Sears Canada Inc. v. The Queen, 86 DTC 6304, [1986] 2 CTC 80 (FCTD), aff'd 89 DTC 5039 (FCA)

McNair, J.:—This is an appeal by the plaintiff from the Minister's reassessments with respect to the 1976, 1977 and 1978 taxation years whereby portions of reserves claimed by the plaintiff were disallowed and added back into income. Three statements of claim were filed, one for each of the taxation years in issue, and three statements of defence were entered in answer thereto. An order was made at the commencement of trial, pursuant to agreement of counsel, that the three cases be heard and tried together based on common evidence.

The plaintiff is a retailer who sells, inter alia, appliances bearing its trade name. The performance and components of these appliances are warranted for a specified period of time, usually 12 months, by the plaintiffs product warranty.

The plaintiff also offers for sale to owners of its appliances 12-month Simpsons-Sears Maintenance Agreements. The purchaser of a maintenance agreement prepays the entire purchase price which is determined by assessing, on a Class basis, overall operating expenses, competitive factors, and the age and complexity of the product.

If a maintenance agreement and an appliance are purchased at the same time, the agreement will expire 12 months after the product warranty does. If the purchaser terminates the agreement while the product warranty is still in effect, the entire purchase price of the agreement is refunded. If it is terminated after the product warranty has expired, that portion of the purchase price which corresponds to the number of unexpired months remaining in the agreement will be refunded. The maintenance agreements are assignable to subsequent purchasers of the appliances covered thereby.

The difference in the coverage provided by the plaintiffs product warranties and by its maintenance agreements is that the former cover only defects which develop in products within a certain time after they are sold, whereas the latter provide coverage for non-failure service as well as service and parts for the extended life of the appliances. Under its maintenance agreement, the plaintiff agrees to make all repairs necessitated by normal wear and tear to the appliance. With respect to indemnification for the loss of frozen foods, the plaintiffs warranty on new freezers provides for a maximum cumulative indemnification of $200 during the first five years of ownership. There is no corresponding warranty provision with respect to food loss resulting from the failure of refrigerators. However, purchasers of maintenance agreements will be indemnified for the loss of foods resulting from the failure of a refrigerator or freezer up to a maximum of $100 per claim.

While preventive maintenance is available under the maintenance agreement, there is no predetermined maintenance schedule except with respect to air conditioners. The maintenance agreement for air conditioners provides that before the beginning of the “normal cooling season”, the plaintiff will inspect the machines and make certain adjustments to them.

In its tax returns for each of the taxation years in question, the plaintiff added into income the amount it had received in maintenance agreement prepayments, less the amount refunded to those who terminated their agreements during the year. It also deducted in each of those years, as a reserve for accrued liability, a rounded-off amount representing the unexpired portion of the purchase price of maintenance agreements in force at the year end. The reserves claimed for the 1976, 1977 and 1978 taxation years were $2,650,000, $3,600,000 and $5,500,000, respectively. No reserves were claimed with respect to outstanding product warranties.

In its accounting entries each year, the plaintiff in effect added into income the amount which it had deducted at the end of the previous taxation year as a reserve in respect of goods or services it reasonably anticipated it would have to deliver or render after the end of that taxation year, and deducted from income a new reserve in respect of goods or services it reasonably anticipated would have to be delivered or rendered after the end of the new taxation year. However, the actual accounting entries made were in an abbreviated form. Rather than adding the previous year’s reserve into income and deducting the current year's reserve, one entry was made, namely, the deduction from income of the difference between the previous and current years’ reserves.

By notices of reassessment dated October 2, 1978, June 12, 1981 and February 2, 1982, the Minister reassessed the plaintiff's taxable income for the 1976, 1977 and 1978 taxation years by disallowing $2,473,000 of the $2,650,000, $3,518,000 of the $3,600,000 and $5,374,000 of the $5,500,000 reserves claimed in the respective years. The amounts allowed as reserves represented the plaintiff's obligation to provide preventive maintenance for air conditioners. The Minister further deducted $2,473,000 from the plaintiff's taxable income for the 1977 taxation year, and $3,518,000 for the 1978 taxation year. It is these reassessments that the plaintiff now appeals.

The principal issue is whether the plaintiff is entitled to deduct reserves pursuant to paragraph 20(1)(m) of the Income Tax Act. This in turn poses three corollary issues: (1) whether such reserves are contingent in nature; (2) if they are contingent, whether their deduction is prohibited by paragraph 18(1 )(e); and, (3) whether they are prohibited reserves in respect of guarantees, indemnities or warranties within the meaning of paragraph 20(7)(a).

