expense has not been significant in the past. The allowance
for doubtful accounts at September 2012 was nil, unchanged from the prior year.
The Company may require payment guarantees, such as letters of credit, or obtain
credit insurance coverage.

Liquidity riskLiquidity risk arises from the
possibility that the Company will not be able to meet its financial obligations
as they fall due. The Company has an objective of maintaining liquidity equal to
12 months of maintenance capital expenditures, interest and principal repayments
and seasonal working capital requirements, which would require approximately
$135 million to $150 million of liquidity. As noted previously, the Company had
total cash of $92 million plus unused operating lines of $48 million as at
September 29, 2012.

The Company currently has sufficient available cash resources
and access to additional funding to meet its commitments for at least the next
12-month period. This is based on certain assumptions regarding general economic
conditions, the availability of borrowings on existing credit facilities to fund operating and capital requirements and the projected operating
results of the various business segments. Access to future borrowings is
dependent on meeting the terms and conditions contained in the Companys various
credit facilities. As well, an adverse perception in the capital markets of the
Companys financial condition or prospects could limit future access to debt and
equity markets.

38Tembec Financial Report 2012

---

Managements Discussion and Analysis

The Company is currently proceeding with an ambitious capital
expenditure program, including a $190 million project at the Temiscaming
specialty cellulose mill, which is increasing liquidity risk. The Company has
recently negotiated two credit agreements that will provide up to $105 million
of project financing for the Temiscaming specialty cellulose project. These
project credit facilities contain terms and conditions specific to the project,
including project completion commitments. If general economic conditions were to
deteriorate significantly, or if the Company was unable to meet the terms of the
new project credit facilities, or if future operating performance is
significantly below expectations, the Company may have to reduce or defer its
capital expenditure plans.

Foreign currency riskThis item is discussed in
detail in a subsequent section of the MD&A, Significant Risks and
Uncertainties.

Interest rate riskInterest rate risk is the risk
that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates. This will have little
impact on the Companys financial results since the majority of the Companys
debts are at fixed interest rates.

Commodity price and operational riskThese items are
discussed in detail in a subsequent section of the MD&A, Significant Risks
and Uncertainties.

CONTRACTUAL
      OBLIGATIONS(in millions of dollars)Total
    
    
    Within 1
    
    
    2 - 3
    
    
    4 - 5
    
    
    After 5year
    
    
    years
    
    
    years
    
    
    yearsLong-term debt
    
    352
    
    
    7
    
    
    13
    
    
    11
    
    
    321Interest on long-term debt
    
    227
    
    
    36
    
    
    73
    
    
    71
    
    
    47Operating leases
    
    12
    
    
    4
    
    
    5
    
    
    3
    
    
    Purchase obligations
    
    657
    
    
    178
    
    
    155
    
    
    108
    
    
    216Pension obligations:Current service costs
    
    120
    
    
    8
    
    
    15
    
    
    15
    
    
    82Past service
      costs
    
    167
    
    
    35
    
    
    56
    
    
    30
    
    
    461,535
    
    
    268
    
    
    317
    
    
    238
    
    
    712


The table above shows the Companys contractual obligations as
at September 29, 2012. The Company has long-term debt with contractual
maturities and applicable interest. The operating lease obligations relate
primarily to property and equipment rentals entered into in the normal course of
business. Purchase obligations relate to ongoing normal commercial commitments
to purchase timber, wood chips, energy, chemicals and other operating inputs.
They also include outstanding obligations relating to capital expenditures.
Pension obligations have two components. The current service costs are limited
to a 15-year period and are based on estimated future employee service for
existing registered defined benefit plans. Past service costs include estimated
solvency and going concern amortization payments.

Tembec Financial Report 2012 39

---

Managements Discussion and Analysis

2011 VS. 2010

|FINANCIAL SUMMARY                                                |  |       |  |  |       |  
|---------------------------------------------------------------- |  | ----- |  |  | ----- | -
|(in millions of dollars, unless otherwise noted)                 |  |       |  |  |       |  
|                                                                 |  | 2010  |  |  | 2011  |  
|Sales                                                            |  | 1,877 |  |  | 1,743 |  
|Adjusted EBITDA                                                  |  | 132   |  |  | 95    |  
|Depreciation and amortization                                    |  | 56    |  |  | 45    |  
|Other items                                                      |  | 13    |  |  | 1     |  
|Operating earnings                                               |  | 63    |  |  | 49    |  
|Net earnings
      (loss)                                        |  | 52    |  |  | (3    | )
|Basic and diluted
      net earnings (loss) in dollars per share |  | 0.52  |  |  | (0.03 | )
|Total assets (at
      year-end)                                 |  | 1,104 |  |  | 1,107 |  
|Total long-term
      debt (at year-end) (1)                     |  | 288   |  |  | 289   |  

The following variance analysis relates to the Companys
reported results under previous Canadian Generally Accepted Accounting
Principles (GAAP). The financial results for fiscal 2011 have not been restated
for IFRS so that they may be compared to fiscal 2010 GAAP financial results.

Sales decreased by $134 million as compared to fiscal 2010.
Currency was unfavourable as the Canadian dollar averaged US $1.013, a 5.5%
increase from US $0.960 in the prior year. Forest Products segment sales
increased by $37 million as a result of higher shipments. Dissolving and
Chemical Pulp segment sales declined by $137 million due to significantly lower
shipments, partially offset by higher prices. High-Yield Pulp segment sales
decreased by $17 million due to lower prices, as higher shipments partially
offset the decline. Paper segment sales decreased by $9 million due to lower
shipments, partially offset by higher prices.

Adjusted EBITDA declined by $37 million over the prior year.
Forest Products segment adjusted EBITDA declined by $36 million due to higher
costs and lower pricing. Dissolving and Chemical Pulp segment adjusted EBITDA
increased by $18 million due to higher prices, partially offset by higher costs.
High-Yield Pulp segment adjusted EBITDA decreased by $51 million due to lower
prices. Paper segment adjusted EBITDA increased by $30 million on a combination
of higher prices and lower costs. Corporate expenses for fiscal 2011 included a
charge of $2 million relating to share-based compensation, unchanged from the
prior year.

40Tembec Financial Report 2012

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Managements Discussion and Analysis

OPERATING EARNINGS
      (LOSS)(in millions of dollars)Adjusted
    
    
    
    
    
    OtherTotal
    
    
    EBITDA
    
    
    Depreciation
    
    
    items2010
    
    
    2011
    
    
    variance
    
    
    variance
    
    
    variance
    
    
    varianceForest Products
    
    (24
    )
    
    (63
    )
    
    (39
    )
    
    (36
    )
    
    3
    
    
    (6
    )Dissolving and Chemical Pulp
    
    105
    
    
    120
    
    
    15
    
    
    18
    
    
    9
    
    
    (12
    )High-Yield Pulp
    
    37
    
    
    (14
    )
    
    (51
    )
    
    (51
    )
    
    
    
    
    Paper
    
    (12
    )
    
    25
    
    
    37
    
    
    30
    
    
    
    
    
    7Corporate
    
    (43
    )
    
    (19
    )
    
    24
    
    
    2
    
    
    (1
    )
    
    2363
    
    
    49
    
    
    (14
    )
    
    (37
    )
    
    11
    
    
    12


The Company generated operating earnings of $49 million in
fiscal 2011 compared to operating earnings of $63 million in the prior year. The
previously noted decline in adjusted EBITDA was partially offset by an $11
million decline in depreciation expense and a favourable $12 million variance in
other items.

The Forest Products segment fiscal 2011 results included a
charge of $3 million relating to the permanent closure of the Taschereau,
Quebec, SPF sawmill. It also included a charge of $1 million related to
severance payments at the idled planer facility in Cranbrook, BC. The prior year
included a $2 million gain related to land sales. The Dissolving and Chemical
Pulp segment fiscal 2011 operating earnings increased due to lower depreciation
expense resulting from the sale of two pulp mills in the prior year. In fiscal
2010, the Company had recorded a gain of $12 million related to the sale of the
aforementioned pulp mills. The Paper segment fiscal 2010 results had absorbed a
charge of $7 million related to the permanent closure of a newsprint mill.

The fiscal 2010 Corporate segment results absorbed a charge of
$12 million relating to the write-down of notes receivable. In fiscal 2011, the
Corporate segment results were enhanced by a gain of $8 million related to the
filing of Tembec USA LLC under Chapter 7 of the Bankruptcy Code of the United
States. The Company reduced its accrued benefit obligation by this amount. It
also recorded a $3 million gain related to the sale of its hydro-electric
generating facilities located in Smooth Rock Falls, Ontario.

|INTEREST, FOREIGN
      EXCHANGE AND OTHER |  |      |  |  |      |  
|------------------------------------------ |  | ---- |  |  | ---- | -
|(in millions of dollars)                   |  |      |  |  |      |  
|                                           |  | 2010 |  |  | 2011 |  
|Interest on debt                           |  | 30   |  |  | 32   |  
|Fees - new working capital facility        |  |     |  |  | 2    |  
|Debt prepayment premium                    |  | 6    |  |  |     |  
|Foreign exchange items                     |  | 14   |  |  | (1   | )
|Bank charges and
      other               |  | 2    |  |  | (1   | )
|                                           |  | 52   |  |  | 32   |  

There were no significant interest variances. The major portion
of fiscal 2010 interest on long-term debt related to a US $300 million 11.25%
term loan. This credit facility was repaid in August 2010. The Company issued US
$255 million of senior secured notes maturing in December 2018. Foreign exchange
items relate primarily to gains or losses on the translation of US $ net
monetary assets. When the Canadian dollar strengthens versus the US dollar, as
was the case during fiscal 2010, losses are generated. If the Canadian dollar
weakens, gains are generated.

Tembec Financial Report 2012 41

---

Managements Discussion and Analysis

During fiscal 2011, the Company recorded a loss of $1 million
on the translation of its US $ denominated debt as the relative value of the
Canadian dollar decreased from US $0.975 to US $0.971. There was no gain or loss
on the translation of euro-denominated debt as the value of the euro versus the
Canadian dollar was relatively unchanged.

During fiscal 2010, the Company recorded a gain of $19 million
on the translation of its US $ denominated debt as the relative value of the
Canadian dollar increased from US $0.916 to US $0.975. The Company recorded a
gain of $8 million on the translation of its euro-denominated debt as the
relative value of the euro versus the Canadian dollar decreased from C $1.602 to
C $1.384.

During fiscal 2011, the Company recorded an income tax expense
of $19 million on earnings before income taxes and non-controlling interest of
$16 million. The income tax expense reflected a $15 million unfavourable
variance versus an anticipated tax expense of $4 million based on the Companys
effective tax rate of 27.8% . Fiscal 2011 absorbed an $11 million unfavourable
change in valuation allowance. Based on past financial performance, future
income tax assets of the Companys Canadian operations have not been recognized
as it has not been determined that the future realization of these assets is
more likely than not to occur.

During fiscal 2010, the Company recorded an income tax recovery
of $15 million on earnings before income taxes and non-controlling interests of
$39 million. This income tax recovery reflected a $27 million favourable
variance versus an anticipated income tax expense of $12 million based on the
Companys effective tax rate of 29.8% . The change in valuation allowance
increased the recovery by $20 million. The most significant item included in the
above was a $19 million favourable adjustment relating to the recognition of
future tax assets of the Companys remaining operations in France as it was
determined that the future realization of these assets was more likely than not
to occur. The non-taxable gain on consolidation of foreign integrated
subsidiaries increased the income tax recovery by $10 million.

The Company generated a net loss of $3 million or $0.03 per
share for the year ended September 24, 2011, compared to net earnings of $52
million or $0.52 per share for the year ended September 25, 2010.

CRITICAL ACCOUNTING ESTIMATES

Property, plant and equipment depreciationThe
Company records its property, plant and equipment, primarily production
buildings and equipment, at cost. Interest costs are capitalized for projects in
excess of $1 million that have a duration in excess of one year. Investment tax
credits or capital assistance received reduce the cost of the related assets.
Property, plant and equipment acquired as a result of a business acquisition are
recorded at their estimated fair value. Depreciation of property, plant and
equipment is provided over their estimated useful lives, generally on a
straight-line basis. The estimated useful lives of property, plant and equipment
are based on judgement and the best currently available information. Changes in
circumstances can result in the actual useful lives differing from our
estimates. Revisions to the estimated useful lives of property, plant and
equipment constitute a change in accounting estimate and are dealt with
prospectively by amending the amount of future depreciation expense. There were
no significant revisions to the estimated useful lives of property, plant and
equipment in fiscal 2012 and fiscal 2011.

Impairment of non-financial assetsThe Company must
review the carrying value of non-financial assets when events or changes in
circumstances indicate that the value may have been impaired and is not
recoverable through future operations and cash flows. If any such indication
exists, then the assets recoverable amount is estimated. The recoverable amount
of a non-financial asset is the greater of its value in use and its fair value
less costs to sell. In assessing value in use, the estimated future cash flows
are discounted to their present value using a pre-tax discount rate that
reflects current market assessments of the time value of money and the risks
specific to the asset. For the purpose of impairment testing, assets that cannot be tested individually are grouped
together into the smallest group of assets that generates cash inflows from
continuing use that are largely independent of the cash inflows of other assets
or groups of assets. An impairment loss is recognized if the carrying amount of
an asset exceeds its estimated recoverable amount. Impairment losses are
recognized in profit or loss. An impairment loss recognized in prior periods is
assessed at each reporting date for any indications that the loss has decreased
or no longer exists. An impairment loss is reversed only to the extent that the
assets carrying amount does not exceed the carrying amount that would have been
determined, net of depreciation or amortization, if no impairment loss had been
recognized. To estimate future cash flows, the Company uses operating and
financial assumptions, primarily those contained in its most recent multi-year
operating plan. There were no impairment charges in fiscal 2011. In fiscal 2012,
the Company recorded $50 million related to the impairment of the Chetwynd, BC,
high-yield pulp mill.

42Tembec Financial Report 2012

---

Managements Discussion and Analysis

Employee future benefitsThe Company contributes to
several defined benefit pension plans, primarily related to employees covered by
collective bargaining agreements. The Company also provides post-retirement
benefits to retirees, primarily healthcare related. For post-retirement
benefits, funding of disbursements is done on a pay as you go basis. The
Company uses independent actuarial firms to quantify the amount of pension and
post-retirement obligations. The Company, based on its own experience and
recommendations from its actuarial firms, evaluates the underlying assumptions
on an annual basis. Changes in estimates or assumptions can have a substantial
impact on the amount of pension and post-retirement benefit expense, the
carrying values on the balance sheet, and, in the case of defined benefit plans,
the amount of plan surplus or deficit. At September 29, 2012, (the measurement
date), the fair value of defined benefit pension plan assets was $667 million,
an amount equal to 73% of the estimated accrued benefit pension obligations of
$910 million, generating a deficit of $243 million. The plan deficit was $239
million at the end of the prior year. The deficit increase of $4 million that
occurred over the 12-month period was due to several offsetting items. The
deficit was decreased by $31 million as the return on plan assets exceeded the
assumed rate of return. The deficit was further reduced by $33 million as
employer contributions of $42 million exceeded the current service cost of $9
million. These favourable items were offset by an actuarial loss of $73 million
that increased the obligations at the measurement date. This item was caused by
a decrease in the applicable discount rate from 4.42% to 3.69% . The discount
rate is tied to rates applicable to high-quality corporate bonds (AA or higher)
in effect at the measurement date. Pension expense in fiscal 2012 was $14
million, as compared to $19 million in the prior year. Based on current
assumptions under IFRS, employer contributions and pension expense in fiscal
2013 are expected to be approximately $44 million and $2 million respectively.
There is no assurance that current assumptions will materialize in future
periods. The defined benefit pension plans may be unable to earn the assumed
rate of return. Market driven changes to discount rates and other variables may
result in changes to anticipated Company contribution amounts.

With regard to other employee future benefit plans, the accrued
benefit obligation at the measurement date was $41 million, a decrease from $44
million in the prior year. Employer contributions were $1 million, compared to
$2 million in the prior year. In fiscal 2012, the Company recognized an expense
of $3 million, compared to a credit of $1 million in the prior year. Based on
current assumptions under IFRS, the amount of employer contributions and the
amount of expense to be recognized in fiscal 2013 are expected to be
approximately $2 million and $3 million respectively.

Deferred income taxesDeferred income tax is provided
for using the asset and liability method and recognizes temporary differences
between the tax values and the financial statement carrying amounts of balance
sheet items as well as certain carry-forward items. The Company only recognizes
a deferred income tax asset to the extent that, in its opinion, the future
realization of the tax asset is probable. This opinion is based on estimates and
assumptions as to the future financial performance of the various taxable legal
entities in the various tax jurisdictions. At September 29, 2012, the Company
had unrecognized deferred tax assets of $563 million, an increase from $520
million at the end of the prior year.

Tembec Financial Report 2012 43

---

Managements Discussion and Analysis

USE OF NON-IFRS FINANCIAL
MEASURES

The following summarizes non-IFRS financial measures utilized
in the MD&A. As there is no generally accepted method of calculating these
financial measures, they may not be comparable to similar measures reported by
other companies.

Adjusted EBITDA refers to earnings before interest, income
taxes, depreciation, amortization and other items. Since the Company excludes
other items such as gains and losses on significant asset disposals,
restructuring charges and custodial costs for permanently idled facilities, it
differs from EBITDA. Adjusted EBITDA does not have any standardized meaning
according to IFRS. The Company defines adjusted EBITDA as sales less cost of
sales and selling, general and administrative expenses, meaning it represents
operating earnings before depreciation, amortization and other items. The
Company considers adjusted EBITDA to be a useful indicator of the financial
performance of the Company, the business segments and the individual business
units. The most comparable financial measure is operating earnings or loss. The
following table is a reconciliation of operating earnings to the Companys
definition of adjusted EBITDA:

|(in millions of
      dollars) |  | 2011 |  |  | 2012 |  
|------------------------------ |  | ---- |  |  | ---- | -
|Operating earnings (loss)      |  | 47   |  |  | (32  | )
|Depreciation and amortization  |  | 48   |  |  | 46   |  
|Other items                    |  | 3    |  |  | 50   |  
|Adjusted EBITDA                |  | 98   |  |  | 64   |  

Free cash flow refers to cash provided by operating activities
before changes in non-cash working capital balances less interest expense and
capital expenditures. Working capital changes are excluded as they are often
seasonal and temporary in nature. The Company considers free cash flow to be a
useful indicator of its ability to generate discretionary cash flow, thereby
improving its overall liquidity position.

Net debt refers to debt less cash, cash equivalents and cash
held in trust.

Total capitalization refers to net debt plus deferred income
taxes, other long-term liabilities and credits, and shareholders equity.

Net debt to total capitalization is used by the Company to
measure its financial leverage.

|(in millions of
      dollars)               |  | 2011 |   |  | 2012 |      
|-------------------------------------------- |  | ---- | - |  | ---- | -----
|Long-term debt                               |  | 271  |   |  | 323  |      
|Net unamortized financing costs              |  | 13   |   |  | 13   |      
|Current portion of long-term debt            |  | 18   |   |  | 16   |      
|Operating bank loans / Bank indebtedness     |  | 6    |   |  | 68   |      
|Less: total cash                             |  | (105 | ) |  | (92  | )    
|Net debt                                     |  | 203  |   |  | 328  |      
|Other long-term liabilities and credits      |  | 303  |   |  | 304  |      
|Shareholders
      equity                   |  | 233  |   |  | 102  |      
|Total
      capitalization                   |  | 739  |   |  | 734  |      
|Net debt to total
      capitalization ratio |  | 27   | % |  | 45   | **%**

44Tembec Financial Report 2012

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Managements Discussion and Analysis

CHANGES IN ACCOUNTING POLICIES AND
ESTIMATES

During the years ended September 24, 2011 and September 29,
2012, there were no new standards that impacted the Companys consolidated
financial statements.

IMPACT OF ACCOUNTING PRONOUNCEMENTS ON FUTURE
REPORTING PERIODS

|IFRS 7 FINANCIAL INSTRUMENTS  DISCLOSURES
|------------------------------------------

In December 2011, the IASB amended the standard IFRS 7,
Financial Instruments  Disclosures, to provide additional information
about of fsetting of financial assets and financial liabilities. IFRS 7 has been
amended to require disclosures that will enable users of financial statements to
evaluate the ef fect or potential ef fect of netting arrangements, including
rights of set-off associated with an entitys recognized financial assets and
recognized financial liabilities, on the entitys balance sheet. An entity
provides information including the gross amounts subject to rights of set-off,
amounts set off in accordance with the offsetting criteria, amounts of financial
instruments subject to master netting arrangements or similar agreements, and
the related net amounts to meet the disclosure objective.

These amendments are effective for annual periods beginning on
or after January 1, 2013. The Company has not yet begun the process of assessing
the impact that the new standard will have on its financial statements and does
not plan to early adopt the new requirement.

|IFRS 9 FINANCIAL INSTRUMENTS
|----------------------------

In November 2009, the IASB issued IFRS 9, Financial
Instruments(IFRS 9), and in October 2010, the IASB published amendments to
IFRS 9 (IFRS 9 R).

IFRS 9 R supersedes IFRS 9 and is effective for annual periods
beginning on or after January 1, 2015, with early adoption permitted. For annual
periods beginning before January 1, 2015, either IFRS 9 or IFRS 9 R may be
applied. This standard provides guidance on the classification and measurement
of financial liabilities and the presentation of gains and losses on financial
liabilities designated at fair value through profit and loss. When an entity
elects to measure a financial liability at fair value, gains or losses due to
changes in the credit risk of the instrument must be recognized in other
comprehensive income. The Company has not yet begun the process of assessing the
impact that the new standard will have on its financial statements and does not
plan to early adopt the new requirement.

|IFRS 13 FAIR VALUE MEASUREMENT
|------------------------------

In May 2011, the IASB issued the standard, IFRS 13, Fair
Value Measurement. The new standard is effective for annual periods
beginning on or after January 1, 2013, with early adoption permitted. IFRS 13 is
a comprehensive standard for fair value measurement and disclosure requirements
for use across all IFRS standards. The new standard clarifies that fair value is
the price that would be received to sell an asset, or paid to transfer a
liability in an orderly transaction between market participants, at the
measurement date. It also establishes disclosures about fair value measurement.
Under existing IFRS, guidance on measuring and disclosing fair value is
dispersed among the specific standards requiring fair value measurements and in
many cases does not reflect a clear measurement basis or consistent disclosures.
This new standard is not expected to have an impact on the amounts recorded in
the financial statements. The Company does not plan to early adopt the
standard.