The relevant provisions of the Income Tax Act are paragraphs 12(1)(a), 12(1)(e), 18(1)(e), 20(1)(m), and 20(7)(a) which read:

s.12(1). There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(a) any amount received by the taxpayer in the year in the course of a business

(i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, or

(ii) under an arrangement or understanding that it is repayable in whole or in part on the return or resale to the taxpayer of articles in or by means of which goods were delivered to a customer;

(e) any amount

(i) deducted under paragraph 20(1)(m) (including any amount substituted by virtue of subsection 20(6) for any amount deducted under that paragraph) or subsection 20(7), or

(ii) deducted under paragraph 20(1)(n),

in computing the taxpayer’s income from a business for the immediately preceding year;

s.18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(e) an amount transferred or credited to a reserve, contingent account or sinking fund except as expressly permitted by this Part;

s.20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably regarded as applicable thereto:

(m) subject to subsection (6), where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer’s income from a business for the year or a previous year, a reasonable amount as a reserve in respect of [or]

(i) goods that it is reasonably anticipated will have to be delivered after the end of the year,

(ii) services that it is reasonably anticipated will have to be rendered after the end of the year

(7) Paragraph (1)(m) does not apply to allow a deduction

(a) as a reserve in respect of guarantees, indemnities or warranties

At trial, the parties were agreed that the money received by the plaintiff from the sale of the maintenance agreements was required by paragraph 12(1)(a) to be brought into income in the year in which it was received. The dispute was over the deductibility of a paragraph 20(1)(m) reserve.

The plaintiff’s argument may be reduced to the following propositions. The reserves claimed are reserves in respect of goods or services reasonably expected to be delivered or rendered after the end of each taxation year in question. As such, they are deductions expressly permitted by paragraph 20(1)(m) and, therefore, paragraph 18(1)(e) is not applicable. However, even if that paragraph were applicable, it would not prohibit the deduction of these reserves because they are not contingent. There are no contingencies involved because sales of maintenance agreements, once completed, are certain, and because the reserves claimed are precisely calculated mathematical reserves of revenue for the unexpired portions of the maintenance agreements. Furthermore, because the maintenance agreements are service contracts and cannot be classified as guarantees, indemnities or warranties, paragraph 20(7)(a) does not operate to disallow the deduction of these reserves.

Counsel for the defendant agrees that the reserves claimed are reserves in respect of goods or services reasonably expected to be delivered or rendered after the end of each of the taxation years in question. However, counsel argued that for such reserves to be deductible pursuant to paragraph 20(1)(m), it must be shown that they are not contingent within the meaning of paragraph 18(1)(e).

The defendant's position is that the reserves claimed by the plaintiff are contingent, except for those relating to the maintenance of air conditioners. At the end of each of the taxation years in question there was uncertainty whether the plaintiff would be called upon to fulfil its obligation to repair under any particular maintenance agreement. Furthermore, there was no predetermined maintenance schedule except with respect to air conditioners. Although the plaintiff knew from experience that it would be called upon to make repairs and to provide maintenance under some of its maintenance agreements, the actual extent thereof could not be known until all of the calls from holders of the maintenance agreements had been received and answered. The defendant’s position is that the reserves are therefore contingent and their deduction is prohibited by paragraph 18(1)(e) of the Act.

Counsel for the defendant pressed the alternative submission that even if the deduction of the reserves is not prohibited by paragraph 18(1)(e), it is nevertheless prohibited by subsection 20(7). She argued that because the purpose of maintenance agreements is to protect their purchasers from maintenance or repair costs, they are guarantees, indemnities or warranties within the meaning of that subsection and their deduction as reserves is prohibited.

Mr. A. P. Dilworth, a highly qualified chartered accountant, was called by the plaintiff as an expert on generally accepted accounting principles in so far as these pertain to the plaintiff's treatment of its maintenance agreements for accounting purposes. In his Report, Mr. Dilworth referred to section 3290 of the CICA Handbook with respect to the definition of “contingency", and concluded as follows:

While the definition is not as clear as for reserves, the definition of contingency would imply that there must be a related future event whose occurrence is uncertain and which is not of a normal or recurring nature in the business of the enterprise. These criteria do not apply to the Sears’ MA sales. The sale event is certain and the unearned portion is totally related to the passage of the contract. The only uncertainty is the extent and cost of service that must be supplied by the corporation, a common situation in accounting for transactions which require the use of estimates. However, use of estimates does not mean they are “contingencies”.

On the basis of the authoritative literature, it is my opinion that the unearned revenue of Sears for MA contracts is neither a reserve nor a contingency and is properly classified as an accrued liability.

The first issue is accrued liability or contingent account and the case of Harlequin Enterprises Ltd. v. The Queen, [1974] C.T.C. 838; 74 D.T.C. 6634 (F.C.T.D.); [1977] C.T.C. 208; 77 D.T.C. 5164 (F.C.A.), is helpful in determining the outcome.

The taxpayer was a publisher who marketed its books in Canada and the United States under distributorship agreements. The agreements provided for rebates to the Canadian distributor and refunds of royalties to the American distributor on the return of unsold books. In computing its income for the taxation year in question, the taxpayer deducted amounts as credit reserves for refunds and rebates with respect to unsold books. The Minister disallowed these deductions and the taxpayer appealed, contending, inter alia, that the amounts were current liabilities and as such were deductible. The appeals were dismissed in both courts on the ground that the amounts set aside were contingent accounts and were not deductible by virtue of paragraph 12(1)(e), the predecessor of the present paragraph 18(1)(e) of the Act.

At trial, Mahoney, J., concluded that the taxpayer's liability under the distributorship agreements was contingent. He stated at 849 (D.T.C. 6642):

Certain as it was that the plaintiff would, in due course, be obliged to give rebates on royalties or on returns of books, the fact is the plaintiffs liability to do so, under the terms of the agreements which were, in practice, observed, did not arise until the plaintiff was presented with a demand for the credit. The plaintiffs obligation to the distributors in respect of credits for returns was a contingent liability. So was its obligation to rebate royalties to Simon & Shuster. An account set up to provide for those contingent liabilities whether by way of a provision for returns and allowances on its balance sheet or a deduction from earnings in the calculation of its taxable income was a contingent account within the meaning of paragraph 12(1)(e). No deduction in respect of that account, even to the extent that generally accepted accounting principles required it to be set up, is permitted in the calculation of the plaintiff’s taxable income.

On appeal, Urie, J., per curiam, specifically approved the conclusion and the reasoning of the trial judge, and stated at 212-13 (D.T.C. 5166):

. . . I agree that the provision for returns is contingent, because in any fiscal period, although it was known from experience that there would be returns, the number and actual value thereof could not be fully known until all returns on sales made within that fiscal period had actually been received which might not be until some considerable period of time had elapsed after the end of the fiscal period. Therefore, the provision falls within the prohibition contained in paragraph 12(1)(e).

In Cummings v. The Queen, [1981] C.T.C. 285; 81 D.T.C. 5207 (F.C.A.) the court disallowed a lease pick-up amount of $500,000 as a contingent liability prohibited by paragraph 12(1)(e) of the Act. The amount had been shown on the taxpayer's balance sheet as a fixed liability and there was expert evidence to the effect that this was in accordance with generally accepted accounting principles.

Heald, J., dealt with this at 294 (D.T.C. 5214):

. . . The answer to this submission is that the fact of the acceptability in accounting practice dealing with a particular item in a particular manner, cannot, by itself, make that practice a proper deduction for income tax purposes. Notwithstanding the evidence of accounting practice, the fact remains that, on the facts here present, the deduction is prohibited by paragraph 12(1)(e) of the Act. . . .

On the basis of these decisions, I am compelled to conclude in the present case that the deductions claimed by the taxpayer are in fact contingent. While it was certain that the plaintiff would be called upon to deliver goods and render services to its maintenance agreement customers, the obligation to do so did not arise until it was contacted by those customers. It follows that the liability under the maintenance agreements was therefore contingent in nature. I further find that because the actual amount of the plaintiffs liability under the maintenance agreements was unascertained and unascer- tainable at the end of each of the taxation years in question, the amounts sought to be deducted in respect thereof are necessarily uncertain and contingent.

Counsel for the plaintiff submitted that the Supreme Court of Canada decision in Time Motors Ltd. v. M.N.R., [1969] C.T.C. 190; 69 D.T.C. 5149 requires that I reach a different result. I disagree. In my view, the case is readily distinguishable from the case at bar in that the deductions claimed there were with respect to existing and ascertained current liability. Mr. Justice Urie noted the distinction in the Harlequin case, supra.