Tembec Financial Report 2012 45

---

Managements Discussion and Analysis

|IAS 1 PRESENTATION OF FINANCIAL STATEMENTS
|------------------------------------------

IAS 1 has been amended to require entities to separate items
presented in other comprehensive income into two groups, based on whether or not
items may be recycled to net income in the future. Entities that choose to
present other comprehensive income items before tax will be required to show the
amount of tax related to the two groups separately. The amendment is effective
for annual periods beginning on or after July 1, 2012, with earlier application
permitted. IAS 1 is not expected to have an impact on amounts recorded in the
financial statements of the Company. The Company does not plan to early adopt
the standard.

|AMENDMENTS TO IAS 19 EMPLOYEE BENEFITS
|--------------------------------------

In June 2011, the IASB published an amended version of IAS 19,
Employee Benefits. Adoption of the amendment is required for annual
periods beginning on or after January 1, 2013, with early adoption permitted.
This standard was amended to:

|a) | eliminate the option to defer the recognition of gains
      and losses arising in defined benefit plans;                                      
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------
|   |                                                                                                                                                
|b) | require gains and losses relating to those plans to be
      presented in other comprehensive income; and                                      
|   |                                                                                                                                                
|c) | improve the disclosure requirements concerning the
      characteristics of defined benefit plans and the risks arising from those
      plans.

The amended standard also incorporates changes to the
accounting for termination benefits. The amendment is generally applied
retrospectively with certain exceptions. The Company is still in the process of
assessing the full impact that the new standard will have on its financial
statements and does not plan to early adopt the new requirement.

|IAS 32 FINANCIAL INSTRUMENTS  PRESENTATION
|-------------------------------------------

In December 2011, the IASB amended the standard IAS 32,
Financial Instruments  Presentation, to address inconsistencies
identified in applying some of the offsetting criteria. IAS 32 clarifies the
meaning of the offsetting criterion currently has a legally enforceable right
to set off and the principle behind net settlement, including identifying when
some gross settlement systems may be considered equivalent to net
settlement.

These amendments are effective for annual periods beginning on
or after January 1, 2014. This new standard is not expected to have an impact on
the amounts recorded in the financial statements. The Company does not plan to
early adopt the standard.

46Tembec Financial Report 2012

---

Managements Discussion and Analysis

SIGNIFICANT RISKS AND
UNCERTAINTIES

|PRODUCT PRICES
|--------------

The Companys financial performance is dependent on the selling
prices of its products. The markets for most lumber, pulp and paper products are
cyclical and are influenced by a variety of factors. These factors include
periods of excess product supply due to industry capacity additions, periods of
decreased demand due to weak general economic activity, inventory de-stocking by
customers, and fluctuations in currency exchange rates. During periods of low
prices, the Company is subject to reduced revenues and margins, resulting in
substantial declines in profitability and possibly net losses.

Based on 2013 planned sales volumes, the following table
illustrates the approximate annual impact of changes to average Canadian dollar
selling prices on adjusted EBITDA:

|SELLING
      PRICE SENSITIVITY                 |  |                 |  | 
|----------------------------------------------- |  | --------------- |  | 
|                                                |  | Impact on       |  | 
|                                                |  | adjusted EBITDA |  | 
|                                                |  | ($ millions)    |  | 
|                                                |  |                 |  | 
|Pulp - $25/tonne                                |  | 26              |  | 
|Coated bleached board and newsprint - $25/tonne |  | 10              |  | 
|SPF lumber -
      $10/mbf                      |  | 8               |  | 

The Companys strategy is to mitigate price volatility by
maintaining operations in three core sectors, namely wood products, pulp and
paper; maintaining low cost, high-quality flexible production facilities;
establishing and developing long-term relationships with its customers;
developing specialty niche products where possible. In addition, the Company may
periodically purchase lumber, pulp and newsprint derivative commodity contracts
to mitigate the impact of price volatility. At September 29, 2012, the Company
did not hold any significant product derivative commodity contracts, unchanged
from the prior year end.

|FOREIGN EXCHANGE
|----------------

The Companys revenues for most of its products are affected by
fluctuations in the relative exchange rates of the Canadian dollar, the US
dollar and the euro. The Company generates approximately $1.1 billion of US $
denominated sales annually from its Canadian operations. As a result, any
decrease in the value of the US dollar and the euro relative to the Canadian
dollar reduces the amount of revenues realized on sales in local currency. In
addition, since business units purchase the majority of their production inputs
in local currency, fluctuations in foreign exchange can significantly affect the
units relative cost position when compared to competing manufacturing sites in
other currency jurisdictions.

Based on 2013 planned sales volumes and prices, the following
table illustrates the impact of a 1% change in the value of the US dollar versus
the Canadian dollar and the euro. For illustrative purposes, an increase of 1%
in the value of the US dollar is assumed. A decrease would have the opposite
effects of those shown below:

|FOREIGN EXCHANGE
      SENSITIVITY                 |  |    | 
|-------------------------------------------------- |  | -- | 
|(in millions of dollars)                           |  |    | 
|Sales increase                                     |  | 11 | 
|Cost of sales
      increase                       |  | 3  | 
|Adjusted EBITDA increase                           |  | 8  | 
|Interest expense
      increase                    |  |   | 
|Cash flow increase                                 |  | 8  | 
|Loss on
      translation of US $ denominated debt |  | 3  | 
|Pre-tax earnings
      increase                    |  | 5  | 

Tembec Financial Report 2012 47

---

Managements Discussion and Analysis

Direct US $ purchases of raw materials, supplies and services
provide a partial offset to the impact on sales. The above does not include the
potential indirect impact of currency on the cost of items purchased in Canadian
dollars.

To potentially further reduce the impact of fluctuations in the
value of the US dollar, the Company has a policy, which permits hedging up to
50% of its anticipated US $ receipts for up to 36 months in duration. At
September 29, 2012 and September 24, 2011, the Company did not hold any foreign
exchange contracts.

|OPERATIONAL RISKS
|-----------------

The manufacturing activities conducted by the Companys
operations are subject to a number of risks including availability and price of
fibre, competitive prices for purchased energy, a productive and reliable
workforce, compliance with environmental regulations, maintenance and
replacement/upgrade of process equipment to manuf ac ture competitive qualit y
produc t s and the requirement to operate the manufacturing facilities at high
rates of utilization and efficiency to maintain a competitive cost
structure.

Fibre represents the Companys major raw material in the
production of wood products, pulp and paper. In Canada, virgin fibre or timber
is sourced primarily by agreements with provincial governments. The agreements
are granted for various terms from five to 25 years and are generally subject to
regular renewals every five years. The agreements incorporate commitments with
respect to sustainable forest management, silvicultural work, forest and soil
renewal, as well as cooperation with other forest users. In addition, the
Company has undertaken, on a voluntary basis, to have its timber harvesting
certified by the Forest Stewardship Council® (FSC®). The Company expects the
agreements to be extended as they come up for renewal. Aboriginal groups have
claimed substantial portions of land in various provinces over which they claim
aboriginal title or in which they have a traditional intere s t and for which
they are seeking compensation from various levels of government. The Company has
taken a proactive approach to enhance the economic participation of First
Nations in its operations wherever feasible. The Companys operation in France
sources its fibre requirements from various private sources, primarily through
long-term supply arrangements.

Energy is an important component of mill costs, especially for
high-yield pulp mills and newsprint mills. In 2012, purchased energy costs
totalled approximately $125 million, 63% of which was electricity. Electrical
purchases are made primarily from large public utilities, at rates set by
regulating bodies. In certain jurisdictions, electricity is deregulated, which
can lead to greater price volatility. To mitigate the effect of price
fluctuations on its financial performance, the Company employs several tactics,
including the securing of longer term supply agreements, the purchase of
derivative commodity contracts and operational curtailments in periods of high
prices (load shedding). At September 2012 and September 2011, the Company did
not hold any derivative commodity contracts relating to purchased electricity.
Fossil fuels, primarily natural gas, are purchased at market rates. The Company
periodically purchases derivative commodity contracts to reduce its exposure. At
September 29, 2012 and September 24, 2011, the Company did not hold any natural
gas derivative commodity contracts.

Nearly all the Companys manufacturing units have a unionized
workforce. Over the past 30 years, the Company has successfully negotiated new
collective agreements in nearly all instances, with relatively few work
stoppages. At many of the Companys facilities, as well as those of the North
American industry as a whole, we have seen reductions in employment levels
resulting from technological and process improvements resulting in a workforce
with more years of service. This increases the relative costs of pensions and benefits. At September 201 2, the Company had approximately
2,500 employees covered by collective bargaining agreements. At September 29,
2012, there were seven agreements covering 431 employees that had expired.
During fiscal 2013, no collective agreements will expire. The remaining
contracts expire at various dates up to January 2019. The Company anticipates it
will reach satisfactory agreements on contracts currently under active
negotiations and those expiring in the future.

48Tembec Financial Report 2012

---

Managements Discussion and Analysis

The Companys operations are subject to industry-specific
environmental regulations relating to air emissions, wastewater (effluent)
discharges, solid waste, landfill operations, forestry practices, and site
remediation. The Company has made significant progress in reducing the
environmental impact of its operations over the last 15 years. This has occurred
as a result of changes in manufacturing processes, the installation of
specialized equipment to treat/eliminate the materials being discharged and the
implementation of standardized practices such as ISO 14001.

The production of lumber, pulp and paper is capital intensive.
The Company estimates that it must invest approximately $35 million to $40
million per year on capital expenditures to avoid degradation of its current
operations. As the majority of the funding is provided by cash flow from
operations, there can be no assurance that the funds will be available to meet
all of the Companys capital expenditure needs. Failure to reinvest can lead to
older equipment that is less productive, less reliable and more costly to
maintain and operate. The risk of technological obsolescence also increases.
Capital expenditure projects can be large in scale, requiring the Company to
maintain and/or acquire expertise in the design, planning and execution of major
capital projects. There are inherent risks in the capital expenditure process,
including the potential for project cost overruns, new equipment that does not
perform to anticipated or projected levels, a lengthy start-up period and
disruptions to normal operations. Due to relatively low operating cash flow
generation over the last several years, the Company has limited capital
expenditures. This has led to a backlog of capital expenditure projects in
many operating facilities. The Company is currently proceeding with a $190
million modernization project at the Temiscaming specialty cellulose mill. This
is the first of two phases that will total in excess of $300 million to be spent
over the next four to five years. As a significant portion of the funding for
the modernization project is to be provided by operating cash flows, there is a
risk that the Company may experience delays or cost overruns in executing this
project or other required capital expenditures.

Because of the relatively high fixed cost component of certain
manufacturing processes, especially in pulp and paper, the operations are 24/7
with target efficiency in the 80-85% range. Failure to operate at these levels
jeopardizes the continued existence of a mill. Producers are forced to operate
the facilities at full rate even when demand is not sufficient to absorb all
of the output. This can lead to oversupply and lower prices, further increasing
the inherent cyclicality of the industry.

Tembec Financial Report 2012 49

---

Managements Discussion and Analysis

|TRADE RESTRICTIONS / LUMBER EXPORT TAXES
|----------------------------------------

The Companys manufacturing operations are located primarily in
Canada. However, sales into the Canadian market represented only 18% of
consolidated sales in 2012. As such, the Companys financial results are highly
dependent on its ability to sell its products into the export markets. Tariffs
and trade barriers that reduce or prohibit the movement of our products across
international borders constitute an ongoing risk. The agreement between Canada
and the United States over softwood lumber is a case in point. On October 12,
2006, Canada and the United States entered into an agreement to govern the
shipment of Canadian softwood lumber into the United States. The outcome was
less than satisfactory. Through a combination of quotas and export taxes, the
agreement will ensure that Canadian producers of softwood lumber will remain at
a competitive disadvantage versus U.S. producers when it comes to accessing the
U.S. market.

|FINANCIAL RISKS / DEBT SERVICE
|------------------------------

Of the total long-term debt of $352 million, 85% relates to the
US $305 million senior secured notes maturing December 2018. The notes do not
require periodic payments for principal amortization. Since the entire principal
amount will become due on the maturity date, it is possible the Company will not
have the required funds/liquidity to repay the principal due. The Company may
require access to the public or private debt markets to issue new debt
instruments to replace or partially replace the notes. There is no assurance
that the Company will be able to refinance the notes on commercially acceptable
terms.

In addition to the above significant risks, the Companys
Annual Information Form (AIF) provides a comprehensive list of risk factors
related to the Companys operations. The AIF can be found on SEDAR.

50Tembec Financial Report 2012

---

Managements Discussion and Analysis

EVALUATION OF DISCLOSURE CONTROLS AND
PROCEDURES

The Companys President and Chief Executive Officer and the
Companys Executive Vice President, Finance and Chief Financial Officer have
designed, or have caused to be designed under their supervision, disclosure
controls and procedures to provide reasonable assurance that material
information relating to the Company has been made known to them and that
information required to be disclosed in the Companys annual filings, interim
filings or other reports filed by it or submitted by it under securities
legislation is recorded, processed, summarized and reported within the time
periods specified by applicable securities legislation. The Companys President
and Chief Executive Officer and the Companys Executive Vice President, Finance
and Chief Financial Officer have evaluated, or caused to be evaluated under
their supervision, the effectiveness of the Companys disclosure controls and
procedures and have determined, based on that evaluation, that such disclosure
controls and procedures are effective at the financial year-end.

INTERNAL CONTROL OVER FINANCIAL
REPORTING

The Companys President and Chief Executive Officer and the
Companys Executive Vice President, Finance and Chief Financial Officer have
designed, or have caused to be designed under their supervision, internal
control over financial reporting as defined under National Instrument 52-109 
Certification of Disclosure in Issuers Annual and Interim Filings, to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with IFRS. The Companys President and Chief Executive Officer and the Companys
Executive Vice President, Finance and Chief Financial Officer have evaluated, or
caused to be evaluated under their supervision, the effectiveness of the
Companys internal control over financial reporting and have determined, based
on the criteria established in Enterprise Risk Management  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
and on this evaluation, that such internal controls over financial reporting are
effective at the financial year-end.

CHANGES IN INTERNAL CONTROLS

During the period covered by this report, there have been no
changes that have materially affected, or are reasonably likely to materially
affect Tembecs internal control over financial reporting.

OVERSIGHT ROLE OF AUDIT COMMITTEE AND BOARD OF
DIRECTORS

The Audit Committee reviews the Companys annual MD&A and
related financial statements with management and the external auditors, and
recommends their approval to the Board. Management and the internal auditor of
the Company also present periodically to the committee a report of their
assessment of the Companys internal controls and procedures for financial
reporting. The external auditor reports any internal control weaknesses
identified during the quarterly reviews and the annual audit to the Audit
Committee.

ADDITIONAL INFORMATION

Additional information relating to Tembec, including the Annual
Information Form, can be found on SEDAR at sedar.com and on the Companys
website at tembec.com.

Tembec Financial Report 2012 51

---

MANAGEMENTRESPONSIBILITY

The consolidated financial statements and all information in
the Financial Report are the responsibility of the Companys management. The
consolidated financial statements have been prepared by management in accordance
with International Financial Reporting Standards (IFRS) as issued by the
International Accounting Standards Board (IASB) and, where necessary, include
amounts which are based on best estimates and judgement. Financial information
presented throughout the Financial Report is consistent with the data presented
in the consolidated financial statements.

A system of internal accounting and administrative controls is
maintained by management in order to provide reasonable assurance that
transactions are appropriately authorized, assets are safeguarded and financial
records are properly maintained to provide accurate and reliable financial
statements.

The Companys external auditors are responsible for auditing
the consolidated financial statements and giving an opinion thereon. The
external auditors also report any significant internal control deficiencies
identified during the course of the annual audit. In addition, the Company
employs internal auditors to evaluate the effectiveness of its systems, policies
and procedures.

The Board of Directors has appointed an Audit Committee,
consisting solely of independent directors, which reviews the consolidated
financial statements and recommends their approval to the Board of Directors.
The Committee meets periodically with the external auditors, the internal
auditors and management to review their respective activities and the discharge
of each of their responsibilities. Both the external and internal auditors have
direct access to the Committee to discuss the scope of their audit work and the
adequacy of internal control systems and financial reporting procedures.

The accompanying consolidated financial statements have been
audited by the external auditors, KPMG LLP, whose report follows.

|                                      |                                                                    
|------------------------------------- | -------------------------------------------------------------------
|JAMES M. LOPEZ                        | MICHEL J. DUMAS                                                    
|President and Chief Executive Officer | Executive Vice President, Finance and Chief
      Financial Officer
|                                      |                                                                    
|November 30, 2012                     |                                                                    

52Tembec Financial Report 2012

---

INDEPENDENTAUDITORS
REPORT

To the Shareholders of Tembec Inc.

We have audited the accompanying consolidated financial
statements of Tembec Inc., which comprise the consolidated balance sheets as at
September 29, 2012, September 24, 2011 and September 26, 2010, the consolidated
statements of net earnings (loss), comprehensive earnings (loss), changes in
shareholders equity and cash flows for the years ended September 29, 2012 and
September 24, 2011, and notes, comprising a summary of significant accounting
policies and other explanatory information.

Managements Responsibility for the Consolidated Financial
StatementsManagement is responsible for the preparation and fair
presentation of these consolidated financial statements in accordance with
International Financial Reporting Standards as issued by the International
Accounting Standards Board, and for such internal control as management
determines is necessary to enable the preparation of consolidated financial
statements that are free from material misstatement, whether due to fraud or
error.

Auditors ResponsibilityOur responsibility is to
express an opinion on these consolidated financial statements based on our
audits. We conducted our audits in accordance with Canadian generally accepted
auditing standards. Those standards require that we comply with ethical
requirements and plan and perform the audit to obtain reasonable assurance about
whether the consolidated financial statements are free from material
misstatement.

An audit involves performing procedures to obtain audit
evidence about the amounts and disclosures in the consolidated financial
statements. The procedures selected depend on our judgment, including the
assessment of the risks of material misstatement of the consolidated financial
statements, whether due to fraud or error. In making those risk assessments, we
consider internal control relevant to the entitys preparation and fair
presentation of the consolidated financial statements in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the entitys internal control. An
audit also includes evaluating the appropriateness of accounting policies used
and the reasonableness of accounting estimates made by management, as well as
evaluating the overall presentation of the consolidated financial
statements.

We believe that the audit evidence we have obtained in our
audits is sufficient and appropriate to provide a basis for our audit
opinion.

OpinionIn our opinion, the consolidated financial
statements present fairly, in all material respects, the consolidated financial
position of Tembec Inc. as at September 29, 2012, September 24, 2011 and
September 26, 2010, and its consolidated financial performance and its
consolidated cash flows for the years ended September 29, 2012 and September 24,
2011 in accordance with International Financial Reporting Standards as issued by
the International Accounting Standards Board.

November 30, 2012 Montreal, Canada

*CPA auditor, CA, public accounting permit no. A110592

Tembec Financial Report 2012 53

---

Consolidated Financial Statements

|CONSOLIDATED
      BALANCE SHEETS                                         |  
|------------------------------------------------------------------------- | -
|As at September 29, 2012, September 24, 2011 and September
      26, 2010 |  
|(in millions of Canadian dollars)                                         |  
|                                                                          |  
|ASSETS                                                                    |  
|Current assets:                                                           |  
|Cash and cash equivalents                                                 | $
|Cash held in trust                                                        |  
|Trade and other receivables (notes 9 and 19)                              |  
|Inventories (notes 5 and 9)                                               |  
|Prepaid
      expenses                                                    |  
|                                                                          |  
|                                                                          |  
|Property, plant and equipment (note 6)                                    |  
|Biological assets (note 7)                                                |  
|Employee future benefits (note 12)                                        |  
|Other long-term receivables (note 8)                                      |  
|Deferred tax
      assets (note 18)                                       |  
|                                                                          | $
|                                                                          |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                      |  
|Current liabilities:                                                      |  
|Operating bank loans (note 9)                                             | $
|Trade, other payables and accrued charges                                 |  
|Interest payable                                                          |  
|Income tax payable                                                        |  
|Provisions (note 11)                                                      |  
|Current
      portion of long-term debt (note 10)                         |  
|                                                                          |  
|                                                                          |  
|Long-term debt (note 10)                                                  |  
|Provisions (note 11)                                                      |  
|Employee future benefits (note 12)                                        |  
|Other long-term
      liabilities                                         |  
|                                                                          |  
|                                                                          |  
|Shareholders equity:                                                     |  
|Share capital (note 13)                                                   |  
|Deficit                                                                   |  
|Accumulated
      other comprehensive earnings (loss)                     |  
|                                                                          |  
|                                                                          | $

Guarantees, commitments and contingencies (note 14) The
accompanying notes are an integral part of these consolidated financial
statements.

On behalf of the Board:

|                      |                              
|--------------------- | -----------------------------
|James V. Continenza   | James M. Lopez               
|Chairman of the Board | President and Chief Executive

54Tembec Financial Report 2012

---

Consolidated Financial Statements

|CONSOLIDATED
      STATEMENTS OF NET EARNINGS (LOSS)                    |  
|----------------------------------------------------------------------- | -
|Years ended September 29, 2012 and September 24, 2011                   |  
|(in millions of Canadian dollars, unless otherwise noted)               |  
|                                                                        |  
|Sales                                                                   | $
|Freight and other deductions                                            |  
|Lumber export taxes                                                     |  
|Cost of sales (excluding depreciation and amortization)
      (note 15) |  
|Selling, general and administrative (note 15)                           |  
|Share-based compensation (note 13)                                      |  
|Depreciation and amortization                                           |  
|Other items (note
      16)                                             |  
|Operating earnings
      (loss)                                         |  
|                                                                        |  
|Interest, foreign exchange and other                                    |  
|Exchange loss
      (gain) on long-term debt                            |  
|Net finance costs
      (note 17)                                       |  
|Earnings (loss) before income taxes                                     |  
|                                                                        |  
|Income tax expense
      (note 18)                                      |  
|Net loss                                                                |  
|                                                                        |  
|                                                                        |  
|Basic and diluted
      net loss in dollars per share (note 13)         | $

|CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE EARNINGS (LOSS)                                |  
|--------------------------------------------------------------------------------------------- | -
|Years ended September 29, 2012 and September 24, 2011                                         |  
|(in millions of Canadian dollars)                                                             |  
|                                                                                              |  
|Net loss                                                                                      | $
|Other comprehensive earnings (loss), net of income taxes:                                     |  
|Defined benefit pension plans (note 12)                                                       |  
|Other benefit plans (note 12)                                                                 |  
|Foreign currency
      translation differences for foreign operations                         |  
|Total
      comprehensive loss                                                                | $
|The accompanying notes are an integral part of
      these consolidated financial statements.

Tembec Financial Report 2012 55

---

Consolidated Financial Statements

|CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS
      EQUITY      |  
|--------------------------------------------------------------------- | -
|Years ended September 29, 2012 and September 24, 2011                 |  
|(in millions of Canadian dollars)                                     |  
|                                                                      |  
|                                                                      |  
|                                                                      |  
|                                                                      |  
|Balance - beginning of year, September 26, 2010                       | $
|                                                                      |  
|Net loss                                                              |  
|Other comprehensive earnings (loss), net of income taxes:             |  
|Defined benefit pension plans (note 12)                               |  
|Other benefit plans (note 12)                                         |  
|Foreign
      currency translation differences for foreign operations |  
|                                                                      |  
|Balance - end of year, September 24, 2011                             |  
|                                                                      |  
|Net loss                                                              |  
|Other comprehensive earnings (loss), net of income taxes:             |  
|Defined benefit pension plans (note 12)                               |  
|Other benefit plans (note 12)                                         |  
|Foreign
      currency translation differences for foreign operations |  
|                                                                      |  
|Balance - end of
      year, September 29, 2012                       | $

The accompanying notes are an integral part of these
consolidated financial statements.

56Tembec Financial Report 2012

---

Consolidated Financial Statements

|CONSOLIDATED
      STATEMENTS OF CASH FLOWS                                                   |  
|--------------------------------------------------------------------------------------------- | -
|Years ended September 29, 2012 and September 24, 2011                                         |  
|(in millions of Canadian dollars)                                                             |  
|                                                                                              |  
|Cash flows from operating activities:                                                         |  
|Net loss                                                                                      | $
|Adjustments for:                                                                              |  
|Depreciation and amortization                                                                 |  
|Net finance costs (note 17)                                                                   |  
|Income tax expense (note 18)                                                                  |  
|Income tax paid                                                                               |  
|Excess cash contributions over employee future
      benefits expense                         |  
|Provisions (note 11)                                                                          |  
|Impairment loss (note 16)                                                                     |  
|Gain on sale of assets and deconsolidation of
      a subsidiary                              |  
|Other                                                                                         |  
|                                                                                              |  
|Changes in non-cash working capital:                                                          |  
|Trade and other receivables                                                                   |  
|Inventories                                                                                   |  
|Prepaid expenses                                                                              |  
|Trade, other
      payables and accrued charges                                               |  
|                                                                                              |  
|                                                                                              |  
|Cash flows from investing activities:                                                         |  
|Additions to property, plant and equipment                                                    |  
|Proceeds from sale of net assets (note 16)                                                    |  
|Other                                                                                         |  
|                                                                                              |  
|Cash flows from financing activities:                                                         |  
|Change in operating bank loans                                                                |  
|Increase in long-term debt                                                                    |  
|Repayments of long-term debt                                                                  |  
|Interest paid                                                                                 |  
|Other                                                                                         |  
|                                                                                              |  
|                                                                                              |  
|Foreign exchange
      loss on cash and cash equivalents held in foreign currencies           |  
|Net increase (decrease) in cash and cash equivalents                                          |  
|Cash and cash
      equivalents, beginning of year                                            |  
|Cash and cash
      equivalents, end of year                                                  | $
|                                                                                              |  
|The accompanying notes are an integral part of
      these consolidated financial statements.

Tembec Financial Report 2012 57

---

Consolidated Financial Statements

|CONSOLIDATED
      BUSINESS SEGMENT INFORMATION      
|-----------------------------------------------------
|Years ended September 29, 2012 and September 24, 2011
|(in millions of
      Canadian dollars)              

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The Company operates an integrated forest products
      business, which is managed in four segments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Intersegment transfers of wood chips, pulp and other
      services are recorded at transfer prices agreed to by the parties, which
      are intended to approximate fair market value. The basis of presentation
      and the accounting policies used in these business segments are the same
      as those described in notes 2 and 3.                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|The financial performance of each segment is measured
      based on earnings before interest, income taxes, depreciation and
      amortization, and other specific or non-recurring items (adjusted EBITDA).
      This measure is included in the internal reports that are reviewed by
      senior management. Segment adjusted EBITDA is used to measure performance
      as management believes that such information is the most relevant in
      evaluating financial results relative to other entities that operate
      within similar businesses. Net finance costs and income tax are not
      allocated to operating segments.

56Tembec Financial Report 2012

---

Consolidated Financial Statements

|CONSOLIDATED BUSINESS SEGMENT INFORMATION(CONTINUED)        |  
|----------------------------------------------------------- | -
|Years ended September 29, 2012 and September 24,
      2011 |  
|(in millions of Canadian dollars)                           |  
|                                                            |  
|                                                            |  
|                                                            |  
|                                                            |  
|Sales:                                                      |  
|External                                                    | $
|Internal                                                    |  
|                                                            |  
|                                                            |  
|Freight and other deductions                                |  
|Lumber export taxes                                         |  
|Cost of sales                                               |  
|Selling, general and administrative                         |  
|Share-based
      compensation                              |  
|                                                            |  
|Earnings (loss) before the following (adjusted EBITDA):     |  
|Depreciation and amortization                               |  
|Other
      items (note 16)                                 |  
|Operating earnings
      (loss)                             | $
|                                                            |  
|Additions to
      property, plant and equipment            | $
|Total assets                                                | $

|                                                        |   |          |   |   |               |  |   |       |   |   |       |  |   |           |   |   |               |   |   | 2011         | 
|------------------------------------------------------- | - | -------- | - | - | ------------- |  | - | ----- | - | - | ----- |  | - | --------- | - | - | ------------- | - | - | ------------ | 
|                                                        |   |          |   |   | Specialty     |  |   | High- |   |   |       |  |   |           |   |   |               |   |   |              | 
|                                                        |   | Forest   |   |   | Cellulose and |  |   | Yield |   |   |       |  |   |           |   |   | Consolidation |   |   |              | 
|                                                        |   | Products |   |   | Chemical Pulp |  |   | Pulp  |   |   | Paper |  |   | Corporate |   |   | adjustments   |   |   | Consolidated | 
|Sales:                                                  |   |          |   |   |               |  |   |       |   |   |       |  |   |           |   |   |               |   |   |              | 
|External                                                | $ | 375      |   | $ | 681           |  | $ | 348   |   | $ | 339   |  | $ |          |   | $ |              |   | $ | 1,743        | 
|Internal                                                |   | 96       |   |   | 12            |  |   | 30    |   |   |      |  |   | 7         |   |   | (145          | ) |   |             | 
|                                                        |   | 471      |   |   | 693           |  |   | 378   |   |   | 339   |  |   | 7         |   |   | (145          | ) |   | 1,743        | 
|                                                        |   |          |   |   |               |  |   |       |   |   |       |  |   |           |   |   |               |   |   |              | 
|Freight and other deductions                            |   | 47       |   |   | 66            |  |   | 79    |   |   | 45    |  |   |          |   |   |              |   |   | 237          | 
|Lumber export taxes                                     |   | 13       |   |   |              |  |   |      |   |   |      |  |   |          |   |   |              |   |   | 13           | 
|Cost of sales                                           |   | 441      |   |   | 464           |  |   | 299   |   |   | 255   |  |   | 7         |   |   | (145          | ) |   | 1,321        | 
|Selling, general and administrative                     |   | 17       |   |   | 23            |  |   | 3     |   |   | 10    |  |   | 19        |   |   |              |   |   | 72           | 
|Share-based
      compensation                          |   |         |   |   |              |  |   |      |   |   |      |  |   | 2         |   |   |              |   |   | 2            | 
|                                                        |   |          |   |   |               |  |   |       |   |   |       |  |   |           |   |   |               |   |   |              | 
|Earnings (loss) before the following (adjusted EBITDA): |   | (47      | ) |   | 140           |  |   | (3    | ) |   | 29    |  |   | (21       | ) |   |              |   |   | 98           | 
|Depreciation and amortization                           |   | 14       |   |   | 19            |  |   | 11    |   |   | 3     |  |   | 1         |   |   |              |   |   | 48           | 
|Other
      items (note 16)                             |   | 3        |   |   |              |  |   |      |   |   |      |  |   |          |   |   |              |   |   | 3            | 
|Operating earnings
      (loss)                         | $ | (64      | ) | $ | 121           |  | $ | (14   | ) | $ | 26    |  | $ | (22       | ) | $ |              |   | $ | 47           | 
|                                                        |   |          |   |   |               |  |   |       |   |   |       |  |   |           |   |   |               |   |   |              | 
|Additions to
      property, plant and equipment        | $ | 10       |   | $ | 38            |  | $ | 5     |   | $ | 5     |  | $ |          |   | $ |              |   | $ | 58           | 
|Total assets                                            | $ | 267      |   | $ | 491           |  | $ | 173   |   | $ | 122   |  | $ | 40        |   | $ |              |   | $ | 1,093        | 

The accompanying notes are an integral part of these
consolidated financial statements.

Tembec Financial Report 2012 59

---

Consolidated Financial Statements

CONSOLIDATED GEOGRAPHIC AREA INFORMATIONYears ended September 29, 2012 and September 24,
      2011(in millions of Canadian dollars)2012SpecialtyForest
    
    
    Cellulose and
    
    
    High-YieldProducts
    
    
    Chemical Pulp
    
    
    Pulp
    
    
    Paper
    
    
    ConsolidatedSales (by final destination):Canada
    $
    194
    
    $
    49
    
    $
    
    
    $
    61
    
    $
    304United States
    
    145
    
    
    202
    
    
    2
    
    
    265
    
    
    614China
    
    6
    
    
    112
    
    
    116
    
    
    
    
    
    234European Union
    
    
    
    
    209
    
    
    57
    
    
    10
    
    
    276Other
    
    3
    
    
    78
    
    
    147
    
    
    10
    
    
    238$
    348
    
    $
    650
    
    $
    322
    
    $
    346
    
    $
    1,666


2011SpecialtyForest
    
    
    Cellulose and
    
    
    High-YieldProducts
    
    
    Chemical Pulp
    
    
    Pulp
    
    
    Paper
    
    
    ConsolidatedSales (by final destination):Canada
    $
    208
    
    $
    52
    
    $
    2
    
    $
    59
    
    $
    321United States
    
    146
    
    
    191
    
    
    2
    
    
    252
    
    
    591China
    
    15
    
    
    158
    
    
    170
    
    
    
    
    
    343European Union
    
    1
    
    
    195
    
    
    55
    
    
    11
    
    
    262Other
    
    5
    
    
    85
    
    
    119
    
    
    17
    
    
    226$
    375
    
    $
    681
    
    $
    348
    
    $
    339
    
    $
    1,743


|                               |   | 2012 |  |   | 2011 |  |   | 2010 | 
|------------------------------ | - | ---- |  | - | ---- |  | - | ---- | 
|Property, plant and equipment: |   |      |  |   |      |  |   |      | 
|Canada                         | $ | 393  |  | $ | 407  |  | $ | 424  | 
|France                         |   | 91   |  |   | 83   |  |   | 70   | 
|Other                          |   | 1    |  |   | 1    |  |   | 2    | 
|                               | $ | 485  |  | $ | 491  |  | $ | 496  | 

60Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements (in millions of
Canadian dollars, unless otherwise noted)

|1. REPORTING ENTITY AND NATURE OF OPERATIONS
|--------------------------------------------

Tembec Inc. (the Corporation) and its subsidiaries
(collectively Tembec or the Company) operate an integrated forest products
business.

The Corporation is incorporated and domiciled in Canada and
listed on the Toronto Stock Exchange under the symbol TMB. The address of the
Companys registered office is 800 René-Lévesque Blvd. West, Suite 1050,
Montreal, Quebec, Canada, H3B 1X9.

|2. BASIS OF PRESENTATION
|------------------------

STATEMENT OF COMPLIANCE

Effective September 26, 2010, the Company fully adopted
International Financial Reporting Standards (IFRS) as issued by the
International Accounting Standards Board (IASB) as the basis for preparation of
financial information and accounting.

These audited consolidated financial statements and the notes
thereto represent the first annual consolidated financial statements of the
Company that have been prepared in accordance with IFRS as issued by the IASB.
The Company has also complied with the requirements of IFRS 1, First-time
Adoption of IFRS. Subject to certain transition elections and exceptions
disclosed in note 22, the Company consistently applied the accounting policies
used in its opening IFRS consolidated balance sheet as at September 26, 2010,
throughout all periods presented as if these policies had always been in
effect.

An explanation of how the transition to IFRS has affected the
reported financial position, financial performance and cash flows of the Company
is provided in note 22.

These audited consolidated financial statements were authorized
for issue by the Board of Directors on November 15, 2012.

BASIS OF MEASUREMENT

The audited consolidated financial statements have been
prepared on the historical cost basis, except for the following items in the
consolidated balance sheet:

| | the defined benefit liability is recognized as the net
      total of the present value of the defined benefit obligation less the fair
      value of the plan assets;
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | biological assets are measured at fair value less costs
      to sell;                                                                                                 
| | asset retirement obligations and reforestation
      obligations are measured at the discounted value of expected future cash
      flows;                             
| | liabilities for cash-settled share-based payment
      arrangements are measured at fair value;                                                                        
| | warrants classified as liabilities are measured at fair
      value; and                                                                                               
| | embedded and freestanding derivative financial
      instruments are measured at fair value.                                                                           

Tembec Financial Report 2012 61

---

Notes to Consolidated Financial Statements

|2. BASIS OF PRESENTATION(CONTINUED)
|-----------------------------------

FUNCTIONAL AND PRESENTATION CURRENCY

These audited consolidated financial statements are presented
in Canadian dollars, which is the Companys functional currency. Management
believes that the Canadian dollar best reflects the currency of the primary
economic environment in which Tembec operates. All financial information
presented has been rounded to the nearest million, unless otherwise noted.

USE OF ESTIMATES AND JUDGEMENTS

The preparation of financial statements in conformity with IFRS
requires management to make judgements, estimates and assumptions that affect
the application of accounting policies and 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 of revenues and expenses
during the period. Actual results could differ from those estimates.

Estimates and underlying assumptions are reviewed on an ongoing
basis. Revisions to accounting estimates are recognized in the period in which
the estimates are revised and in any future periods affected.

Significant areas requiring the use of management estimates in
applying accounting policies that have the most significant effect on the
amounts recognized in the consolidated financial statements and that may result
in material adjustments to the carrying amounts within the next fiscal year
include the determination of the net realizable value of inventories,
provisions, recoverability of deferred tax assets, the measurement of defined
benefit obligations and the valuation of pension plan assets.

Other areas requiring the use of management estimates include
the determination of the value of biological assets, financial instruments,
guarantees, commitments, and contingencies. It also includes collectability of
accounts receivable, estimating the useful life and residual value of property,
plant and equipment, as well as assessing the recoverability of property, plant
and equipment, and long-term receivables.

|3. SIGNIFICANT ACCOUNTING POLICIES
|----------------------------------

The accounting policies set out below have been applied
consistently in the audited consolidated financial statements and in preparing
the opening IFRS balance sheet at September 26, 2010 (the Transition Date),
for the purposes of the transition to IFRS.

BASIS OF CONSOLIDATION

These audited consolidated financial statements include the
accounts of the Company. Investments over which the Corporation has effective
control are fully consolidated. The financial statements of subsidiaries are
included in the consolidated financial statements from the date that control
commences until the date that control ceases. The accounting policies of
subsidiaries have been changed when necessary to align them with the policies
adopted by the Company.

62Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

FOREIGN CURRENCY

Foreign currency transactionsTransactions in foreign
currencies are translated to the respective functional currencies of each
operation using exchange rates at the dates of the transactions. Monetary assets
and liabilities denominated in foreign currencies at the reporting date are
translated to the functional currency using the exchange rate at that date.
Non-monetary assets and liabilities denominated in foreign currencies that are
measured at fair value are translated to the functional currency using the
exchange rate at the date that the fair value was determined. Non-monetary items
that are measured in terms of historical cost in a foreign currency are
translated using the exchange rate at the date of the transaction. Foreign
currency differences arising on translation are recognized in profit or
loss.

Foreign operationsThe assets and liabilities of
foreign operations with functional currencies other than the Canadian dollar are
translated to Canadian dollars using the exchange rates at the reporting date.
The income and expenses of foreign operations are translated to Canadian dollars
using the average exchange rates during the reporting period.

Foreign currency differences are recognized in other
comprehensive income. When a foreign operation is disposed of, in part or in
full, the relevant amount in the foreign currency translation reserve is
transferred to the statement of earnings (loss) as part of the gain or loss on
disposal.

FINANCIAL INSTRUMENTS

Non-derivative financial assets and liabilitiesCash
and cash equivalents, trade and other receivables and long-term receivables are
classified as loans and receivables, which is the Companys only non-derivative
financial asset. Operating bank loans, trade and other payables, interest
payable and long-term debt are classified as other liabilities, which is the
Companys only non-derivative financial liability.

The Company initially recognizes all financial assets and
liabilities on the date that they are originated. Subsequent to initial
recognition at fair value, the financial assets are accounted for on an
amortized cost basis using the effective interest rate method. Subsequent to
initial recognition at fair value plus any directly attributable transaction
costs, the financial liabilities are accounted for on an amortized cost basis
using the effective interest rate method.

Transaction costs incurred upon the issuance of debt
instruments or modification of a financial liability are deducted from the
financial liability and are amortized using the effective interest method over
the expected life of the related liability.

Tembec Financial Report 2012 63

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

FINANCIAL INSTRUMENTS(CONTINUED)

Derivative financial instrumentsThe Company may
manage, from time to time, its foreign exchange exposure on anticipated net cash
inflows, principally US dollars and euros, through the use of options and
forward contracts.

The Company may manage, from time to time, its exposure to
commodity price risk associated with sales of lumber, pulp and newsprint through
the use of cash-settled hedge (swap) contracts. The Company does not hold or
issue derivative financial instruments for trading or speculative purposes.

The Company does not currently apply hedge accounting.

The Company has also previously issued liability-classified
derivatives over its own equity, all of which expired on February 29, 2012.

All derivatives are recognized initially at fair value.
Attributable transaction costs are recognized in profit or loss as incurred.
Subsequent to initial recognition, derivatives are measured at fair value and
changes therein are accounted for in net finance costs.

Common sharesCommon shares are classified as equity.
Incremental costs directly attributable to the issue of common shares are
recognized as a deduction from equity, net of any tax effects.

INVENTORIES

Finished goods, work-in-process, wood chips, logs, and other
raw materials are valued at the lower of cost, determined on an average cost
basis, and net realizable value. In the case of manufactured inventories and
work-in-process, cost includes expenditure incurred in acquiring raw materials,
production or conversion costs and other costs incurred in bringing the
inventory to their existing location and conditions as well as an appropriate
share of production overheads based on normal operating capacity. For all raw
materials to be used in the production of finished goods, net realizable value
is determined on an as-converted-to-finished-goods basis. Operating, maintenance
and spare parts inventories are valued at lower of average cost and net
realizable value.

PROPERTY, PLANT AND EQUIPMENT

Recognition and measurementProperty, plant and
equipment are recorded at cost, after deducting investment tax credits and
government assistance, less accumulated depreciation and accumulated impairment
losses.

Cost includes expenditures that are directly attributable to
acquiring and bringing the assets to a working condition for their intended use.
The Company capitalizes borrowing costs, which are directly attributable to the
acquisition, construction or production of qualifying assets, unless development
activities on these qualifying assets are suspended, in which case borrowing
costs are expensed.

64Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
|----------------------------------------------

PROPERTY, PLANT AND EQUIPMENT(CONTINUED)

Subsequent costsThe cost of replacing a component of
an item of property, plant and equipment is recognized in the carrying amount of
the item if it is probable that the future economic benefits embodied within the
part will flow to the Company, and its cost can be measured reliably. The
carrying amount of the replaced component is derecognized. The costs of the
day-to-day servicing of property, plant and equipment are recognized in profit
or loss as incurred.

DepreciationDepreciation is calculated over the
depreciable amount, which is the cost of an asset less its residual value.
Depreciation is recognized in profit or loss on a straight-line basis over the
estimated useful lives of each part of an item of property, plant and
equipment.

The estimated useful lives of the current and comparative
periods are as follows:

|Assets                    | Period       
|------------------------- | -------------
|Buildings                 | 20  30 years
|Production equipment:     |              
|Pulp and paper            | 20  30 years
|Sawmill                   | 10  15 years
|Forest access
      roads | 3  20 years 

Assets under construction are recognized at cost and are not
depreciated as the assets are not available for use. Repairs and maintenance as
well as planned shutdown maintenance are charged to expense as incurred.

Depreciation methods, useful lives and residual values are
reviewed at each financial year-end and adjusted if appropriate.

BIOLOGICAL ASSETS

Standing timber on privately held forest land that is managed
for timber production is characterized as a biological asset. Accordingly, on
each balance sheet date, the biological asset is valued at its fair value less
costs to sell with any change therein, as a result of growth, harvest and change
in valuation assumptions recognized in net income (loss) for the period.
Standing timber is transferred to inventory at its fair value less costs to sell
at the date the logs are removed from the forest. Land under standing timber is
measured at cost and included in property, plant and equipment.

LEASED ASSETS

Leases in terms of which the Company assumes substantially all
the risks and rewards of ownership are classified as finance leases. Upon
initial recognition, the leased asset is measured at an amount equal to the
lower of its fair value and the present value of the minimum lease payments.
Subsequent to initial recognition, the asset is accounted for in accordance with
the accounting policy applicable to that asset.

Other leases are operating leases and the leased assets are not
recognized in the Companys balance sheet.

Tembec Financial Report 2012 65

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

IMPAIRMENT

Financial assets (including receivables)A financial
asset not carried at fair value through profit or loss is assessed at each
reporting date to determine whether there is objective evidence that it is
impaired. A financial asset is impaired if objective evidence indicates that a
loss event has occurred after the initial recognition of the asset, and that the
loss event had a negative effect on the estimated future cash flows of that
asset that can be estimated reliably.

Impairment losses recognized in prior periods are assessed at
each balance sheet date for any indication that the loss has decreased or no
longer exists. For financial assets measured at amortized cost, the reversal is
recognized in profit or loss.

Non-financial assetsThe carrying amounts of the
Companys non-financial assets, other than biological assets, inventories and
deferred tax assets, are reviewed at each reporting date to determine whether
there is any indication of impairment. If any such indication exists, then the
assets recoverable amount is estimated.