In my opinion the plaintiffs argument that the reserves are not contingent because they are precisely calculated mathematical reserves of revenue for the unexpired portion of the maintenance agreements must also fail: In reaching this conclusion I adopt the reasoning of Mahoney, J., in Harlequin, where he stated at 848 (D.T.C. 6641):

The adjective “contingent” means “‘liable to happen or not; of uncertain occurrence or incidence” (The Oxford English Dictionary). The term “contingent account” taken literally would appear to be nonsense. An account, once set up is itself not contingent; it has, so to speak, happened and is not uncertain. It exists. The term must be taken to mean “account for a contingency”. In other words, it is not the account that must be found to be contingent but rather the thing in respect of which it was set up: in this case the liability to pay or give credit for the refunds and rebates.

[Emphasis added.]

The “thing” in respect of which the reserve was set up by Sears Canada Inc. was the liability to repair and maintain appliances pursuant to its maintenance agreements. While a mathematical formula was utilized to calculate the amounts claimed as reserves, the plaintiff’s liability to repair and maintain and the costs incurred in connection therewith have all the earmarks of contingency.

Does the finding of fact that the reserves are contingent automatically preclude their deduction, without more? In my opinion, it does not because to rule otherwise would be to totally ignore the statutory scheme contemplated by paragraphs 12(1)(a) and (e), paragraph 20(1)(m) and paragraph 20(7)(a) of the Income Tax Act, having regard to the exception provided by the words “except as expressly permitted by this Part” in paragraph 18(1 )(e). The plaintiffs position is this: because these are reserves on account of goods and services that it is reasonably anticipated will have to be delivered after the end of the year, their deduction is expressly permitted by paragraph 20(1)(m) which brings the matter within the exception set out in paragraph 18(1)(e) of the Act. I agree with the plaintiffs position on this issue and find that the reserves claimed by the taxpayer do fall within the “expressly permitted” exception of paragraph 18(1)(e). I reject the defendant's argument that for the reserves to be deductible under paragraph 20(1 )(m) it must first be shown that they are not prohibited under paragraph 18(1)(e) as being contingent. I consider that paragraph 20(1)(m) expressly permits the deduction of reserves for the type claimed here and that the reserves be certain and not contingent does not appear, as it seems to me, to be a precondition for their deductibility. In my opinion, the paragraph allows for the deduction for reserves which are contingent both as to amount and liability so long as the amounts are reasonable.

The final issue is whether the deductions are prohibited by subsection 20(7) of the Act.

In Mister Muffler Ltd. v. The Queen, [1974] C.T.C. 813; 74 D.T.C. 6615 (F.C.T.D.) the issue was whether a reserve for the replacement of guaranteed mufflers was permissible under paragraphs 12(1 )(e), 85(1)(a) and (c), or was prohibited by subsection 85B(4). These statutory provisions are the counterparts of paragraphs 18(1)(e), 12(1)(a), 20(1)(m) and subsection 20(7) of the new Act. The taxpayer, which operated a chain of retail automobile exhaust system installation shops, issued a guarantee to its customers to replace any muffler that the company installed free and without labour charges "as long as you will own and possess the vehicle . .. should this muffler become defective through no fault of your own.” The purchase price of the original muffler included an allowance for replacement, which was treated as gross income, and a reserve was established for that part of the purchase price which related to replacement mufflers. The taxpayer company sought to deduct this reserve from its income, and the Minister disallowed it. The Minister contended that the deduction of reserves in respect of guarantees, indemnities or warranties for goods to be delivered or services to be rendered in the future was prohibited by subsection 85B(4), and the court so held.

The case was one of new product warranty and may be distinguishable for that reason from the case at bar. However, Mr. Justice Walsh’s analysis of the statutory scheme of paragraphs 12(1 )(e), 85(1 )(a) and (c), and subsection 85B (4) of the Act and their interactive effect must be taken as authoritative with respect to those provisions and their present successors. The learned judge had no difficulty in determining at the outset that paragraph 12(1)(e) (now paragraph 18(1)(e) ) did not apply. He went on to point out that the decision in the case would turn on whether the reserve was set up in respect of a guarantee, indemnity or warranty. The learned judge concluded at 824-25 (D.T.C. 6623):

. . . It appears to be pointless to attempt to seek the meaning of subsection 85B(4) in dictionaries or judicial definitions. The scheme of the Act does not permit deductions of reserves with respect to guarantees, indemnities or warranties and I am of the view that it is intended that these words should be comprehensive enough to include all types of guarantees, indemnities or warranties, which the Act intended to exclude from immediate deduction by way of reserves because of their contingent and uncertain nature.