The recoverable amount of an asset or cash-generating unit
(CGU) is the greater of its value in use and its fair value less costs to sell.
In assessing value in use, the estimated future cash flows are discounted to
their present value using a pre-tax discount rate that reflects current market
assessments of the time value of money and the risks specific to the asset or
the CGU. For the purpose of impairment testing, assets that cannot be tested
individually are grouped together into the smallest group of assets that
generates cash inflows from continuing use that are largely independent of the
cash inflows of other assets or groups of assets.

An impairment loss is recognized if the carrying amount of an
asset or CGU exceeds its estimated recoverable amount. Impairment losses are
recognized in profit or loss. Impairment losses recognized in respect of CGUs
reduce the carrying amounts of the assets in the unit that is subject to the
impairment test on a pro rata basis.

An impairment loss recognized in prior periods is assessed at
each reporting date for any indications that the loss has decreased or no longer
exists. An impairment loss is reversed only to the extent that the assets
carrying amount does not exceed the carrying amount that would have been
determined, net of depreciation or amortization, if no impairment loss had been
recognized.

66Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

PROVISIONS

A provision is recognized if, as a result of a past event, the
Company has a present legal or constructive obligation that can be estimated
reliably, and it is probable that an outflow of economic benefits will be
required to settle the obligation. Provisions are determined by discounting the
expected future cash flows at a pre-tax rate that reflects current market
assessments of the time value of money and the risks specific to the liability.
The unwinding of the discount is recognized as finance cost.

Environmental costsThe Company is subject to
environmental laws and regulations enacted by federal, provincial, state and
local authorities. Environmental expenditures that relate to current operations
are expensed or capitalized as appropriate. Expenditures that relate to an
existing condition caused by past operations and that are not expected to
contribute to current or future operations are expensed. Liabilities are
recorded when environmental assessments and/or remedial efforts are likely, and
when the costs, based on a specific plan of action in terms of the technology to
be used and the extent of the corrective action required, can be reasonably
estimated.

ReforestationForestry legislation in British
Columbia requires the industry to assume the cost of reforestation on certain
harvest licences. Accordingly, the Company records a liability for the costs of
reforestation in the period in which the timber is harvested. In periods
subsequent to the initial measurement, changes in the liability resulting from
the passage of time and revisions to managements estimates are recognized in
net income as they occur.

Site restorationIn accordance with the Companys
published environmental policy and applicable legal requirements, a provision
for site restoration in respect of contaminated land, and the related expense,
is recognized when the land is contaminated.

RestructuringA provision for restructuring is
recognized when the Company has approved a detailed and formal restructuring
plan, and the restructuring either has commenced or has been announced publicly.
Future operating costs and losses are recognized on the same basis as if they
arose independently of the restructuring.

Onerous contractsA provision for onerous contracts
is recognized when the expected benefits to be derived by the Company from a
contract are lower than the unavoidable cost of meeting its obligations under
the contract. The provision is measured at the present value of the lower of the
expected cost of terminating the contract and the expected net cost of
continuing with the contract. Before a provision is established, the Company
recognizes any impairment loss on the assets associated with that contract.

Tembec Financial Report 2012 67

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

PROVISIONS (CONTINUED)

Contingent liabilityA contingent liability is a
possible obligation that arises from past events and of which the existence will
be confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not within the control of the Company, or a present obligation
that arises from past events (and therefore exists), but is not recognized
because it is not probable that a transfer or use of assets, provision of
services or any other transfer of economic benefits will be required to settle
the obligation, or the amount of the obligation cannot be estimated reliably.

EMPLOYEE FUTURE BENEFITS

Employee future benefits include pension plans and other
benefit plans. Other benefit plans include post-employment life insurance
programs, healthcare and dental care benefits as well as certain other long-term
benefits provided to disabled employees.

Defined contribution pension plansA defined
contribution plan is a post-employment benefit plan under which an entity pays
fixed contributions into a separate entity and will have no legal or
constructive obligation to pay further amounts. Obligations for contributions to
defined contribution pension plans are recognized as an employee benefit expense
in profit or loss in the periods during which services are rendered by
employees.

Defined benefit pension plansA defined benefit plan
is a post-employment benefit plan other than a defined contribution plan. The
Companys net obligation in respect of defined benefit pension plans is
calculated separately for each plan by estimating the amount of future benefit
that employees have earned in return for their service in the current and prior
periods; that benefit is discounted to determine its present value. Any
unrecognized past service costs and the fair value of any plan assets are
deducted. The discount rate is the yield at the reporting date on AA
credit-rated bonds that have maturity dates approximating the terms of the
Companys obligations and that are denominated in the same currency in which the
benefits are expected to be paid. The calculation is performed annually by a
qualified actuary using the projected unit credit method. When the calculation
results in a benefit to the Company, the recognized asset is limited to the
total of any unrecognized past service costs and the present value of economic
benefits available in the form of any future refunds from the plan or reductions
in future contributions to the plan. In order to calculate the present value of
economic benefits, consideration is given to any minimum funding requirements
that apply to any plan in the Company. An economic benefit is available to the
Company if it is realizable during the life of the plan, or on settlement of the
plan liabilities.

When the benefits of a plan are improved, the portion of the
increased benefit relating to past service by employees is recognized in profit
or loss on a straight-line basis over the average period until the benefits
become vested. To the extent that the benefits vest immediately, the expense is
recognized immediately in the statement of earnings (loss).

68Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

EMPLOYEE FUTURE BENEFITS(CONTINUED)

The Company recognizes the current service cost in the employee
future benefit costs. Interest cost and the expected return on plan assets are
recognized in interest, foreign exchange and other. The actuarial gains and
losses arising from defined benefit plans are recognized in other comprehensive
income.

Other benefit plansThe Companys net obligation in
respect of long-term employee benefits, other than pension plans, is the amount
of future benefit that employees have earned in return for their service in the
current and prior periods. That benefit is discounted to determine its present
value, and the fair value of any related assets is deducted. The discount rate
is the yield at the reporting date on AA credit-rated bonds that have maturity
dates approximating the terms of the Companys obligations. The calculation is
performed using the projected unit credit method. Any actuarial gains and losses
are recognized in the statement of comprehensive earnings (loss) in the period
in which they arise.

OTHER EMPLOYEE BENEFITS

Short-term employee benefitsShort-term employee
benefit obligations are measured on an undiscounted basis and are expensed as
the related service is provided.

A liability is recognized for the amount expected to be paid
under the short-term incentive plan if the Company has a present legal or
constructive obligation to pay this amount as a result of past service provided
by the employee, and the obligation can be estimated reliably.

Share-based compensation transactionsThe Company
uses the fair value based approach of accounting for all share options granted
to its employees, whereby a compensation expense is recognized over the vesting
period of the options, with a corresponding increase to contributed surplus. The
Company bases the accruals of compensation cost on the best available estimate
of the number of options that are expected to vest and revises that estimate if
subsequent information indicates that actual forfeitures are likely to differ
from initial estimates. Any consideration paid by plan participants in the
exercise of share options or purchase of shares is credited to share capital.
The contributed surplus component of share-based compensation is transferred to
share capital upon the issuance of common shares.

Deferred Share Units (DSU) are recognized in compensation
expense and accrued liabilities as they are earned. DSUs are remeasured at each
reporting period at fair value, until settlement.

Performance-Conditioned Restricted Share Units (PCRSU) and
Performance-Conditioned Share Units (PCSU) are recognized in compensation
expense and accrued liabilities when it is likely that the performance
conditions attached to the unit will be met. Compensation cost is prorated based
on the underlying service period and the liability is remeasured at each
reporting period at fair value, until settlement.

Tembec Financial Report 2012 69

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

OTHER EMPLOYEE BENEFITS(CONTINUED)

Termination benefitsTermination benefits are
recognized as an expense when the Company is committed demonstrably, without
realistic possibility of withdrawal, to a formal detailed plan to either
terminate employment before the normal retirement date, or to provide
termination benefits as a result of an offer made to encourage voluntary
redundancy. Termination benefits for voluntary redundancies are recognized as an
expense if the Company has made an offer of voluntary redundancy, it is probable
that the offer will be accepted, and the number of acceptances can be estimated
reliably. If benefits are payable more than 12 months after the reporting
period, then they are discounted to their present value.

SALES

Sale of goods is measured at the fair value of the
consideration received or receivable, net of returns, trade discounts and volume
rebates. Revenue is recognized when persuasive evidence exists, usually in the
form of an executed sales agreement, that the significant risks and rewards of
ownership have been transferred to the buyer, recovery of the consideration is
probable, the associated costs and possible return of goods can be estimated
reliably, there is no continuing management involvement with the goods, and the
amount of revenue can be measured reliably. If it is probable that discounts
will be granted and the amount can be measured reliably, then the discount is
recognized as a reduction of revenue as the sales are recognized.

INVESTMENT TAX CREDIT AND GOVERNMENT ASSISTANCE

Amounts received resulting from government assistance programs,
including grants and investment tax credits for scientific research and
experimental development, are reflected as a reduction of the cost of the asset
or expense to which they relate at the time the eligible expenditure is
incurred. Government financial assistance is recorded when there is reasonable
assurance that the Company will comply with relevant conditions. Investment tax
credits are recognized when the Company has made the qualifying expenditures and
there is reasonable assurance that the credits will be realized.

FINANCE COSTS AND FINANCE INCOME

Finance costs comprise interest expense on borrowings,
unwinding of the discount on provisions and the amortization of other related
transactions costs. Borrowing costs that are not directly attributable to the
acquisition, construction or production of a qualifying asset are recognized in
profit or loss using the effective interest method.

Foreign currency gains and losses, gain or loss on embedded and
freestanding derivative instruments, and interest on employee future benefit
obligations and pension plan assets are reported on a net basis as finance cost
or finance income.

INCOME TAXES

Income tax expense comprises current and deferred tax. Current
tax and deferred tax are recognized in profit or loss except to the extent that
it relates to a business combination, or items recognized directly in equity or
in other comprehensive income.

70Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|3. SIGNIFICANT ACCOUNTING POLICIES(CONTINUED)
|---------------------------------------------

INCOME TAXES(CONTINUED)

Current tax is the expected tax payable or receivable on the
taxable income or loss for the year, using tax rates enacted or substantively
enacted at the reporting date, and any adjustment to tax payable in respect of
previous years.

Deferred tax is recognized using the balance sheet method, with
respect to temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for taxation
purposes. Deferred tax is not recognized for the following temporary
differences: the initial recognition of assets or liabilities in a transaction
that is not a business combination and that affects neither accounting nor
taxable profit or loss, and differences relating to investments in subsidiaries
and associates to the extent that it is probable that they will not reverse in
the foreseeable future. Deferred tax is measured at the tax rates that are
expected to be applied to temporary differences when they reverse, based on the
laws that have been enacted or substantively enacted by the reporting date.
Deferred tax assets and liabilities are offset if there is a legally enforceable
right to offset current tax liabilities and assets, and they relate to income
taxes levied by the same tax authority on the same taxable entity, or on
different tax entities, but they intend to settle current tax liabilities and
assets on a net basis or their tax assets and liabilities will be realized
simultaneously.

A deferred tax asset is recognized for unused tax losses, tax
credits and deductible temporary differences, to the extent that it is probable
that future taxable profits will be available against which they can be
utilized. Deferred tax assets are reviewed at each reporting date and are
reduced to the extent that it is no longer probable that the related tax benefit
will be realized.

FREIGHT AND OTHER DEDUCTIONS

Freight associated with shipping products to customer and
handling finished goods as well as discounts on prompt payment are included in
Freight and other deductions in the consolidated statements of net earnings
(loss).

Tembec Financial Report 2012 71

---

Notes to Consolidated Financial Statements

|4. NEW STANDARDS AND INTERPRETATION NOT YET ADOPTED
|---------------------------------------------------

IFRS 7 FINANCIAL INSTRUMENTS  DISCLOSURES

In December 2011, the IASB amended the standard IFRS 7,
Financial Instruments  Disclosures, to provide additional information
about offsetting of financial assets and financial liabilities. IFRS 7 has been
amended to require disclosures that will enable users of financial statements to
evaluate the effect or potential effect of netting arrangements, including
rights of set-off associated with an entitys recognized financial assets and
recognized financial liabilities, on the entitys balance sheet. An entity
provides information including the gross amounts subject to rights of set-off,
amounts set off in accordance with the offsetting criteria, amounts of financial
instruments subject to master netting arrangements or similar agreements, and
the related net amounts to meet the disclosure objective.

These amendments are effective for annual periods beginning on
or after January 1, 2013. The Company has not yet begun the process of assessing
the impact that the new standard will have on its financial statements and does
not plan to early adopt the new requirement.

IFRS 9 FINANCIAL INSTRUMENTS

In November 2009, the IASB issued IFRS 9,Financial
Instruments (IFRS 9), and in October 2010, the IASB published amendments to
IFRS 9 (IFRS 9 R).

IFRS 9 R supersedes IFRS 9 and is effective for annual periods
beginning on or after January 1, 2015, with early adoption permitted. For annual
periods beginning before January 1, 2015, either IFRS 9 or IFRS 9 R may be
applied. This standard provides guidance on the classification and measurement
of financial liabilities and the presentation of gains and losses on financial
liabilities designated at fair value through profit and loss. When an entity
elects to measure a financial liability at fair value, gains or losses due to
changes in the credit risk of the instrument must be recognized in other
comprehensive income. The Company has not yet begun the process of assessing the
impact that the new standard will have on its financial statements and does not
plan to early adopt the new requirement.

IFRS 13 FAIR VALUE MEASUREMENT

In May 2011, the IASB issued the standard, IFRS 13, Fair
Value Measurement. The new standard is effective for annual periods
beginning on or after January 1, 2013, with early adoption permitted. IFRS 13 is
a comprehensive standard for fair value measurement and disclosure requirements
for use across all IFRS standards. The new standard clarifies that fair value is
the price that would be received to sell an asset, or paid to transfer a
liability in an orderly transaction between market participants, at the
measurement date. It also establishes disclosures about fair value measurement.
Under existing IFRS, guidance on measuring and disclosing fair value is
dispersed among the specific standards requiring fair value measurements and in
many cases does not reflect a clear measurement basis or consistent disclosures.
This new standard is not expected to have an impact on the amounts recorded in
the financial statements. The Company does not plan to early adopt the
standard.

72Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|4. NEW STANDARDS AND INTERPRETATION NOT YET ADOPTED(CONTINUED)
|--------------------------------------------------------------

IAS 1 PRESENTATION OF FINANCIAL STATEMENTS

IAS 1 has been amended to require entities to separate items
presented in other comprehensive income into two groups, based on whether or not
items may be recycled to net income in the future. Entities that choose to
present other comprehensive income items before tax will be required to show the
amount of tax related to the two groups separately. The amendment is effective
for annual periods beginning on or after July 1, 2012, with earlier application
permitted. IAS 1 is not expected to have an impact on amounts recorded in the
financial statements of the Company. The Company does not plan to early adopt
the standard.

AMENDMENTS TO IAS 19 EMPLOYEE BENEFITS

In June 2011, the IASB published an amended version of IAS 19,
Employee Benefits. Adoption of the amendment is required for annual
periods beginning on or after January 1, 2013, with early adoption permitted.
This standard was amended to:

| | a) | eliminate the option to defer the recognition of gains
      and losses arising in defined benefit plans;                                      
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                
| | b) | require gains and losses relating to those plans to be
      presented in other comprehensive income; and                                      
| |    |                                                                                                                                                
| | c) | improve the disclosure requirements concerning the
      characteristics of defined benefit plans and the risks arising from those
      plans.

The amended standard also incorporates changes to the
accounting for termination benefits. The amendment is generally applied
retrospectively with certain exceptions. The Company is still in the process of
assessing the full impact that the new standard will have on its financial
statements and does not plan to early adopt the new requirement.

IAS 32 FINANCIAL INSTRUMENTS  PRESENTATION

In December 2011, the IASB amended the standard IAS 32,
Financial Instruments  Presentation, to address inconsistencies
identified in applying some of the offsetting criteria. IAS 32 clarifies the
meaning of the offsetting criterion currently has a legally enforceable right
to set off and the principle behind net settlement, including identifying when
some gross settlement systems may be considered equivalent to net
settlement.

These amendments are effective for annual periods beginning on
or after January 1, 2014. This new standard is not expected to have an impact on
the amounts recorded in the financial statements. The Company does not plan to
early adopt the standard.

Tembec Financial Report 2012 73

---

Notes to Consolidated Financial Statements

|5. INVENTORIES
|--------------

|                                                  |   | 2012 |  |   | 2011 |  |   | 2010 | 
|------------------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Finished goods                                    | $ | 118  |  | $ | 112  |  | $ | 111  | 
|Logs and wood chips                               |   | 61   |  |   | 66   |  |   | 64   | 
|Supplies and
      materials                      |   | 76   |  |   | 83   |  |   | 80   | 
|                                                  | $ | 255  |  | $ | 261  |  | $ | 255  | 
|Inventories
      carried at net realizable value | $ | 48   |  | $ | 32   |  | $ | 30   | 

For the years ended in September 2012 and 2011, cost of sales
consists primarily of inventories recognized as an expense. Inventories at
September 29, 2012, were written down by $6 million (2011 - $4 million; 2010 -
$4 million) to reflect net realizable value being lower than cost. The
write-down and reversal, if any, are included in cost of sales.

The provision for net realizable values relating to logs and
finished goods were as follows:

|                                      |   | 2012 |  |   | 2011 |  |   | 2010 | 
|------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Forest Products                       | $ | 1    |  | $ | 3    |  | $ | 4    | 
|Specialty Cellulose and Chemical Pulp |   | 1    |  |   |     |  |   |     | 
|High-Yield Pulp                       |   | 4    |  |   | 1    |  |   |     | 
|Paper                                 |   |     |  |   |     |  |   |     | 
|                                      | $ | 6    |  | $ | 4    |  | $ | 4    | 

74Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|6. PROPERTY, PLANT AND EQUIPMENT
|--------------------------------

**Production
      equipment**
    
    
    Forest
    
    
    AssetsPulp and
    
    
    
    
    
    access
    
    
    underLand
    
    
    Buildings
    
    
    Paper
    
    
    Sawmill
    
    
    roads
    
    
    construction
    
    
    TotalCostBalance, September 26, 2010
    $
    12
    
    $
    77
    
    $
    440
    
    $
    90
    
    $
    11
    
    $
    11
    
    $
    641Additions
    
    
    
    
    2
    
    
    21
    
    
    3
    
    
    6
    
    
    26
    
    
    58Disposals
    
    
    
    
    
    
    
    (21
    )
    
    (1
    )
    
    
    
    
    
    
    
    (22
    )Balance, September 24, 2011
    
    12
    
    
    79
    
    
    440
    
    
    92
    
    
    17
    
    
    37
    
    
    677Additions
    
    
    
    
    1
    
    
    47
    
    
    7
    
    
    3
    
    
    62
    
    
    120Interest capitalized on assets under construction
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2
    
    
    2Disposals
    
    (1
    )
    
    (4
    )
    
    (4
    )
    
    (30
    )
    
    (12
    )
    
    (4
    )
    
    (55
    )Effect of
      movements in exchange rates
    
    
    
    
    (1
    )
    
    (8
    )
    
    
    
    
    
    
    
    (1
    )
    
    (10
    )Balance, September
      29, 2012
    $
    11
    
    $
    75
    
    $
    475
    
    $
    69
    
    $
    8
    
    $
    96
    
    $
    734DepreciationBalance, September 26, 2010
    $
    
    
    $
    14
    
    $
    81
    
    $
    50
    
    $
    
    
    $
    
    
    $
    145Depreciation
    
    
    
    
    5
    
    
    31
    
    
    11
    
    
    1
    
    
    
    
    
    48Disposals
    
    
    
    
    
    
    
    (7
    )
    
    
    
    
    
    
    
    
    
    
    (7
    )Balance, September 24, 2011
    
    
    
    
    19
    
    
    105
    
    
    61
    
    
    1
    
    
    
    
    
    186Depreciation
    
    
    
    
    6
    
    
    31
    
    
    8
    
    
    1
    
    
    
    
    
    46Impairment loss
    
    
    
    
    
    
    
    43
    
    
    
    
    
    1
    
    
    
    
    
    44Disposals
    
    
    
    
    (3
    )
    
    (2
    )
    
    (19
    )
    
    (1
    )
    
    
    
    
    (25
    )Effect of
      movements in exchange rate
    
    
    
    
    
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (2
    )Balance, September
      29, 2012
    $
    
    
    $
    22
    
    $
    175
    
    $
    50
    
    $
    2
    
    $
    
    
    $
    249Carrying amountsAt September 26,
      2010
    $
    12
    
    $
    63
    
    $
    359
    
    $
    40
    
    $
    11
    
    $
    11
    
    $
    496At September 24,
      2011
    $
    12
    
    $
    60
    
    $
    335
    
    $
    31
    
    $
    16
    
    $
    37
    
    $
    491At September 29,
      2012
    $
    11
    
    $
    53
    
    $
    300
    
    $
    19
    
    $
    6
    
    $
    96
    
    $
    485


During fiscal 2012, the Company recorded an impairment loss of
$44 million related to property, plant and equipment of the Chetwynd, British
Columbia, high-yield pulp mill. Subsequent to the announced indefinite idling of
the pulp mill and following a review of its business plan, the Company undertook
an impairment review and found that the carrying value of its assets exceeded
their recoverable amount being the fair value less cost to sell. The recoverable
amount was determined to be nominal.

As at the end of September 2012, assets under construction
include $59 million (2011  $3 million) of the $190 million capital investment
to upgrade the specialty cellulose manufacturing facility at Temiscaming, Quebec
(see note 14, Commitments  Capital Investment).

Tembec Financial Report 2012 75

---

Notes to Consolidated Financial Statements

|7. BIOLOGICAL ASSETS
|--------------------

The Companys private timberlands are classified as a growing
forest, with the standing timber defined and recognized as a biological asset at
fair value less costs to sell at each reporting date, with the underlying land
being considered a component of property, plant and equipment and recognized at
cost.

|Balance, September
      26, 2010             | $ | 7  |  
|--------------------------------------------- | - | -- | -
|Harvested timber transferred to inventories   |   | (1 | )
|Change in fair
      value less costs to sell |   | (2 | )
|Balance, September 24, 2011                   | $ | 4  |  
|Disposals                                     |   | (1 | )
|Change in fair
      value less costs to sell |   | 1  |  
|Balance, September
      29, 2012             | $ | 4  |  

|            |   | 2012 |  |   | 2011 |  |   | 2010 | 
|----------- | - | ---- |  | - | ---- |  | - | ---- | 
|            |   |      |  |   |      |  |   |      | 
|Current     | $ |     |  | $ |     |  | $ |     | 
|Non-current |   | 4    |  |   | 4    |  |   | 7    | 
|            | $ | 4    |  | $ | 4    |  | $ | 7    | 

|8. OTHER LONG-TERM RECEIVABLES
|------------------------------

|                              |   | 2012 |  |   | 2011 |  |   | 2010 | 
|----------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|                              |   |      |  |   |      |  |   |      | 
|Loan receivable - Temlam Inc. | $ | 7    |  | $ | 23   |  | $ | 23   | 
|Long-term loans to employees  |   | 2    |  |   | 1    |  |   | 2    | 
|Other                         |   | 3    |  |   | 4    |  |   | 3    | 
|                              | $ | 12   |  | $ | 28   |  | $ | 28   | 

In October 2008, the Company assumed the rank of secured lender
in Temlam Inc. by effecting a payment of $22 million plus $1 million of
custodial fees. The Company retains a 50% ownership position in Temlam Inc.,
which is currently under creditor protection and owns an idled laminated veneer
lumber (LVL) facility located in Amos, Quebec. During fiscal 2012, the Company
recorded an impairment loss of $16 million related to the loan receivable. The
cutting rights that were previously attached to the LVL facility were granted to
another company. In the absence of a guaranteed fiber supply, the Company has
concluded that the re-start of the facility is unlikely and has adjusted its
carrying value to the amount anticipated to be realized upon liquidation or
sale.

76Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|9. OPERATING BANK LOANS
|-----------------------

On March 4, 2011, the Company entered into a new $200 million
asset-based revolving five-year working capital facility (ABL) expiring in
February 2016. The facility has a first priority charge over the receivables and
inventories of the Companys Canadian operations. As at September 29, 2012, the
amount available, based on eligible receivables and inventories, was $144
million of which $65 million was drawn and $48 million was reserved for letters
of credit. Interest is calculated based either on the BA Rate, the LIBOR, the
Canadian Prime Rate or the U.S. Base Rate, as the case may be, plus an
applicable margin.

In April 2011, the Ontario Court of Appeal rendered a decision
in the restructuring proceedings involving Indalex Limited under the
Companies Creditors Arrangement Act(CCAA). The Court of Appeal held
that defined benefit pension plan deficiency claims had priority over security
held by debtor-in-possession (DIP) lenders in the context of a sale made under a
CCAA proceeding. This decision is currently being appealed to the Supreme Court
of Canada. In light of the uncertainty surrounding the Ontario Court of Appeal
decision, the ABL agent requested that the Company refrain from making any
further draws or utilization of the ABL facility until such priority issue is
dealt with by the Supreme Court of Canada. The Company is currently under
discussions with the ABL agent regarding this request as it considers the risk
to be minimal and the position of the ABL agent to be unwarranted.

The French operations are supported by receivable factoring
agreements. As such, the borrowing base fluctuates periodically, depending on
shipments and cash receipts. At the end of September 2012, the amount available
was $20 million of which $3 million was drawn.

The Companys exposure to interest rate risk, foreign currency
and liquidity risk is disclosed in note 19.

Tembec Financial Report 2012 77

---

Notes to Consolidated Financial Statements

|10. LONG-TERM DEBT
|------------------

|                                                                                                                                                                                                                                                |   | 2012 |  |   | 2011 |  |   | 2010 | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Tembec Industries Inc.                                                                                                                                                                                                                          |   |      |  |   |      |  |   |      | 
|11.25% senior secured notes US $305 million (2011 and 2010
      - US $255 million), due December 15, 2018, with semi-annual interest
      payments due June 15 and December 15 of each year                                                   | $ | 300  |  | $ | 262  |  | $ | 261  | 
|Tembec Tartas SAS                                                                                                                                                                                                                               |   |      |  |   |      |  |   |      | 
|Secured term loans € 6million (2011 - € 5 million; 2010 -
      nil), bearing interest at EURIBOR plus 2%, repayable in quarterly
      instalments beginning in March 2012 and maturing in December 2017                                       |   | 8    |  |   | 7    |  |   |     | 
|Unsecured term loans € 11 million (2011 - € 12 million;
      2010 - € 9 million), non-interest bearing, repayable and maturing at
      various dates from June 2014 to September 2020. The effective interest
      rate on these loans is 6% |   | 14   |  |   | 17   |  |   | 12   | 
|Other                                                                                                                                                                                                                                           |   |     |  |   | 1    |  |   | 2    | 
|Tembec Energy LP                                                                                                                                                                                                                                |   |      |  |   |      |  |   |      | 
|6.35% secured term loan, interest payable on a monthly
      basis, repayable in blended monthly instalments beginning July 15, 2014 to
      June 15, 2022 with a balloon payment of $12 million in July 2022                                  |   | 20   |  |   |     |  |   |     | 
|Kirkland Lake Engineered Wood Products Inc.                                                                                                                                                                                                     |   | 8    |  |   | 8    |  |   | 8    | 
|Tembec Inc.                                                                                                                                                                                                                                     |   |      |  |   |      |  |   |      | 
|6% unsecured notes                                                                                                                                                                                                                              |   |     |  |   | 5    |  |   | 9    | 
|Other                                                                                                                                                                                                                                           |   | 2    |  |   | 2    |  |   | 2    | 
|Tembec
      Envirofinance SAS                                                                                                                                                                                                                  |   |     |  |   |     |  |   | 7    | 
|                                                                                                                                                                                                                                                | $ | 352  |  | $ | 302  |  | $ | 301  | 
|Less current portion                                                                                                                                                                                                                            |   | 16   |  |   | 18   |  |   | 17   | 
|Less unamortized
      financing costs                                                                                                                                                                                                          |   | 13   |  |   | 13   |  |   | 13   | 
|                                                                                                                                                                                                                                                | $ | 323  |  | $ | 271  |  | $ | 271  | 

On February 23, 2012, the Company completed an add-on offering
of US $50 million in aggregate principal amount of 11.25% senior secured notes
due December 15, 2018. The add-on offering notes were offered as additional
notes under the indenture dated as of August 17, 2010, pursuant to which the
Company had previously issued US $255 million in aggregate principal amount of
11.25% senior secured notes due December 15, 2018. The notes are senior
obligations secured by a first priority lien on certain of the property and
assets of the Company and the guarantors of the notes, other than receivables,
inventory and certain intangibles upon which the note holders have a second
priority lien. The notes are guaranteed by the Company and certain of its
subsidiaries.

78Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|10. LONG-TERM DEBT(CONTINUED)
|-----------------------------

The previously issued notes were registered following an
exchange offer and registration with the Securities and Exchange Commission
(SEC) completed on March 31, 2011. The add-on offering notes were registered
following an exchange offer and registration with the SEC completed on September
28, 2012. Since registration, the add-on offering notes are trading fungibly
with the previously issued notes.

In addition, the Company must maintain their registration with
the SEC throughout the life of the notes. If the obligations under the
registration rights agreement are not satisfied, the Company will be required to
pay additional interest to the holders of the notes up to a maximum annual
amount of US $3 million.

On June 29, 2012, the Company entered into a $30 million term
loan facility to assist with the financing of the specialty cellulose project in
Temiscaming, Quebec, which is described in more detail in note 14. The interest
rate on this loan will be the greater of 6.35% and the yield on equivalent term
Government of Canada bonds plus 4.25% at the date the funds are advanced. The
loan will be reimbursed in blended monthly instalments over a period of eight
years beginning approximately 24 months after the initial advance, with a
balloon payment of $18 million to be repaid at the end of the ten-year term
period. The loan is secured by the project assets. On July 12, 2012, the Company
drew a first tranche of $20 million bearing interest at 6.35% .

The Companys credit agreements contain covenants that could in
certain circumstances restrict the ability of the Company to incur or guarantee
additional indebtedness, to encumber or dispose of its assets or make certain
payments or distributions.

The Companys exposure to interest rate risk, foreign currency
and liquidity risk is disclosed in note 19.

Instalments on consolidated long-term debt for the five years
following September 29, 2012, are as follows:

|2013 | $ | 16 | 
|---- | - | -- | 
|2014 | $ | 6  | 
|2015 | $ | 7  | 
|2016 | $ | 7  | 
|2017 | $ | 4  | 

Tembec Financial Report 2012 79

---

Notes to Consolidated Financial Statements

|11. PROVISIONS
|--------------

|                                               |   | Site        |  |   |               |   |   |       |  |   | Total      |  
|---------------------------------------------- | - | ----------- |  | - | ------------- | - | - | ----- |  | - | ---------- | -
|                                               |   | restoration |  |   | Reforestation |   |   | Other |  |   | provisions |  
|                                               |   |             |  |   |               |   |   |       |  |   |            |  
|Balance, beginning of year, September 26, 2010 | $ | 4           |  | $ | 13            |   | $ | 5     |  | $ | 22         |  
|Provisions made during the year                |   |            |  |   | 5             |   |   |      |  |   | 5          |  
|Unwinding of discount                          |   |            |  |   | 1             |   |   |      |  |   | 1          |  
|Paid during the
      year                     |   |            |  |   | (4            | ) |   |      |  |   | (4         | )
|Balance, end of year, September 24, 2011       |   | 4           |  |   | 15            |   |   | 5     |  |   | 24         |  
|Provisions made during the year                |   | 9           |  |   | 4             |   |   |      |  |   | 13         |  
|Paid during the year                           |   |            |  |   | (1            | ) |   |      |  |   | (1         | )
|Sale of BC
      sawmills (note 16)            |   |            |  |   | (16           | ) |   |      |  |   | (16        | )
|Balance, end of
      year, September 29, 2012 | $ | 13          |  | $ | 2             |   | $ | 5     |  | $ | 20         |  

|            |   | 2012 |  |   | 2011 |  |   | 2010 | 
|----------- | - | ---- |  | - | ---- |  | - | ---- | 
|Current     | $ | 3    |  | $ | 8    |  | $ | 5    | 
|Non-current |   | 17   |  |   | 16   |  |   | 17   | 
|            | $ | 20   |  | $ | 24   |  | $ | 22   | 

SITE RESTORATION

In accordance with Canadian law, land fill sites have a
predetermined life and must be restored to their original condition at the end
of their life. Because of the long-term nature of the liability, the most
significant uncertainty in estimating the provision is the costs that will be
incurred. In particular, the Company has assumed that the land fill sites will
be restored using technology and materials that are currently available. The
Company has been provided with a range of reasonably possible outcomes of the
total cost, reflecting different assumptions about changes in technology and
pricing of the individual components of the cost. The restoration is expected to
occur over the next 30 years.

Fiscal 2012 includes a charge of $4 million relating to the
Marathon, Ontario, NBSK pulp mill site. An agreement was reached with the
Province of Ontario and other implicated parties as to future remediation work.
As part of the settlement, the Company received $2 million from a previous owner
and agreed to carry out remediation work totalling approximately $6 million over
the next several years.

Fiscal 2012 includes charges of $3 million for other sites for
which the Company has a legal obligation to carry out remediation.

80Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|11. PROVISIONS(CONTINUED)
|-------------------------

REFORESTATION

In accordance with British Columbia law, the Company has an
obligation to perform certain reforestation activities during periods of 12 to
15 years following the harvest. Because of the long-term nature of the
liability, the most significant uncertainty in estimating the provision is the
costs that will be incurred. In particular, the Company has assumed that current
reforestation practice will continue to meet government policy, that adequate
forest fire protection is in place, that suitable external funding will be made
available to manage incremental forest pests and disease issues and that
government policy with respect to reforestation will not change materially. The
provision includes reforestation of different harvested areas, which are at
different stages in the reforestation process. On March 23, 2012, the Company
sold its British Columbia sawmills and, as part of the agreement, the buyer
assumed the related reforestation obligation for an amount of $16 million.

|12. EMPLOYEE FUTURE BENEFITS
|----------------------------

DEFINED CONTRIBUTION PENSION PLANS

The Company contributes to defined contribution pension plans,
provincial and labour sponsored pension plans, group registered retirement
savings plans, deferred profit sharing plans, and 401(k) plans. The pension
expense of $9 million (2011  $11 million) under these plans is equal to the
Companys contribution.

DEFINED BENEFIT PENSION PLANS

The Company has several defined benefit pension plans.
Non-unionized employees in Canada joining the Company after January 1, 2000,
participate in defined contribution pension plans. Some of the defined benefit
pension plans are contributory. The pension expense and the obligation related
to the defined benefit pension plans are actuarially determined using
managements most probable assumptions.

OTHER BENEFIT PLANS

The Company offers post-employment life insurance, healthcare
and dental care plans to some of its retirees. The Company offers other
long-term benefits as healthcare and dental care plans to disabled employees.
The Company also assumes other long-term benefits as life insurance coverage to
some of its disabled employees.

The other benefit plans expenses and the obligations related to
these plans are actuarially determined using managements most probable
assumptions.

Actuarial valuations of these plans for accounting purposes are
conducted on a triennial basis unless there are significant changes affecting
the plans. The latest actuarial valuations were conducted as at May 1, 2012 or
January 1, 2010.

The other benefit plans are unfunded.

Tembec Financial Report 2012 81

---

Notes to Consolidated Financial Statements

|12. EMPLOYEE FUTURE BENEFITS(CONTINUED)
|---------------------------------------

COMPANY CONTRIBUTIONS

Total cash payments for employee future benefits consist of
cash contributed by the Company to its funded pension plans, cash payments
directly to beneficiaries for its unfunded benefit plans and cash contributed to
its defined contribution plans. The Company contributions were $53 million for
2012 (2011  $44 million). In 2013, the Company expects to contribute
approximately $54 million to all its plans in accordance with its normal funding
policy.

DESCRIPTION OF FUND ASSETS

The assets of the registered defined benefit pension plans are
held by an independent trustee and accounted for separately in the Companys
pension funds. Based on the fair value of assets held at September 29, 2012, the
defined benefit pension plan assets were comprised of 1% (1% in 2011) in cash
and short-term investments, 5% (5% in 2011) in real estate, 47% (52% in 2011) in
bonds and 47% (42% in 2011) in Canadian, U.S. and foreign equity.

FUNDING POLICY

The Companys funding policy for registered defined benefit
pension plans is to contribute annually the amount required to provide for
benefits earned in the year and to fund past service obligations over periods
not exceeding those permitted by the applicable regulatory authorities.
Actuarial valuations for funding purposes are conducted on a triennial basis,
unless required earlier by pension legislation or as deemed appropriate by
management from time to time. The latest funding actuarial valuations were
conducted for two plans on January 1, 2012, 12 plans on December 31, 2011, one
plan on December 31, 2010, and one plan on December 31, 2009.

INVESTMENT POLICY

The Company follows a disciplined investment strategy, which
provides diversification of investments by asset class, foreign currency, sector
and company. The Corporate Governance and Human Resources Committee of the Board
of Directors has approved an investment policy that establishes long-term asset
mix targets based on a review of historical returns achieved by world-wide
investment markets. Investment managers may deviate from these targets to the
extent permitted by the investment policy. Their performance is evaluated in
relation to the market performance on the target mix.

The actual return on plan assets was $70 million for the year
ended September 29, 2012, and $13 million for the year ended September 24,
2011.

As at September 29, 2012, September 24, 2011 and September 26,
2010, the assets of the plan do not directly include the Companys own financial
instruments or any property occupied by, or other assets issued by, the
Company.

82Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|12. EMPLOYEE FUTURE BENEFITS(CONTINUED)
|---------------------------------------

INFORMATION ABOUT THE COMPANYS DEFINED BENEFIT PLANS IN
AGGREGATE

The following tables present the change in the defined benefit
obligation for the defined benefit plans as calculated by independent actuaries
and the change in the fair value of plan assets:

Change in defined benefit obligations for defined benefit
plans:

|                                                                      |   | Pension plans |   |   | Other benefit plans |  
|--------------------------------------------------------------------- | - | ------------- | - | - | ------------------- | -
|                                                                      |   | 2012          |   |   | 2011                |  
|Defined benefit obligation, at beginning of year                      | $ | 857           |   | $ | 812                 |  
|Current service cost                                                  |   | 9             |   |   | 8                   |  
|Interest cost                                                         |   | 37            |   |   | 39                  |  
|Employee contributions                                                |   | 2             |   |   | 2                   |  
|Benefits paid                                                         |   | (61           | ) |   | (46                 | )
|Actuarial loss (gain)                                                 |   | 73            |   |   | 41                  |  
|Decrease in obligation due to curtailment                             |   | (2            | ) |   |                    |  
|Decrease in obligation due to deconsolidation of Tembec USA
      LLC |   |              |   |   |                    |  
|Past service cost                                                     |   | 1             |   |   |                    |  
|Foreign exchange
      rate changes                                   |   | (6            | ) |   | 1                   |  
|Defined benefit
      obligation, at end of year                      | $ | 910           |   | $ | 857                 |  

Change in fair value of plan assets for defined benefit
plans:

|                                                                      |   | Pension plans |   |   | Other benefit plans |  
|--------------------------------------------------------------------- | - | ------------- | - | - | ------------------- | -
|                                                                      |   | 2012          |   |   | 2011                |  
|Fair value of defined benefit plan assets, at beginning of
      year | $ | 618           |   | $ | 617                 |  
|Expected return on plan assets                                        |   | 39            |   |   | 40                  |  
|Actuarial gain (loss)                                                 |   | 31            |   |   | (27                 | )
|Employer contributions                                                |   | 42            |   |   | 32                  |  
|Employee contributions                                                |   | 2             |   |   | 2                   |  
|Benefits paid                                                         |   | (61           | ) |   | (46                 | )
|Foreign exchange
      rate changes                                   |   | (4            | ) |   |                    |  
|Fair value of
      defined benefit plan assets, at end of year       | $ | 667           |   | $ | 618                 |  

Tembec Financial Report 2012 83

---

Notes to Consolidated Financial Statements

|12. EMPLOYEE FUTURE BENEFITS(CONTINUED)
|---------------------------------------

The following table presents the difference between the fair
value of plan assets and the actuarially determined defined benefit obligation
for defined benefit plans. This difference is also referred to as either the
deficit or surplus, as the case may be, or the funded status of the plans.

Reconciliation of funded status for defined benefit plans:

Pension plans
    
    
    
    
    
    Other benefit plans2012
    
    
    2011
    
    
    2010
    
    
    2012
    
    
    2011
    
    
    2010Fair value of plan assets
    $
    667
    
    $
    618
    
    $
    617
    
    $
    
    
    $
    
    
    $
    Defined benefit
      obligation, wholly or partially funded plans
    
    (867
    )
    
    (820
    )
    
    (777
    )
    
    
    
    
    
    
    
    Plan deficit
    
    (200
    )
    
    (202
    )
    
    (160
    )
    
    
    
    
    
    
    
    Defined benefit obligation, unfunded plans
    
    (43
    )
    
    (37
    )
    
    (35
    )
    
    (41
    )
    
    (44
    )
    
    (47
    )Unamortized past service costs
    
    1
    
    
    
    
    
    1
    
    
    1
    
    
    2
    
    
    Liability arising
      from minimum funding requirement
    
    (3
    )
    
    (3
    )
    
    (7
    )
    
    
    
    
    
    
    
    Net defined
      benefit liability
    $
    (245
    )
    $
    (242
    )
    $
    (201
    )
    $
    (40
    )
    $
    (42
    )
    $
    (47
    )


The following table presents the experience adjustments arising
from plan liabilities and plan assets as a result of the differences between
actuarial assumptions made at the beginning of the year and the actual
experience during the year:

Pension plans
    
    
    Other benefit plans2012
    
    
    2011
    
    
    2010
    
    
    2012
    
    
    2011
    
    
    2010Experience loss (gain) arising from plan liabilities
    $
    (4
    )
    $
    (9
    )
    
    n/a
    
    $
    (6
    )
    $
    
    
    
    n/aExperience loss
      (gain) arising from plan assets
    $
    (31
    )
    $
    27
    
    
    n/a
    
    $
    
    
    $
    
    
    
    n/a


Amounts recognized in the consolidated balance sheets for
defined benefit plans:

Pension plans
    
    
    Other benefit plans2012
    
    
    2011
    
    
    2010
    
    
    2012
    
    
    2011
    
    
    2010Defined benefit asset
    $
    
    
    $
    1
    
    $
    
    
    $
    
    
    $
    
    
    $
    Defined benefit
      liability
    
    (245
    )
    
    (243
    )
    
    (201
    )
    
    (40
    )
    
    (42
    )
    
    (47
    )Net defined
      benefit liability
    $
    (245
    )
    $
    (242
    )
    $
    (201
    )
    $
    (40
    )
    $
    (42
    )
    $
    (47
    )


84Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|12. EMPLOYEE FUTURE BENEFITS(CONTINUED)
|---------------------------------------

COMPONENTS OF BENEFIT COST

The following tables present the impact on net earnings (loss)
and other comprehensive earnings (loss) of the Companys employee future
benefits:

RECOGNIZED IN NET EARNINGS (LOSS)

|                                                      |   | Pension plans |   |   | Other benefit plans |  
|----------------------------------------------------- | - | ------------- | - | - | ------------------- | -
|                                                      |   | 2012          |   |   | 2011                |  
|Recognized costs for defined benefit plans:           |   |               |   |   |                     |  
|Current service cost                                  | $ | 9             |   | $ | 8                   |  
|Past service
      cost                               |   |              |   |   | 1                   |  
|Total
      included in personnel expenses            |   | 9             |   |   | 9                   |  
|Curtailment gain                                      |   | (2            | ) |   |                    |  
|Deconsolidation of Tembec USA LLC                     |   |              |   |   |                    |  
|Total
      included in other items                   |   | (2            | ) |   |                    |  
|Interest cost                                         |   | 37            |   |   | 39                  |  
|Expected
      return on plan assets                  |   | (39           | ) |   | (40                 | )
|Total
      included in net finance costs             |   | (2            | ) |   | (1                  | )
|                                                      |   | 5             |   |   | 8                   |  
|Recognized costs
      for defined contribution plans |   | 9             |   |   | 11                  |  
|Total expense for
      employee future benefits      | $ | 14            |   | $ | 19                  |  

RECOGNIZED IN OTHER COMPREHENSIVE EARNINGS (LOSS)

|                                               |   | Pension plans |  |   | Other benefit plans |  
|---------------------------------------------- | - | ------------- |  | - | ------------------- | -
|                                               |   | 2012          |  |   | 2011                |  
|Actuarial loss (gain)                          | $ | 42            |  | $ | 68                  |  
|Effect of limit on
      recognition of assets |   |              |  |   | (4                  | )
|Defined benefit
      plans                    | $ | 42            |  | $ | 64                  |  

The cumulative amount recognized in deficit as at September 29,
2012, is $102 million (2011  $64 million; 2010  nil).