Clearly, Walsh, J., was influenced in reaching this result by the guarantee aspect of the transaction, as attested by the following statement near the end of his reasons for judgment:

. . . The very wording of the undertaking itself, which is entitled “Guarantee” and undertakes to “guarantee” replacement “should this muffler become defective” indicates the contingent nature of the undertaking . . .

Counsel for the Crown submits that the broad approach to statutory construction taken by Walsh, J., without resort to dictionary meanings, is amply justified in view of the broad connotation accorded the words “in respect of" and she cites two cases to support that proposition: Goldsbrough Mort. & Co. Ltd. v. Federal Commissioner of Taxation, 12 A.L.R. 593; and Nowegi- jick v. The Queen et al., [1983] C.T.C. 20 at 25; 83 D.T.C. 5041 (S.C.C.) at 5045.

The case at bar is very much on all fours with Paul Burden Ltd. v. M.N.R., [1981] C.T.C. 2847; 81 D.T.C. 651 (T.R.B.). The taxpayer, a retailer of office machines, also operated a service department which offered to its custo- mers service contracts to cover maintenance and repair of their office machines. Under the terms of the prepaid service contract, entitled "Extended Warranty Agreement” the taxpayer was obligated to maintain and repair office machines when called upon to do so by the customer. The taxpayer categorized its service contract fee income as earned or unearned in the year by prorating it on the basis of the unexpired term of the contract, and in that respect claimed a reserve on income for services to be provided after the year end. The Minister disallowed the reserve and the taxpayer appealed to the Tax Review Board. The evidence indicated that there was no predetermined maintenance schedule and service was provided only upon request of the customer. The appeal was allowed with respect to consent to judgment for an agreed variation of the assessment but on the issue of entitlement to the service contract reserve the Board held that the contract was one of indemnity to secure the customer against maintenance and repair costs and was therefore specifically excluded by paragraph 20(7)(a).

Mr. Bonner, following the decision in Mr. Muffler, supra, said at 2851 (D.T.C. 654):

Nothing . . . supports a suggestion that an obligation to indemnify cannot exist where the obligation is not to pay monetary compensation but rather is one to perform an act or provide a service. The contracts in question obliged the Appellant to maintain in order to prevent breakdown and to repair in order to rectify breakdown. Those are the principal obligations for which the appellant is paid. By those contracts the customer is kept free from or secured against maintenance and repair costs. He is, in a word, indemnified.

I fully agree with the reasoning and conclusion of the Tax Review Board in Burden and adopt the same as conclusive for purposes of the disposition of this appeal. I consider that the maintenance agreements there are identical to those of Sears Canada Inc. in the present case. Moreover, I favour the broad approach to statutory construction taken by Mr. Justice Walsh in Mister Muffler. In the result, it is my opinion that while the reserves claimed by the plaintiff were in respect of goods or services that it was reasonably anticipated would have to be delivered or rendered after the end of each of the 1976, 1977 and 1978 taxation years, their deduction is expressly prohibited by paragraph 20(7)(a) of the Income Tax Act because of their indemnity nature.

Counsel for the plaintiff argued that if it should transpire that the deduction of these reserves was disallowed then $2 million of the $2.650 million deducted by the plaintiff as a reserve at the end of its 1975 taxation year should not have to be added back into income at the beginning of the 1976 taxation year because the end result of what the plaintiff did by its accounting methodology was to deduct as a reserve only $650,000. Counsel for the defendant contends that it is the fact of what was done and not its effect that must govern and that in consequence the full amount must be brought back into income in 1976 and she cites in support of this submission the case of Dominion of Canada General Insurance Company v. The Queen, [1984] C.T.C. 190; 84 D.T.C. 6197 (F.C.T.D.). Unless I misapprehend the matter, the plaintiffs argument brings into question the methodology and validity of the 1975 assessment, which is not under appeal. Consequently, the assessment for that year must be deemed valid and binding. In my opinion, it is therefore irrelevant whether the deduction of the reserve in 1975 was correctly calculated or not. The plaintiff’s argument for the exclusion of $2 million from its income in the 1976 taxation year must therefore fail.

For these reasons, the plaintiff’s appeals are dismissed with costs. I would add that there shall be only one set of costs to the defendant.

Appeals dismissed.