Tembec Financial Report 2012 85

---

Notes to Consolidated Financial Statements

|12. EMPLOYEE FUTURE BENEFITS(CONTINUED)
|---------------------------------------

ASSUMPTIONS

Significant assumptions for defined benefit pension plans
(weighted average):

|                                           |  | 2012  |  |  | 2011  |  |  | 2010  | 
|------------------------------------------ |  | ----- |  |  | ----- |  |  | ----- | 
|Defined benefit obligation at end of year: |  |       |  |  |       |  |  |       | 
|Discount rate                              |  | 3.69% |  |  | 4.42% |  |  | 4.87% | 
|Rate of compensation increase              |  | 2.50% |  |  | 2.50% |  |  | 2.50% | 
|Net periodic benefit cost for the year:    |  |       |  |  |       |  |  |       | 
|Discount rate                              |  | 4.42% |  |  | 4.87% |  |  | n/a   | 
|Rate of compensation increase              |  | 2.50% |  |  | 2.50% |  |  | n/a   | 
|Expected
      long-term return on assets  |  | 6.39% |  |  | 6.53% |  |  | n/a   | 

Significant assumptions for other future benefit plans
(weighted average):

|                                                                    |   | 2012  |   |   | 2011  |   |   | 2010  | 
|------------------------------------------------------------------- | - | ----- | - | - | ----- | - | - | ----- | 
|Defined benefit obligation at end of year:                          |   |       |   |   |       |   |   |       | 
|Discount rate                                                       |   | 3.68% |   |   | 4.19% |   |   | 4.73% | 
|Rate of compensation increase                                       |   | 2.50% |   |   | 2.50% |   |   | 2.50% | 
|Net periodic benefit cost for the year:                             |   |       |   |   |       |   |   |       | 
|Discount rate                                                       |   | 4.19% |   |   | 4.73% |   |   | n/a   | 
|Rate of compensation increase                                       |   | 2.50% |   |   | 2.50% |   |   | n/a   | 
|Assumed healthcare cost trend rate at end of year:                  |   |       |   |   |       |   |   |       | 
|Initial healthcare cost trend                                       |   | 7.00% |   |   | 7.50% |   |   | 8.00% | 
|Annual rate of decline in trend rate                                |   | 0.50% |   |   | 0.50% |   |   | 0.50% | 
|Ultimate healthcare cost trend rate                                 |   | 5.00% |   |   | 5.00% |   |   | 5.00% | 
|Year ultimate rate is reached                                       |   | 2016  |   |   | 2016  |   |   | 2016  | 
|Effect of change in healthcare cost trend rate (1%
      increase): |   |       |   |   |       |   |   |       | 
|Total of service cost and interest cost                             | $ |      |   | $ |      |   | $ |      | 
|Defined benefit obligation                                          | $ | 2     |   | $ | 3     |   | $ |      | 
|Effect of change in healthcare cost trend rate (1%
      decrease): |   |       |   |   |       |   |   |       | 
|Total of service cost and interest cost                             | $ |      |   | $ |      |   | $ |      | 
|Defined
      benefit obligation                                    | $ | (2    | ) | $ | (3    | ) | $ |      | 

86Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|13. SHARE CAPITAL
|-----------------

AuthorizedUnlimited number of common voting shares, without par
value.

Unlimited number of non-voting Class A preferred shares
issuable in series without par value, with other attributes to be determined at
time of issuance.

Nil warrants (2011 and 2010  11,111,111) convertible in equal
amount of common shares that expired unexercised on February 29, 2012.

Issued and fully paid

|                                                                                          |   | 2012 |  |   | 2011 |  |   | 2010 | 
|----------------------------------------------------------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|100,000,000 common shares                                                                 | $ | 564  |  | $ | 564  |  | $ | 564  | 
|Nil warrants (2011
      and 2010 - 11,093,943) (included in other long-term liabilities) |   |     |  |   |     |  |   | 5    | 

Net loss per shareThe following table provides the reconciliation between basic
and diluted net loss per share:

|                                                                   |   | 2012        |   |   | 2011        |  
|------------------------------------------------------------------ | - | ----------- | - | - | ----------- | -
|Net loss                                                           | $ | (82         | ) | $ | (5          | )
|Weighted average number of common shares outstanding               |   | 100,000,000 |   |   | 100,000,000 |  
|Dilutive effect of employee share options and warrants             |   |            |   |   |            |  
|Weighted average number of diluted common shares
      outstanding |   | 100,000,000 |   |   | 100,000,000 |  
|Basic and diluted
      net loss in dollars per share              | $ | (0.82       | ) | $ | (0.05       | )

The warrants and employees share options had no dilutive effect
for the above periods; however, these securities could potentially dilute
earnings per share in future periods.

WarrantsConcurrently with the first drawdown on the $75 million term
loan facility to assist with the $190 million capital investment to upgrade its
specialty cellulose manufacturing facility at Temiscaming, Quebec, the Company
has granted the lender an option to acquire 3 million common shares of the
Corporation at a price of $7 per share. These warrants vest on the first loan
disbursement date and expire on August 30, 2017. The Company received, on
October 19, 2012, its first draw of $9 million on the term loan (see note 14,
Commitments  Capital Investment).

Tembec Financial Report 2012 87

---

Notes to Consolidated Financial Statements

|13. SHARE CAPITAL(CONTINUED)
|----------------------------

Share-based compensationUnder the prior Long-Term Incentive Plan, the Company had, from
time to time, granted options to its employees. The plan provided for the
issuance of common shares at an exercise price equal to the market price of the
Companys common shares on the date of the grant. These options vest over a
five-year period and expire ten years from the date of issue. No options have
been granted since 2006. No compensation expense was recorded for the years
ended September 29, 2012 and September 24, 2011.

The following table summarizes the changes in options
outstanding and the impact on weighted average per share exercise price during
the year:

|                               |  |         |   |   | 2012           |  |  |         |   |   | 2011           | 
|------------------------------ |  | ------- | - | - | -------------- |  |  | ------- | - | - | -------------- | 
|                               |  |         |   |   | Weighted       |  |  |         |   |   | Weighted       | 
|                               |  |         |   |   | average        |  |  |         |   |   | average        | 
|                               |  | Shares  |   |   | exercise price |  |  | Shares  |   |   | exercise price | 
|Balance, beginning of year     |  | 122,020 |   | $ | 75.01          |  |  | 161,123 |   | $ | 89.01          | 
|Options cancelled              |  | (17,033 | ) |   | 129.74         |  |  | (39,103 | ) |   | 132.67         | 
|Balance, end of
      year     |  | 104,987 |   | $ | 66.13          |  |  | 122,020 |   | $ | 75.01          | 
|Exercisable, end
      of year |  | 104,987 |   | $ | 66.13          |  |  | 122,020 |   | $ | 75.01          | 

Of the total 17,033 (2011  39,103) options cancelled, 5,791
(2011  4,001) expired and 11,242 (2011  35,102) were forfeited.

The following table summarizes the weighted average per share
exercise price and the weighted remaining contractual life of the options
outstanding as at September 29, 2012:

|             |  | Outstanding options and exercisable options | 
|------------ |  | ------------------------------------------- | 
|             |  |                                             | 
|             |  | Number of                                   | 
|Year granted |  | options                                     | 
|2003         |  | 4,375                                       | 
|2004         |  | 5,326                                       | 
|2005         |  | 48,484                                      | 
|2006         |  | 46,802                                      | 
|             |  | 104,987                                     | 

88Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|13. SHARE CAPITAL(CONTINUED)
|----------------------------

Other share-based compensationDuring fiscal 2009, the Company established a
Performance-Conditioned Restricted Share Units (PCRSU) plan for designated
senior executives. During the December 2011 quarter, 880,968 PCRSUs were
forfeited as performance conditions attached to it were not achieved, and the
remaining 1,143,039 PCRSUs were paid for a total consideration of $3 million.
There are no PCRSUs outstanding and this plan was terminated.

The following table summarizes the grant of PCRSUs that has
occurred over the past three years:

|                           |  | 2012       |   |  | 2011      |   |  | 2010      |  
|-------------------------- |  | ---------- | - |  | --------- | - |  | --------- | -
|Balance, beginning of year |  | 2,024,007  |   |  | 1,563,000 |   |  | 1,116,000 |  
|Grants                     |  |           |   |  | 732,201   |   |  | 536,000   |  
|Paid                       |  | (1,143,039 | ) |  |          |   |  |          |  
|Forfeitures                |  | (880,968   | ) |  | (271,194  | ) |  | (89,000   | )
|Balance, end of
      year |  |           |   |  | 2,024,007 |   |  | 1,563,000 |  
|Vested, end of
      year  |  |           |   |  | 622,940   |   |  |          |  

Directors of the Company, which are not employees of the
Company, are given the option to receive part of their annual retainer, meeting
fees and awards under the Directors Share Award Plan in the form of Deferred
Share Units (DSU). Each DSU is equivalent in value to a common share of the
Company and is notionally credited with dividends when shareholders receive
dividends from the Company. A DSU is paid to a director upon termination of
Board service and is payable in the form of cash.

The following table summarizes the grant of DSUs that has
occurred over the past three years:

|                           |  | 2012      |  |  | 2011      |   |  | 2010    | 
|-------------------------- |  | --------- |  |  | --------- | - |  | ------- | 
|Balance, beginning of year |  | 1,119,836 |  |  | 411,222   |   |  | 411,222 | 
|Grants                     |  |          |  |  | 750,999   |   |  |        | 
|Paid                       |  |          |  |  | (42,385   | ) |  |        | 
|Balance, end of
      year |  | 1,119,836 |  |  | 1,119,836 |   |  | 411,222 | 
|Vested, end of
      year  |  | 869,503   |  |  | 619,170   |   |  | 411,222 | 

On November 17, 2010, under the Directors Share Award Plan,
non-executive members of the Board were granted 655,175 DSUs, and on January 27,
2011, 95,824 additional DSUs were granted. These DSUs vest in three equal
amounts over the next three Annual General Shareholders meetings beginning on
January 27, 2011.

Tembec Financial Report 2012 89

---

Notes to Consolidated Financial Statements

|13. SHARE CAPITAL(CONTINUED)
|----------------------------

Other share-based compensation(continued)
On November 15, 2011, the Board approved the establishment of a
Performance-Conditioned Share Unit (PCSU) plan. Under the PCSU plan, designated
senior executives will be granted a specified number of DSUs or PCSUs annually,
which vest over successive three-year periods, based on total shareholder return
over the performance period as determined relative to a peer group and the
increase in value of the Companys weighted average share price over the
performance period. On January 26, 2012, 373,147 DSUs were granted.

The following table summarizes the grant of DSUs that has
occurred during the year:

|                           |  | 2012    |  
|-------------------------- |  | ------- | -
|Balance, beginning of year |  |        |  
|Grants                     |  | 373,147 |  
|Forfeited                  |  | (5,564  | )
|Balance, end of
      year |  | 367,583 |  
|Vested, end of
      year  |  |        |  

The following table summarizes the details of share-based
compensation expenses relating to its different share-based compensation
plans:

|                                                                         |   | 2012 |   |   | 2011 | 
|------------------------------------------------------------------------ | - | ---- | - | - | ---- | 
|Performance-conditioned restricted share unit plan                       | $ |     |   | $ | 2    | 
|Directors share award plan                                              |   | (1   | ) |   |     | 
|Performance-conditioned share unit plan                                  |   |     |   |   |     | 
|                                                                         | $ | (1   | ) | $ | 2    | 
|Total carrying
      amount of liabilities for cash-settled arrangements | $ | 2    |   | $ | 5    | 

|14. GUARANTEES, COMMITMENTS AND CONTINGENCIES
|---------------------------------------------

GUARANTEES

The Company and certain of its subsidiaries have granted
irrevocable letters of credit, issued by highly-rated financial institutions, to
third parties to indemnify them in the event the Company does not perform its
contractual obligations. The Company has not recorded any additional liability
with respect to these guarantees, as the Company does not expect to make any
payments in excess of what is recorded in the Companys financial statements.
The letters of credit mature at various dates in fiscal 2013.

90Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|14. GUARANTEES, COMMITMENTS AND CONTINGENCIES(CONTINUED)
|--------------------------------------------------------

COMMITMENTS

Capital investmentOn March 16, 2012, the Company
announced a $190 million capital investment to upgrade its specialty cellulose
manufacturing facility at Temiscaming, Quebec. The project involves the
replacement of three old boilers with a new high-pressure boiler designed to
burn waste sulphite liquor, a co-product of the specialty cellulose
manufacturing process, producing steam for use at the facility. The project also
calls for the installation of a new electrical turbine that will increase the
Temiscaming facilitys electricity production capacity from its current 10
megawatts to 60 megawatts. As at the end of September 2012, the Company had
incurred $59 million of capital expenditures for this project and had $51
million of outstanding commitments.

The Company has entered into a 25-year power purchase contract
with Hydro-Quebec that will allow the Company to sell to Hydro-Quebec up to 50
megawatts of the incremental electricity generated by the new turbine at green
energy rates of $106 per MW/hour, indexed annually to the consumer price
index.

In connection with the project, the Company entered into the
following term loan facilities to assist with the financing:

| | a $75 million term loan facility, bearing interest at
      5.5%. The loan has a 15-year term consisting of a three-year construction
      or drawdown period followed by a 12-year amortization period. The term of
      the loan will be shortened by three years if the Company does not complete
      certain future capital expenditures at the Temiscaming specialty cellulose
      mill. The loan will be secured by the project assets. The Company has also
      granted the lender a five-year option expiring on August 30, 2017, to
      acquire 3 million common shares of the Corporation at a price of $7 per
      share. On October 19, 2012 and November 14, 2012, the Company received $9
      million and $6 million respectively on the term loan.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | a $30 million term loan facility of which the Company
      drew a first tranche of $20 million on July 12, 2012. Details related to
      this new facility are disclosed in note 10 .                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

Operating leasesThe Company has entered into
operating leases for expected cash outflows of $12 million. Outflows for the
years following September 29, 2012, are as follows:

|2013                      | $ | 4 | 
|------------------------- | - | - | 
|2014                      | $ | 3 | 
|2015                      | $ | 2 | 
|2016                      | $ | 2 | 
|2017 and
      thereafter | $ | 1 | 

CONTINGENCIES

The Company is party to claims and litigations arising in the
normal course of operations. The Company does not expect that the resolution of
these matters will have a material adverse effect on the Companys financial
condition, earnings or liquidity.

Tembec Financial Report 2012 91

---

Notes to Consolidated Financial Statements

|15. ANALYSIS OF EXPENSES BY NATURE
|----------------------------------

|                                            |   | 2012  |   |   | 2011  |  
|------------------------------------------- | - | ----- | - | - | ----- | -
|Wages and salaries                          | $ | 275   |   | $ | 271   |  
|Employee benefits expense                   |   | 97    |   |   | 109   |  
|Raw materials and other manufacturing costs |   | 1,004 |   |   | 1,000 |  
|Changes in inventories                      |   | (37   | ) |   | (7    | )
|Other expenses                              |   | 25    |   |   | 20    |  
|                                            | $ | 1,364 |   | $ | 1,393 |  
|                                            |   |       |   |   |       |  
|Cost of sales                               | $ | 1,290 |   | $ | 1,321 |  
|Selling, general
      and administrative   |   | 74    |   |   | 72    |  
|                                            | $ | 1,364 |   | $ | 1,393 |  

|16. OTHER ITEMS
|---------------

The following table provides a summary of the other items by
business segment of the Company:

|                                                              |   | 2012 |   |   | 2011 |  
|------------------------------------------------------------- | - | ---- | - | - | ---- | -
|High-Yield Pulp:                                              |   |      |   |   |      |  
|Impairment
      loss - Chetwynd, British Columbia, pulp mill | $ | 50   |   | $ |     |  
|                                                              |   | 50   |   |   |     |  
|Forest Products:                                              |   |      |   |   |      |  
|Gain on sale of British Columbia sawmills                     |   | (24  | ) |   |     |  
|Loss on sale/closure of hardwood flooring plants              |   | 2    |   |   |     |  
|Cranbrook planer mill closure charge                          |   |     |   |   | 1    |  
|Taschereau
      sawmill closure charge                       |   |     |   |   | 2    |  
|                                                              |   | (22  | ) |   | 3    |  
|Corporate:                                                    |   |      |   |   |      |  
|Costs for permanently idled facilities                        |   | 10   |   |   | 7    |  
|Impairment loss - Temlam loan receivable                      |   | 16   |   |   |     |  
|Gain on sale of minority equity investment                    |   | (4   | ) |   |     |  
|Gain on sale of Smooth Rock Falls, Ontario, assets            |   |     |   |   | (3   | )
|Gain on
      deconsolidation of Tembec USA LLC               |   |     |   |   | (4   | )
|                                                              |   | 22   |   |   |     |  
|Other items                                                   | $ | 50   |   | $ | 3    |  

92Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|16. OTHER ITEMS(CONTINUED)
|--------------------------

2012

During the September 2012 quarter, the Company recorded an
impairment loss of $50 million related to property, plant and equipment,
including the related supplies and materials of the Chetwynd, British Columbia,
high-yield pulp mill. Subsequent to the announced indefinite idling of the pulp
mill and following a review of its business plan, the Company undertook an
impairment review and found that the carrying value of its assets exceeded their
recoverable amount being the fair value less costs to sell. The recoverable
amount was determined to be nominal.

During the year, the Company recorded charges of $10 million
relating to several permanently idled facilities. The costs relate to custodial,
site security, legal and remediation activities.

On March 23, 2012, the Company sold its British Columbia
Southern Interior wood products assets for proceeds of $66 million. The sale
included the Elko and Canal Flats sawmills and approximately 1.1 million cubic
meters of combined Crown tenures, private land and contract annual allowable
cut. As a result of the sale, the Company recorded a gain of $24 million in the
March 2012 quarter. The following table provides information related to balance
sheet items of the two sawmills at the time of sale:

|Current assets                           | $ | 35  |  
|---------------------------------------- | - | --- | -
|Long-term assets                         |   | 28  |  
|Current liabilities                      |   | (10 | )
|Long-term reforestation obligations      |   | (9  | )
|Employee future
      benefits and other |   | (2  | )
|                                         | $ | 42  |  

During the March 2012 quarter, the Company recorded an
impairment loss of $16 million related to the loan receivable from Temlam Inc.
The latter is currently under creditor protection and owns an idled laminated
veneer lumber (LVL) facility located in Amos, Quebec. The Company has a 50%
secured interest in the facility. The cutting rights that were previously
attached to the LVL facility were granted to another company. In the absence of
a guaranteed fiber supply, the Company has concluded that the re-start of the
facility is unlikely and has adjusted its carrying value to the amount
anticipated to be realized upon liquidation or sale.

On December 22, 2011, the Company recorded a gain of $4 million
relating to the sale of a minority equity position in two dissolving pulp mills
located in the Province of New Brunswick.

On November 25, 2011, the Company sold its Toronto, Ontario,
hardwood flooring plant for proceeds of $13 million. Concurrently, the Company
also announced the closure of its Huntsville, Ontario, hardwood flooring plant.
The sale of the Toronto plant and the closure of the Huntsville plant resulted
in a charge of $2 million that has been recorded in the December 2011
quarter.

Tembec Financial Report 2012 93

---

Notes to Consolidated Financial Statements

|16. OTHER ITEMS(CONTINUED)
|--------------------------

2011

During fiscal 2011, the Company recorded charges of $7 million
relating to several permanently idled facilities. The costs relate to legal
costs, site security and custodial costs.

During the June 2011 quarter, the Company finalized the sale of
its hydro-electric generating assets located in Smooth Rock Falls, Ontario, and
recorded a gain of $3 million. Total consideration for the assets, which had a
capacity of 7.4 megawatts, was $16 million paid in cash.

During the June 2011 quarter, the Company announced that its
non-operating U.S. subsidiary, Tembec USA LLC, had filed a petition seeking
relief under Chapter 7 of the Bankruptcy Code of the United States. As a result
of the filing, the Company determined that it no longer exercised control over
this investment. The Company recorded a gain of $4 million relating to the
deconsolidation of this subsidiary, arising primarily from the reduction in its
consolidated accrued benefit obligation.

During the March 2011 quarter, the Company announced the
permanent closure of the Taschereau, Quebec, sawmill. The facility had been
idled since October 2009. The Company recorded a charge of $2 million relating
to severance and other items.

During the March 2011 quarter, the Company recorded a charge of
$1 million for severance relating to the Cranbrook, British Columbia, planer
mill operation. The mill has been indefinitely idled since November 2007.

|17. NET FINANCE COSTS
|---------------------

|                                                                             |   | 2012 |   |   | 2011 |  
|---------------------------------------------------------------------------- | - | ---- | - | - | ---- | -
|Interest on long-term debt                                                   | $ | 36   |   | $ | 31   |  
|Interest on short-term debt                                                  |   | 2    |   |   | 1    |  
|Bank charges and other financing expenses                                    |   | 2    |   |   | 6    |  
|Net foreign exchange loss (gain), excluding exchange on
      long-term debt |   | 4    |   |   |     |  
|Derivative financial instruments                                             |   |     |   |   | (1   | )
|Interest income                                                              |   | (1   | ) |   | (1   | )
|Exchange loss (gain) on long-term debt                                       |   | (13  | ) |   | 1    |  
|Net change in fair value of warrants                                         |   |     |   |   | (5   | )
|Interest
      capitalized on assets under construction                      |   | (2   | ) |   |     |  
|                                                                             | $ | 28   |   | $ | 32   |  
|Finance costs                                                                | $ | 42   |   | $ | 39   |  
|Finance income                                                               |   | (14  | ) |   | (7   | )
|Net finance costs                                                            | $ | 28   |   | $ | 32   |  

94Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|18. INCOME TAXES
|----------------

The reconciliation of income taxes calculated at the statutory
rate to the actual tax provision is as follows:

|                                                                                                                            |   | 2012 |   |   | 2011 | 
|--------------------------------------------------------------------------------------------------------------------------- | - | ---- | - | - | ---- | 
|Earnings (loss)
      before income taxes                                                                                   | $ | (60  | ) | $ | 15   | 
|Income tax expense
      (recovery) based on combined federal and provincial income tax rates of
      26.3% (2011 - 27.8%) | $ | (16  | ) | $ | 4    | 
|Increase (decrease) resulting from:                                                                                         |   |      |   |   |      | 
|Unrecognized tax asset arising from current losses                                                                          |   | 32   |   |   | 10   | 
|Difference in statutory income tax rate                                                                                     |   | 6    |   |   | 6    | 
|Non-taxable portion of exchange gain on long-term
      debt                                                                |   | (2   | ) |   |     | 
|Other
      permanent differences                                                                                           |   | 2    |   |   |     | 
|                                                                                                                            |   | 38   |   |   | 16   | 
|Income tax expense                                                                                                          | $ | 22   |   | $ | 20   | 
|Income taxes:                                                                                                               |   |      |   |   |      | 
|Current                                                                                                                     | $ | 11   |   | $ | 8    | 
|Deferred                                                                                                                    |   | 11   |   |   | 12   | 
|Income tax expense                                                                                                          | $ | 22   |   | $ | 20   | 

UNRECOGNIZED DEFERRED TAX ASSETS

Deferred tax assets have not been recognized in respect of the
following:

|                                                                                                              |   | 2012 |  |   | 2011 |  |   | 2010 | 
|------------------------------------------------------------------------------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Deferred tax assets:                                                                                          |   |      |  |   |      |  |   |      | 
|Non-capital loss carry-forwards and pool of deductible
      scientific research and development expenditures | $ | 405  |  | $ | 390  |  | $ | 360  | 
|Property, plant and equipment                                                                                 |   | 66   |  |   | 36   |  |   | 27   | 
|Employee future benefits                                                                                      |   | 78   |  |   | 79   |  |   | 69   | 
|Capital loss carry-forwards                                                                                   |   | 3    |  |   | 3    |  |   | 7    | 
|Financing charges                                                                                             |   |     |  |   |     |  |   | 7    | 
|Other                                                                                                         |   | 9    |  |   | 12   |  |   | 15   | 
|                                                                                                              | $ | 561  |  | $ | 520  |  | $ | 485  | 

Deferred tax assets have not been recognized in respect of
these items because it is not probable that future taxable profits will be
available against which the Company can utilize the benefits.

Tembec Financial Report 2012 95

---

Notes to Consolidated Financial Statements

|18. INCOME TAXES(CONTINUED)
|---------------------------

UNRECOGNIZED DEFERRED TAX ASSETS (CONTINUED)

As at September 29, 2012, certain subsidiaries have accumulated
the following losses and deductions for income tax purposes, which may be
carried forward to reduce taxable income and taxes payable in future years:

|                                                                          |   | Amounts |  |  | Expiring dates | 
|------------------------------------------------------------------------- | - | ------- |  |  | -------------- | 
|Non-capital loss carried forward for:                                     |   |         |  |  |                | 
|Canadian subsidiaries                                                     | $ | 1,158   |  |  | 2014 to 2032   | 
|U.S. subsidiaries                                                         | $ | 13      |  |  | 2028 to 2032   | 
|Pool of deductible
      scientific research and experimental development | $ | 368     |  |  | Unlimited      | 

RECOGNIZED DEFERRED TAX ASSETS AND LIABILITIES

|                                               |   | Deferred tax asset |   |   | Deferred tax liabilities |  
|---------------------------------------------- | - | ------------------ | - | - | ------------------------ | -
|                                               |   | Non-capital        |   |   | Property,                |  
|                                               |   | loss carry-        |   |   | plant and                |  
|                                               |   | forwards           |   |   | equipment                |  
|Balance, September 26, 2010                    | $ | 23                 |   | $ | 6                        |  
|Through statement
      of net earnings (loss) |   | (12                | ) |   | (1                       | )
|Balance, September
      24, 2011              |   | 11                 |   |   | 5                        |  
|Through statement
      of net earnings (loss) |   | (11                | ) |   | (1                       | )
|Balance, September
      29, 2012              | $ |                   |   | $ | 4                        |  

|19. FINANCIAL INSTRUMENTS
|-------------------------

FAIR VALUE

The carrying amount of cash and cash equivalents, cash held in
trust, trade and other receivables, bank indebtedness, operating bank loans,
other payables and accrued charges, and interest payable approximates their fair
values because of the near-term maturity of those instruments. The carrying
value of the long-term loans receivable and other long-term liabilities also
approximates their fair values.

The carrying value and the fair value of long-term debt are as
follows:

|               |   | 2012 |  |   | 2011 |  |   | 2010 | 
|-------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Carrying value | $ | 339  |  | $ | 289  |  | $ | 288  | 
|Fair value     | $ | 369  |  | $ | 294  |  | $ | 301  | 

96Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|19. FINANCIAL INSTRUMENTS(CONTINUED)
|------------------------------------

FAIR VALUE(CONTINUED)

The fair value of the senior secured notes was estimated using
quoted market prices; the fair value of the other long-term debt was estimated
based on discounted cash flows using year-end market yields of similar
instruments having the same maturity.

Derivative financial instruments are the only financial
instruments of the Company measured at fair value on a recurring basis and have
been valued in accordance with Level 1 of the fair value hierarchy, which is
based on unadjusted quoted prices in an active market. The Company had no
derivative financial instruments at September 29, 2012 (2011  negligible; 2010
 nil).

FINANCIAL RISK MANAGEMENT

OverviewThe Company has exposure to the following
risks from its use of financial instruments:

- Credit risk
- Liquidity risk
- Market risk

> Foreign currency rate riskInterest rate riskCommodity price and operational risk

The Board of Directors has overall responsibility for the
establishment and oversight of the Companys risk management policy. The policy
defines the method by which the Company manages its risk through properly and
prudently administering the Companys financial assets, liabilities and
derivatives. Internal Audit measures the adequacy of the business control
systems through the execution of an Internal Audit Plan approved by the Audit
Committee.

Exposure to credit riskCredit risk arises from the
possibility that entities to which the Company sells products may experience
financial difficulty and be unable to fulfill their contractual obligations. The
Company does not have a significant exposure to any individual customer or
counterparty. As required in the Risk Management Policy, the Company reviews a
new customers credit history before extending credit and conducts regular
reviews of its existing customers credit performance. All credit limits are
subject to evaluation and revision at any time based on changes in levels of
creditworthiness and must be reviewed at least once per year. Sales orders
cannot be processed unless a credit limit has been properly approved. The
Company may require payment guarantees, such as letters of credit, or obtain
credit insurance coverage. Bad debt expense has not been significant in the
past. The allowance for doubtful accounts for the Company, as at September 29,
2012, was negligible (2011  negligible; 2010 - $1 million).

The Company also has credit risk relating to cash and cash
equivalents. The Company manages risk by dealing only with highly-rated
financial institutions.

Tembec Financial Report 2012 97

---

Notes to Consolidated Financial Statements

|19. FINANCIAL INSTRUMENTS(CONTINUED)
|------------------------------------

FINANCIAL RISK MANAGEMENT(CONTINUED)

Exposure to credit risk (continued)The
carrying amount of financial assets represents the maximum credit exposure. The
maximum exposure to credit risk at the reporting date was:

|                                                                                      |   | 2012 |  |   | 2011 |  |   | 2010 | 
|------------------------------------------------------------------------------------- | - | ---- |  | - | ---- |  | - | ---- | 
|Loans and receivables, other than cash, cash equivalents
      and cash held in trust | $ | 212  |  | $ | 206  |  | $ | 236  | 
|Cash, cash
      equivalents and cash held in trust                                   | $ | 92   |  | $ | 105  |  | $ | 74   | 

The maximum exposure to credit risk for trade accounts
receivable as at September 29, 2012 and September 24, 2011, by geographical
region was as follows:

|                                                    |   | 2012 |  |   | 2011 | 
|--------------------------------------------------- | - | ---- |  | - | ---- | 
|Canada                                              | $ | 19   |  | $ | 24   | 
|United States                                       |   | 51   |  |   | 49   | 
|European Union                                      |   | 42   |  |   | 37   | 
|China                                               |   | 5    |  |   | 15   | 
|Other                                               |   | 24   |  |   | 8    | 
|                                                    |   | 141  |  |   | 133  | 
|Allowance for
      doubtful accounts               |   |     |  |   |     | 
|Trade receivables net                               |   | 141  |  |   | 133  | 
|Other receivables
      including input tax credits |   | 59   |  |   | 49   | 
|Accounts
      receivable                           | $ | 200  |  | $ | 182  | 

The aging of trade accounts receivable was as follows:

|                          |   |       |  |   | 2012      |  |   |       |  |   | 2011      | 
|------------------------- | - | ----- |  | - | --------- |  | - | ----- |  | - | --------- | 
|                          |   | Gross |  |   | Allowance |  |   | Gross |  |   | Allowance | 
|Not past due              | $ | 134   |  | $ |          |  | $ | 125   |  | $ |          | 
|Past due 0-30 days        |   | 5     |  |   |          |  |   | 6     |  |   |          | 
|Past due 31-60
      days |   | 2     |  |   |          |  |   | 2     |  |   |          | 
|                          | $ | 141   |  | $ |          |  | $ | 133   |  | $ |          | 

The movement in the allowance for doubtful accounts receivable
in respect to trade accounts receivable was as follows:

|                           |   | 2012 |  |   | 2011 |  
|-------------------------- | - | ---- |  | - | ---- | -
|Balance, beginning of year | $ |     |  | $ | 1    |  
|Bad debt written
      off |   |     |  |   | (1   | )
|Balance, end of
      year | $ |     |  | $ |     |  

98Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|19. FINANCIAL INSTRUMENTS(CONTINUED)
|------------------------------------

FINANCIAL RISK MANAGEMENT(CONTINUED)

Exposure to liquidity riskLiquidity risk arises from
the possibility that the Company will not be able to meet its financial
obligations as they fall due. The Company has an objective of maintaining
liquidity equal to 12 months of maintenance capital expenditures, interest and
principal repayments and seasonal working capital requirements, which would
require approximately $135 million to $150 million of liquidity.

A liquidity reserve in the form of cash, cash equivalents and
undrawn revolving credit facilities is maintained to assist in the solvency and
financial flexibility of the Company. Liquidity reserves as at September 29,
2012, totalled $140 million (2011  $229 million). Repayment of amounts due
within one year may also be funded by normal collection of current trade
accounts receivable and cash on hand.

In April 2011, the Ontario Court of Appeal rendered a decision
in the restructuring proceedings involving Indalex Limited under the Companies
Creditors Arrangement Act (CCAA). The Court of Appeal held that defined benefit
pension plan deficiency claims had priority over security held by
debtor-in-possession (DIP) lenders in the context of a sale made under a CCAA
proceeding. This decision is currently being appealed to the Supreme Court of
Canada. The agent for the asset-based loan (ABL) lenders syndicate recently
expressed concern regarding the solvency deficits of the Companys Ontario
defined benefit pension plans. In light of the uncertainty surrounding the
Ontario Court of Appeal decision, the ABL agent requested that the Company
refrains from making any further draws or utilization of the ABL facility until
such priority issue is dealt with by the Supreme Court of Canada.

The Company is currently under discussions with the ABL agent
regarding this request as it considers the risk to be minimal and the position
of the ABL agent to be unwarranted. The Companys liquidity position at
September 29, 2012, includes $31 million related to the unutilized portion of
the ABL. If the unutilized ABL portion was to remain unavailable for an extended
period of time, the Companys liquidity would fall below its stated objective of
$135 million to $150 million. In order to address this risk, the Company is
assessing other liquidity enhancing alternatives such as limiting capital
expenditures and seeking other sources of financing or funding.

The following are the contractual maturities of financial
liabilities, including interest payments:

2012Carrying
    
    
    Contractual
    
    
    Year
    
    
    Years
    
    
    Years
    
    
    Afteramount
    
    
    cash flows
    
    
    1
    
    
    2-3
    
    
    4-5
    
    
    5 yearsSecured bank loans
    $
    336
    
    $
    561
    
    $
    37
    
    $
    79
    
    $
    79
    
    $
    366Unsecured loans
    
    16
    
    
    18
    
    
    7
    
    
    7
    
    
    3
    
    
    1Operating bank loans
    
    68
    
    
    68
    
    
    68
    
    
    
    
    
    
    
    
    Trade and others
    
    243
    
    
    243
    
    
    243
    
    
    
    
    
    
    
    
    $
    663
    
    $
    890
    
    $
    355
    
    $
    86
    
    $
    82
    
    $
    367


It is not expected that the cash flows included in the maturity
analysis could occur significantly earlier, or, excluding the effects of foreign
exchange fluctuations on US dollar liabilities, at significantly different
amounts.

Tembec Financial Report 2012 99

---

Notes to Consolidated Financial Statements

|19. FINANCIAL INSTRUMENTS(CONTINUED)
|------------------------------------

FINANCIAL RISK MANAGEMENT(CONTINUED)

Foreign currency rate risk managementThe Company is
exposed to currency risk on sales, purchases and long-term debt that are
denominated in a currency other than the Canadian dollar. The currencies in
which these transactions are primarily denominated are Canadian dollar, US
dollar and euro.

The Companys revenues for most of its products are affected by
fluctuations in the relative exchange rates of the Canadian dollar, the US
dollar and the euro. The Company generates approximately $1.1 billion of US $
denominated sales annually from its Canadian operations. As a result, any
decrease in the value of the US dollar and the euro relative to the Canadian
dollar reduces the amount of revenues realized on sales in local currency. In
addition, since business units purchase the majority of their production inputs
in local currency, fluctuations in foreign exchange can significantly affect the
units relative cost position when compared to competing manufacturing sites in
other currency jurisdictions.

To reduce the impact of fluctuations in the value of the US
dollar, the Company has adopted a policy, which allows for hedging up to 50% of
its anticipated US $ receipts for up to 36 months in duration. As at September
29, 2012, September 24, 2011 and September 26, 2010, the Company does not hold
any foreign exchange contracts.

Foreign currency rate sensitivity analysisBased on
2013 planned sales volumes and prices, the following table illustrates the
impact of a 1% change in the value of the US dollar versus the Canadian dollar
and the euro. For illustrative purposes, an increase of 1% in the value of the
US dollar is assumed. A decrease would have the opposite effects of those shown
below:

|Sales increase                                     | $ | 11 | 
|-------------------------------------------------- | - | -- | 
|Cost of sales
      increase                       |   | 3  | 
|Adjusted EBITDA                                    |   | 8  | 
|Loss on
      translation of US $ denominated debt |   | 3  | 
|Pre-tax earnings
      increase                    | $ | 5  | 

Direct US $ purchases of raw materials, supplies and services
provided a partial offset to the impact on sales. This does not include the
potential indirect impact of currency on the cost of items purchased in the
local currency. Interest expense on the Companys US $ denominated debt provides
a small offset to its US $ exposure.

Interest rate risk management and sensitivity
analysisInterest rate risk is the risk that the fair value or future
cash flows of a financial instrument will fluctuate because of changes in market
interest rates.

Fluctuations of market interest rates have little impact on the
Companys financial results since the majority of the Companys debts are fixed
rate debts.

100Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|19. FINANCIAL INSTRUMENTS(CONTINUED)
|------------------------------------

FINANCIAL RISK MANAGEMENT(CONTINUED)

Commodity price and operational risk managementThe
Companys financial performance is dependent on the selling prices of its
products. The markets for most lumber, pulp and paper products are cyclical and
are influenced by a variety of factors. These factors include periods of excess
product supply due to industry capacity additions, periods of decreased demand
due to weak general economic activity, inventory de-stocking by customers, and
fluctuations in currency exchange rates. During periods of low prices, the
Company is subject to reduced revenues and margins, resulting in substantial
declines in profitability and possibly net losses. The Company may periodically
purchase lumber, pulp and newsprint price derivative commodity contracts to
mitigate the impact of price volatility. The Company did not hold any
significant product price derivative commodity contracts at September 29, 2012,
September 24, 2011 and September 26, 2010.

The manufacturing activities conducted by the Companys
operations are subject to a number of risks, including availability and price of
fibre and competitive prices for purchased energy and raw materials. To mitigate
the impact of price fluctuations, the Company may periodically purchase
derivative commodity contracts. The Company does not currently hold any
significant derivative commodity contracts.

|20. CAPITAL MANAGEMENT
|----------------------

It is the Companys objective to manage its capital to ensure
adequate capital resources exist to support operations while maintaining its
business growth. The Company sets the amount of capital in proportion to risk.
The Company manages the capital structure and makes adjustments to it in light
of changes in economic conditions and the risk of characteristics of the
underlying assets.

The Company monitors capital on the basis of net debt to total
capitalization ratio. Net debt is calculated as a total debt (long-term debt
plus bank indebtedness and operating bank loans) less cash, cash equivalents and
cash held in trust.

Total capitalization includes net debt plus provisions, accrued
benefit liability, deferred income taxes, other long-term liabilities, and
shareholders equity.

The Companys strategy is to maintain the net debt to total
capitalization ratio at 40% or less. The objective is to keep a strong balance
sheet and maintain the ability of the Company to access capital markets at
favourable rates. The net debt to total capitalization ratio for the Company was
45% as at September 29, 2012 (2011  27%; 2010  28%). The increase was due to
fiscal 2012 losses, which reduced shareholders equity, combined with higher net
debt due primarily to finance the Temiscaming specialty cellulose project. The
Company anticipates that the net debt to total capitalization ratio will remain
in excess of its target until the Temiscaming project is completed and begins to
generate the projected incremental adjusted EBITDA.

There were no changes in the Companys approach to capital
management during fiscal 2012.

Tembec Financial Report 2012 101

---

Notes to Consolidated Financial Statements

|21. RELATED PARTIES
|-------------------

KEY MANAGEMENT PERSONNEL COMPENSATION

The key management personnel of the Company are the members of
the Board of Directors and certain executive officers. They control less than 1%
of the voting shares of the Company.

Key management personnel participate in the Companys long-term
incentive plans (see note 13).

Key management personnel compensation is comprised of the
following for the past two years:

|                                 |   | 2012 |   |   | 2011 | 
|-------------------------------- | - | ---- | - | - | ---- | 
|Short-term compensation benefits | $ | 4    |   | $ | 4    | 
|Share-based
      compensation   |   | (1   | ) |   | 2    | 
|                                 | $ | 3    |   | $ | 6    | 

|22. EXPLANATION OF TRANSITION TO IFRS
|-------------------------------------

The accounting policies set out in note 3 have been applied in
preparing the audited consolidated financial statements for the years ended
September 29, 2012 and September 24, 2011.

In preparing its opening IFRS balance sheet, the Company has
adjusted amounts reported previously in financial statements prepared in
accordance with previous Canadian Generally Accepted Accounting Principles
(GAAP). An explanation of how the transition from previous GAAP to IFRS has
affected the Companys financial position, financial performance and cash flows
is set out in the following tables and the notes that accompany the tables.

In such tables, reclassification has been made to conform to
IAS 1  Presentation of Financial Statements, minimum disclosure
requirements. Additionally, in preparing its consolidated financial statements
in accordance with IFRS 1  First-time Adoption of International Financial
Reporting Standards, the Company applied the mandatory exemptions and
elected to apply the following optional exemptions from full retrospective
application:

EMPLOYEE BENEFITS EXEMPTION

IFRS 1 provides the option to retrospectively apply IAS 19,
Employee Benefits, for the recognition of unamortized actuarial gains and
losses, past service costs and transitional obligations and assets or to
recognize these balances previously deferred under previous Canadian GAAP in
opening retained earnings at the Transition Date. The Company has elected to
recognize all unamortized cumulative actuarial losses and past service costs at
the Transition Date as an adjustment to opening retained earnings for all of its
employee future benefit plans.

FOREIGN CURRENCY TRANSLATION DIFFERENCES

Retrospective application of IFRS would require the Company to
determine cumulative currency translation differences in accordance with IAS 21,
The Effects of Changes in Foreign Exchange Rates, from the date a
subsidiary or equity method investee was formed or acquired. IFRS 1 permits
cumulative translation gains and losses to be reset to zero at the Transition
Date. The Company elected to reset all cumulative translation gains and losses
to zero in opening retained earnings at its Transition Date.

102Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

EVENT DRIVEN FAIR VALUE OF PROPERTY, PLANT AND EQUIPMENT AS
DEEMED COST

IFRS 1 provides the choice of recording assets and liabilities
based on a deemed cost, which can be an event driven valuation where some or all
of the assets and liabilities were valued and recognized at fair value under
previous Canadian GAAP. As a result of the recapitalization transaction that
occurred within the Company in 2008, the Company has elected to apply this
exemption to property, plant and equipment and used such event driven fair value
measurements as deemed cost for IFRS at the date of that measurement.

BUSINESS COMBINATIONS EXEMPTION

IFRS 1 provides the option to apply IFRS 3, Business
Combinations, retrospectively or prospectively - either from the Transition
Date or a particular date prior to the Transition Date. The Company has elected
to apply IFRS 3 prospectively to business combinations that occur after the
Transition Date. Accordingly, business combinations prior to this date have not
been restated.

SHARE-BASED PAYMENT TRANSACTION EXEMPTION

IFRS 1 provides an optional exemption to the application of
IFRS 2, Share-based Payment, for those share options granted subsequent
to November 7, 2002, that have fully vested as at the Transition Date and to
liabilities arising from share-based payment transactions that were settled
before the Transition Date. The Company has elected this exemption.

BORROWING COSTS

IFRS 1 provides the option to apply IAS 23, Borrowing
Costs, retrospectively or prospectively from the Transition Date. IAS 23
requires an entity to capitalize borrowing costs that are directly attributable
to the acquisition, construction or production of a qualifying asset as part of
the cost of that asset. A qualifying asset is an asset that necessarily takes a
substantial period of time to get ready for its intended use or sale. The
Company elected to apply this exemption prospectively in respect of qualifying
assets for which the commencement date for capitalization was on or after the
Transition Date.

Tembec Financial Report 2012 103

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

RECONCILIATION OF CONSOLIDATED BALANCE SHEETS

September 26, 2010PreviousCanadian
    
    
    Reclassi-
    
    
    transitionNote
    
    
    GAAP
    
    
    fication
    
    
    to IFRS
    
    
    IFRSASSETSCurrent assets:Cash and cash equivalents
    
    
    
    $
    68
    
    $
    
    
    $
    
    
    $
    68Cash held in trust
    
    
    
    
    6
    
    
    
    
    
    
    
    
    6Trade and other receivables
    
    
    
    
    209
    
    
    
    
    
    
    
    
    209Inventories
    
    
    
    
    255
    
    
    
    
    
    
    
    
    255Prepaid
      expenses
    
    
    
    
    7
    
    
    
    
    
    
    
    
    7545
    
    
    
    
    
    
    
    
    545Property, plant and equipment
    
    (b)(c)(d)
    
    
    498
    
    
    
    
    
    (2
    )
    
    496Biological assets
    
    (a)
    
    
    
    
    
    
    
    
    7
    
    
    7Employee future benefits
    
    (e)
    
    
    
    
    
    6
    
    
    (6
    )
    
    Other long-term receivables
    
    
    
    
    
    
    
    28
    
    
    
    
    
    28Other assets
    
    
    
    
    34
    
    
    (34
    )
    
    
    
    
    Deferred tax
      assets
    
    
    
    
    27
    
    
    
    
    
    
    
    
    27$
    1,104
    
    $
    
    
    $
    (1
    )
    $
    1,103LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Operating bank loans
    
    
    
    $
    1
    
    $
    
    
    $
    
    
    $
    1Trade, other payables and accrued charges
    
    (g)
    
    
    238
    
    
    (5
    )
    
    
    
    
    233Interest payable
    
    
    
    
    3
    
    
    
    
    
    
    
    
    3Income tax payable
    
    
    
    
    
    
    
    
    
    
    
    
    
    Provisions
    
    (g)
    
    
    
    
    
    5
    
    
    
    
    
    5Current
      portion of long-term debt
    
    
    
    
    17
    
    
    
    
    
    
    
    
    17259
    
    
    
    
    
    
    
    
    259Long-term debt
    
    
    
    
    271
    
    
    
    
    
    
    
    
    271Provisions
    
    (g)
    
    
    
    
    
    19
    
    
    (2
    )
    
    17Employee future benefits
    
    (e)
    
    
    
    
    
    187
    
    
    61
    
    
    248Other long-term
      liabilities
    
    (e)(f)(g)
    
    
    209
    
    
    (206
    )
    
    5
    
    
    8739
    
    
    
    
    
    64
    
    
    803Shareholders equity:Share capital
    
    (f)
    
    
    570
    
    
    
    
    
    (6
    )
    
    564Contributed surplus
    
    (h)
    
    
    5
    
    
    
    
    
    (5
    )
    
    Deficit
    
    
    
    
    (210
    )
    
    
    
    
    (54
    )
    
    (264
    )Accumulated
      other comprehensive earnings (loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    365
    
    
    
    
    
    (65
    )
    
    300$
    1,104
    
    $
    
    
    $
    (1
    )
    $
    1,103


104Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

RECONCILIATION OF CONSOLIDATED BALANCE SHEETS
(CONTINUED)

September 24, 2011PreviousCanadian
    
    
    Reclassi-
    
    
    transitionNote
    
    
    GAAP
    
    
    fication
    
    
    to IFRS
    
    
    IFRSASSETSCurrent assets:Cash and cash equivalents
    
    
    
    $
    99
    
    $
    
    
    $
    
    
    $
    99Cash held in trust
    
    
    
    
    6
    
    
    
    
    
    
    
    
    6Trade and other receivables
    
    
    
    
    182
    
    
    
    
    
    
    
    
    182Inventories
    
    
    
    
    261
    
    
    
    
    
    
    
    
    261Prepaid
      expenses
    
    
    
    
    6
    
    
    
    
    
    
    
    
    6554
    
    
    
    
    
    
    
    
    554Property, plant and equipment
    
    (b)(c)(d)
    
    
    493
    
    
    
    
    
    (2
    )
    
    491Biological assets
    
    (a)
    
    
    
    
    
    
    
    
    4
    
    
    4Employee future benefits
    
    (e)
    
    
    
    
    
    16
    
    
    (15
    )
    
    1Other long-term receivables
    
    
    
    
    
    
    
    28
    
    
    
    
    
    28Other assets
    
    
    
    
    44
    
    
    (44
    )
    
    
    
    
    Deferred tax
      assets
    
    (e)
    
    
    16
    
    
    
    
    
    (1
    )
    
    15$
    1,107
    
    $
    
    
    $
    (14
    )
    $
    1,093LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Operating bank loans
    
    
    
    $
    6
    
    $
    
    
    $
    
    
    $
    6Trade, other payables and accrued charges
    
    (g)
    
    
    248
    
    
    (8
    )
    
    
    
    
    240Interest payable
    
    
    
    
    8
    
    
    
    
    
    
    
    
    8Income tax payable
    
    
    
    
    6
    
    
    
    
    
    
    
    
    6Provisions
    
    (g)
    
    
    
    
    
    8
    
    
    
    
    
    8Current
      portion of long-term debt
    
    
    
    
    18
    
    
    
    
    
    
    
    
    18286
    
    
    
    
    
    
    
    
    286Long-term debt
    
    
    
    
    271
    
    
    
    
    
    
    
    
    271Provisions
    
    (g)
    
    
    
    
    
    18
    
    
    (2
    )
    
    16Employee future benefits
    
    (e)
    
    
    
    
    
    168
    
    
    117
    
    
    285Other long-term
      liabilities
    
    (e)(f)(g)
    
    
    188
    
    
    (186
    )
    
    
    
    
    2745
    
    
    
    
    
    115
    
    
    860Shareholders equity:Share capital
    
    (f)
    
    
    570
    
    
    
    
    
    (6
    )
    
    564Contributed surplus
    
    (h)
    
    
    5
    
    
    
    
    
    (5
    )
    
    Deficit
    
    
    
    
    (213
    )
    
    
    
    
    (120
    )
    
    (333
    )Accumulated
      other comprehensive earnings (loss)
    
    (c)
    
    
    
    
    
    
    
    
    2
    
    
    2362
    
    
    
    
    
    (129
    )
    
    233$
    1,107
    
    $
    
    
    $
    (14
    )
    $
    1,093


Tembec Financial Report 2012 105

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

RECONCILIATION OF CONSOLIDATED STATEMENTS OF COMPREHENSIVE
EARNINGS (LOSS)

|                                                                |  | September 24, 2011 | 
|--------------------------------------------------------------- |  | ------------------ | 
|                                                                |  |                    | 
|                                                                |  |                    | 
|                                                                |  | Note               | 
|Sales                                                           |  |                    | 
|Freight and sales deductions                                    |  |                    | 
|Lumber export taxes                                             |  |                    | 
|Cost of sales (excluding depreciation and amortization)         |  | (a)(b)(e)          | 
|Selling, general and administrative                             |  |                    | 
|Share-based compensation                                        |  |                    | 
|Depreciation and amortization                                   |  | (b)                | 
|Other items                                                     |  | (e)                | 
|Operating earnings
      (loss)                                 |  |                    | 
|Interest, foreign exchange and other                            |  | (c)(d)(e)(f)(g)    | 
|Exchange loss on
      long-term debt                           |  | (c)                | 
|Net finance costs                                               |  |                    | 
|Earnings (loss) before income taxes                             |  |                    | 
|Income tax expense                                              |  | (e)                | 
|Net loss                                                        |  |                    | 
|Other comprehensive earnings (loss), net of income taxes:       |  |                    | 
|Defined benefit pension plans                                   |  | (e)                | 
|Other benefit plans                                             |  |                    | 
|Foreign currency translation differences for foreign operations |  | (c)                | 
|Total
      comprehensive loss                                  |  |                    | 
|Basic and diluted
      net loss in dollars per share           |  |                    | 

106Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

NOTES TO THE RECONCILIATION OF EQUITY AND STATEMENT OF
COMPREHENSIVE EARNINGS (LOSS)

|(a) | Biological assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | In accordance with IAS 41, Agriculture, the
      Companys standing timber on its private timberlands is considered to be a
      biological asset that is measured at fair value less costs to sell at each
      reporting date, with changes in fair value less costs to sell recognized
      in net earnings (loss) at each period. As a result of this IFRS guidance,
      the Companys standing timber on its private timberlands has been
      separately identified on the consolidated balance sheet as biological
      assets and recorded at fair value less costs to sell.                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    | The effect of the above on the Companys balance sheet
      resulted in an increase in biological assets of $4 million at September
      24, 2011 (September 26, 2010 - $7 million), and resulted in a decrease of
      the deficit of $4 million (September 26, 2010 - $7 million).                                                                                                                                                                                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    | The impact on total comprehensive loss for the year ended
      September 24, 2011, increased by $3 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|(b) | Component accounting                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    | Under previous Canadian GAAP, the Company did not apply
      component accounting to the significant separable component parts of an
      item of property, plant and equipment since no guidance was provided on
      evaluating the cost of a component, replacement of a component and the
      level at which component accounting was required. Under IFRS, the major
      assets must be separated into components and the cost of replacement or
      overhaul of these components are considered to be a part of property,
      plant and equipment, and are amortized over their individual estimated
      useful lives.                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    | The effect of the above on the Companys balance sheet
      resulted in an increase in property, plant and equipment of $6 million at
      September 24, 2011 (September 26, 2010 - $6 million), and resulted in a
      decrease of the deficit of $6 million (September 26, 2010 - $6
      million).                                                                                                                                                                                                                                                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|    | The impact on total comprehensive loss for the year ended
      September 24, 2011, was negligible.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|(c) | Translation of foreign operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | Under previous Canadian GAAP, non-monetary assets and
      liabilities of the foreign operations were translated to Canadian dollars
      at the historical rate relevant to the particular transaction date at
      which such assets or liabilities were originated. Under IFRS, all assets
      and liabilities of the foreign operations with functional currencies other
      than the Canadian dollar are translated to Canadian dollar at the exchange
      rate prevailing at period-end and are recognized in other comprehensive
      loss. In accordance with IFRS 1, the Company elected to reset all
      cumulative translation gains and losses to zero in opening deficit at its
      Transition Date.

Tembec Financial Report 2012 107

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

NOTES TO THE RECONCILIATION OF EQUITY AND STATEMENT OF
COMPREHENSIVE EARNINGS (LOSS)(CONTINUED)

|(c) | Translation of foreign operations(continued)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | The effect of the above on the Companys balance sheet
      resulted in a decrease in property, plant and equipment of $7 million at
      September 24, 2011 (September 26, 2010 - $7 million), and resulted in an
      increase of the deficit of $9 million (September 26, 2010 - $7 million)
      and an increase of accumulated other comprehensive earnings of $2 million
      (September 26, 2010 - nil).                                                                                                                                                                                                         
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The impact on total comprehensive loss for the year ended
      September 24, 2011, decreased by $2 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|(d) | Site restoration                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|    | Under previous Canadian GAAP, the cost of decommissioning
      and restoration of landfill sites were part of property, plant and
      equipment and depreciated over the estimated useful life of the landfill
      site. Under IFRS, decommissioning and restoration costs incurred through
      the production of inventory are included as part of inventory
  costs.                                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The effect of the above on the Companys balance sheet
      resulted in a decrease in property, plant and equipment of $1 million at
      September 24, 2011 (September 26, 2010 - $1 million), and resulted in an
      increase of the deficit of $1 million (September 26, 2010 - $1
      million).                                                                                                                                                                                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | For the year ended September 24, 2011, the impact on
      total comprehensive loss was negligible.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|(e) | Recognition of unamortized actuarial losses at date of
      transition to IFRS into equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|    | As permitted by previous Canadian GAAP, the Company
      measured its employee future benefits obligation for accounting purposes
      as at June 30 of each fiscal year. This was often referred as the early
      measurement date accounting policy choice. Under IAS 19 - Employee
      Benefits, the measurement date of the employee future benefits
      obligation must coincide with the fiscal year-end of the Company.
      Therefore, upon transition to IFRS, the Company measured its employee
      future benefits obligation at the date of the opening balance sheet in
      accordance with IAS 19.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | In addition, as permitted by IFRS 1 - First-time
      Adoption of International Financial Reporting Standards, management
      elected the optional exemption to recognize all unamortized cumulative
      actuarial losses at the Transition Date as an adjustment to opening
      retained earnings for all of its employee future benefit plans.                                                                                                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | Under IFRS, the Companys accounting policy is to
      recognize all actuarial gains and losses, arising on its defined benefit
      pension and other non-pension post retirement plans, immediately in other
      comprehensive earnings (loss).                                                                                                                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The cumulative effect of the above on the Companys
      balance sheet was to decrease employee future benefits assets by $15
      million at September 24, 2011 (September 26, 2010 - $6 million), and
      increase the employee future benefits liabilities by $117 million
      (September 26, 2010 - $61 million), which resulted in a corresponding
      increase to deficit of $132 million (September 26, 2010 - $67
    million).                                                                                                                                                                              
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | The impact on total comprehensive loss for the year ended
      September 24, 2011 increased by $65 million.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

108Tembec Financial Report 2012

---

Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

NOTES TO THE RECONCILIATION OF EQUITY AND STATEMENT OF
COMPREHENSIVE EARNINGS (LOSS)(CONTINUED)

|(f) | Warrants                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | Under IFRS, the warrants have been classified as a
      liability because of the possibility that they may be settled in cash in
      the event of a change of control. They are recorded at fair value with
      value being adjusted every quarter.                                                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | The effect of the above on the Companys balance sheet
      resulted in a decrease in share capital of $6 million at September 24,
      2011 (September 26, 2010 - $6 million), and resulted in an increase of the
      other long-term liabilities by a negligible amount (September 26, 2010 -
      $5 million), and a decrease of the deficit of $6 million (September 26,
      2010 - $1 million).                                                                                                             
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | Total comprehensive loss decreased by $5 million for the
      year ended September 24, 2011.                                                                                                                                                                                                                                                                                                                                                                                                                           
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|(g) | Provisions                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|    | IAS 37  Provisions, Contingent Liabilities and
      Contingent Assets, has measurement differences when compared to
      previous Canadian GAAP. These measurement differences include the
      requirement to reflect the risks associated with the Companys provisions
      in either the cash flows or the discount rate.                                                                                                                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | The effect of the above on the Companys balance sheet
      resulted in a decrease in long-term provisions of $2 million at September
      24, 2011 (September 26, 2010 - $2 million), and resulted in a decrease of
      the deficit of $2 million (September 26, 2010 - $2 million).                                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | For the year ended September 24, 2011, the impact on
      total comprehensive loss was negligible.                                                                                                                                                                                                                                                                                                                                                                                                                     
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|(h) | Contributed surplus                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|    | The previous Canadian GAAP requires that a future income
      tax asset that was not recognized at the date of a comprehensive
      revaluation as a result of a financial reorganization be subsequently
      recognized first as a reduction of any unamortized intangible asset and
      then in a manner consistent with the revaluation adjustment recorded at
      the date of the comprehensive revaluation. Under IFRS, this recognition of
      a future income tax asset is recorded to profit and loss.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | The effect of the above on the Companys balance sheet
      resulted in a decrease in contributed surplus of $5 million at September
      24, 2011 (September 26, 2010 - $5 million), and resulted in a decrease of
      the deficit of $5 million (September 26, 2010 - $5 million).                                                                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|    | For the year ended September 24, 2011, the impact on
      total comprehensive loss was nil.                                                                                                                                                                                                                                                                                                                                                                                                                            

Tembec Financial Report 2012 109

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Notes to Consolidated Financial Statements

|22. EXPLANATION OF TRANSITION TO IFRS(CONTINUED)
|------------------------------------------------

EXPLANATION OF MATERIAL ADJUSTMENTS TO THE CASH FLOW
STATEMENTS FOR FISCAL 2011

The adoption of IFRS has had no impact on the net cash flows of
the Company. The changes made to the consolidated balance sheet and to the
consolidated statements of net earnings (loss) have resulted in
reclassifications of various amounts on the consolidated statements of cash
flows. There have been no significant changes to the net cash flows, other than
the Companys accounting policy choice to classify interest paid as financing
activity under IFRS compared to operating activity under previous Canadian
GAAP.

|                                   |   | September 24, 2011 | 
|---------------------------------- | - | ------------------ | 
|                                   |   | Cash flow from     | 
|                                   |   | operating          | 
|                                   |   | activities         | 
|Previous Canadian GAAP             | $ | 69                 | 
|Reclassification for interest paid |   | 25                 | 
|Other                              |   | 5                  | 
|IFRS                               | $ | 99                 | 

110Tembec Financial Report 2012

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|DIRECTORS                                                | OFFICERS                                               
|-------------------------------------------------------- | -------------------------------------------------------
|                                                         |                                                        
|JAMES V. CONTINENZA(1) (4)                               | JAMES V. CONTINENZA                                    
|Chairman of the Board, Tembec Inc.                       | Chairman of the Board                                  
|                                                         |                                                        
|JAMES M. LOPEZ(3) (4)                                    | JAMES M. LOPEZ                                         
|President and Chief Executive Officer, Tembec
      Inc. | President and Chief Executive
      Officer            
|                                                         |                                                        
|NORMAN M. BETTS(2)                                       | RÉGINALD BASTIEN                                       
|Associate Professor, Faculty of
      Administration,    | Corporate Controller                                   
|University of New Brunswick                              |                                                        
|                                                         | CHRIS BLACK                                            
|JAMES E. BRUMM(1)                                        | Executive Vice President,                              
|Company Director                                         | President, Paper and Paper Pulp
      Group            
|                                                         |                                                        
|JAMES N. CHAPMAN(1) (4)                                  | MICHEL J. DUMAS                                        
|Company Director                                         | Executive Vice President, Finance                      
|                                                         | and Chief Financial Officer                            
|MICHEL J. DUMAS(3)                                       |                                                        
|Executive Vice President, Finance                        | PATRICK LEBEL                                          
|and Chief Financial Officer                              | Vice President,                                        
|                                                         | General Counsel and Corporate
      Secretary          
|JACQUES LEDUC(2)                                         |                                                        
|Company Director                                         | STEPHEN J. NORRIS                                      
|                                                         | Treasurer                                              
|PIERRE LORTIE(3)                                         |                                                        
|Company Director                                         | YVON PELLETIER                                         
|                                                         | Executive Vice President,                              
|FRANCIS M. SCRICCO(1)                                    | President, Specialty Cellulose
      and Chemical Group
|Company Director                                         |                                                        
|                                                         | DENNIS ROUNSVILLE                                      
|DAVID J. STEUART(3)                                      | Executive Vice President,                              
|Company Director                                         | President, Forest Products Group                       
|                                                         |                                                        
|LORIE WAISBERG(2)                                        |                                                        
|Company Director                                         |                                                        

(1) Member of the Corporate Governance and Human Resources
Committee (2) Member of the Audit Committee (3) Member of the
Environment, Health and Safety Committee (4) Member of the Special Committee
for Strategic Purposes

Tembec Financial Report 2012 111

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SHAREHOLDER INFORMATION

|STOCK EXCHANGE LISTING                                                                                                                                        | ADDITIONAL INFORMATION MAY BE OBTAINED FROM                                                                                                                         
|------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The common shares of Tembec Inc. are listed on the Toronto                                                                                                    | Tembec Inc.                                                                                                                                                         
|Stock Exchange under the symbol TMB.                                                                                                                          | Communications and Public Affairs Department                                                                                                                        
|                                                                                                                                                              | 10 Gatineau Road                                                                                                                                                    
|NUMBER OF SHARES                                                                                                                                              | P.O. Box 5000                                                                                                                                                       
|As at September 29, 2012, there were 100,000,000 Tembec                                                                                                       | Temiscaming, Quebec J0Z 3R0                                                                                                                                         
|common shares outstanding.                                                                                                                                    | Canada                                                                                                                                                              
|                                                                                                                                                              | Tel.: 819 627-4387                                                                                                                                                  
|TRANSFER AGENT AND REGISTRAR                                                                                                                                  | Fax: 819 627-1178                                                                                                                                                   
|Our transfer agent, Computershare Trust Company of Canada,                                                                                                    |                                                                                                                                                                     
|can assist you with a variety of shareholder related
      services,                                                                                          | Tembec files all mandatory information with
      Canadian securities                                                                                               
|including changes of address and lost share certificates.                                                                                                     | regulatory authorities and this information is
      available from                                                                                                 
|                                                                                                                                                              | Tembec upon request.                                                                                                                                                
|Computershare Trust Company of Canada                                                                                                                         |                                                                                                                                                                     
|Customer Service                                                                                                                                              | HEAD OFFICE                                                                                                                                                         
|1500 University Street                                                                                                                                        | Tembec Inc.                                                                                                                                                         
|Suite 700                                                                                                                                                     | 800 René-Lévesque Blvd West                                                                                                                                         
|Montreal, Quebec H3A 3S8                                                                                                                                      | Suite 1050                                                                                                                                                          
|Canada                                                                                                                                                        | Montreal, Quebec H3B 1X9                                                                                                                                            
|Tel.: 1 800 564-6253                                                                                                                                          | Canada                                                                                                                                                              
|                                                                                                                                                              | Tel.: 514 871-0137                                                                                                                                                  
|ANNUAL GENERAL MEETING                                                                                                                                        | Fax: 514 397-0896                                                                                                                                                   
|The Annual General Meeting of Shareholders of Tembec Inc.
      will                                                                                          | tembec.com                                                                                                                                                          
|be held on Thursday, January 31, 2013, at 11:00 a.m.,
      Eastern                                                                                           |                                                                                                                                                                     
|time, at:                                                                                                                                                     | CORPORATE OFFICE                                                                                                                                                    
|                                                                                                                                                              | Tembec Inc.                                                                                                                                                         
|Fairmont The Queen Elizabeth                                                                                                                                  | 10 Gatineau Road                                                                                                                                                    
|Duluth Room                                                                                                                                                   | P.O. Box 5000                                                                                                                                                       
|900 René-Lévesque Blvd West                                                                                                                                   | Temiscaming, Quebec J0Z 3R0                                                                                                                                         
|Montreal, Quebec H3B 4A5                                                                                                                                      | Canada                                                                                                                                                              
|Canada                                                                                                                                                        | Tel.: 819 627-4387                                                                                                                                                  
|Tel.: 514 861-3511                                                                                                                                            | Fax: 819 627-1178                                                                                                                                                   
|                                                                                                                                                              | tembec.com                                                                                                                                                          
|An archived version of the webcast of the Annual General
      Meeting of Shareholders will be available on Tembecs website after the
      Meeting.         |                                                                                                                                                                     
|                                                                                                                                                              |                                                                                                                                                                     
|                                                                                                                                                              |                                                                                                                                                                     
|Additional copies of the following documents and other
      information can also be obtained at the above address or on Tembecs and
      SEDARs websites. | Pour obtenir un exemplaire de la version
      française du rapport financier, veuillez vous adresser au Service des
      communications et des affaires publiques.
|2012 Financial Report                                                                                                                                         |                                                                                                                                                                     
|Quarterly Reports                                                                                                                                             |                                                                                                                                                                     
|Management Information Circular                                                                                                                               |                                                                                                                                                                     
|Annual Information Form                                                                                                                                       |                                                                                                                                                                     

112Tembec Financial Report 2012

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