Amesbury Distributors Ltd. v. The Queen, 85 DTC 5076, [1984] CTC 667 (FCTD)

Cullen, J:—This action arises by way of appeal from the decision of the Minister of National Revenue whereby, in notification of confirmation dated May 29, 1980 the said Minister confirmed the notice of reassessment dated December 11, 1979. The plaintiff was assessed federal income tax and interest by the Minister of National Revenue and the Minister included the amount of $101,456 in the plaintiffs income for the 1978 taxation year as a result of the Minister’s disallowance of the plaintiffs claim for a reserve pursuant to subparagraph 20(l)(m)(ii) of the Income Tax Act on the grounds that the deduction claimed by the plaintiff represented a reserve in respect of a warranty pursuant to subsection 20(7) of the Income Tax Act.

The facts in this case are fairly straightforward. The plaintiff company was incorporated on October 19, 1973 under the laws of the province of Ontario and carries on business in Ottawa as, inter alia, the exclusive distributor in the Ottawa Valley area for home entertainment products imported into Canada by Matshushita Electric of Canada Limited (“MELCA”) and bearing the trade mark “Panasonic”. Pursuant to an agreement dated September 9, 1975 and subsequent ancillary agreements dated February 28, 1977 and January 3, 1978 between “MELCA” and the plaintiff, the plaintiff was appointed the exclusive distributor in the Ottawa Valley area for “MELCA” products. One of the terms and conditions in the said agreement required the plaintiff to provide after-sales service of the “MELCA” products to dealers in return for a stipulated fee from the dealers. Mr Ross Hamre, who joined the plaintiff company on October 19, 1973 as vice-president, appliance and electronic distributor, and became its president in 1979, indicated that the dealer had to receive the invoice and packing slip, a green sticker, and a Panasonic warranty. The green sticker was filed as Exhibit 6 and the warranty as Exhibit 5.

In May of 1977 the products distributed by the plaintiff commenced to be covered by a three-year warranty which in prior years was only of one-year duration. The evidence of the witness Hamre indicated they used the same form of warranty and the green sticker to be affixed to the bill of sale read, “This seal certifies that this Panasonic television set is covered by: Panasonic’s extended three-year warranty subject to conditions of written warranty.” During the one- year warranty period the plaintiff company charged a fee of $10. With the notice received from “MELCA” in May of 1977, that all Panasonic televisions (black/ white and colour) would carry a new extended three-year warranty, they conveyed the information that they would increase the 1 per cent parts allowance by 50 per cent to 1.5 per cent on all televisions (other product parts allowances remained at 1 per cent). In that same communication “MELCA” suggested that the distributors bill the dealers for a colour console $29.95; for a colour portable $19.95; and for a black/white set $6.95 but indicated that the distributor was free to adjust the suggested rates higher or lower to suit requirements in their particular market. Mr Hamre, the witness, indicated that they decided to charge a flat fee of $30 for all sets which was in keeping with the fact that they had earlier charged $10 per year when the warranty was for one year. This price would mean that the servicing would be done at the location of the television set if at all possible. If it was not possible to repair there then the television set would be moved by the servicing agent to its premises, repaired, and then returned to the consumer.

It should be noted here that the plaintiff had the exclusive authority to tell the dealers that the sets must be repaired by the agent designated by the distributor, even in situations where the dealer had its own repair service. Mr Hamre advised that this did not apply to Bleeker’s and sets could in fact be repaired by that company and would be acceptable to the plaintiff company. Mr Hamre further indicated that it was not their intention to make money on this fee and their experience with the one-year warranty and the $10 charge was that they broke about even.

It was established in evidence that the plaintiff company invoiced a dealer separately for the fee and in Exhibit 1, Tab 11 there is an invoice from the plaintiff company to Universal Appliances showing four Panasonic 20” colour TV sets at $392 for a total of $1,568 and four service charges at $30 for a total of $120. It was also established that the moneys received for these “service charges” (the wording used on all invoices) was entered in a general ledger sheet headed, Sales-Services-Panasonic. On this general ledger sheet only the credits are shown and there is no debit shown for repair of sets. The ledger sheet covering the period in question, namely the 1978 taxation year, is shown in Exhibit 1, Tab 11. The total figure is $153,814.66. On the ledger sheet, at the bottom appears the following:

Mr Wilson then confirmed that the auditor’s report which he prepared and signed and is filed as part of Exhibit 4 shows on the balance sheet a heading, Liabilities and Shareholders Equity, and for the year 1978 there is an entry Unearned Income — $101,456 which Mr Wilson indicated in common accounting parlance was a reserve.

This amount of $101,456 was claimed by the plaintiff as a reserve pursuant to subparagraph 20(l)(m)(ii) of the Income Tax Act. This was not allowed by the Minister of National Revenue on the grounds that the deduction claimed by the plaintiff represented a reserve in respect of warranties pursuant to subsection 20(7) of the Income Tax Act. It is of course accepted law that in assessing the taxpayer the Minister of National Revenue must indicate the assumptions of fact made in making its assessment. In the statement of defence, aside from two non-controversial assumptions, the Minister’s pleading reads:

3.(c) in May of 1977, the products distributed by the Plaintiff commenced to be covered by a three year warranty which in prior years was only of a one year duration;

(d) in its 1978 taxation year, the Plaintiff charged its customers and received the amount of $152,184.66 as consideration for the granting of service contracts in respect of the three year warranty for products it sold;

(e) the amount of $152,184.66 was received by the Plaintiff in consideration of a guarantee, warranty, or indemnity.

These assumptions place an onus on the taxpayer to rebut them and the onus is clearly with the taxpayer. The plaintiff argued that, on the basis of the notice of reassessment and the confirmation by the Minister and the evidence obtained during discovery, the only assumption to be rebutted was the assumption of a warranty but that there was in fact no assumption with respect to guaranty or indemnity. It seems to me, however, that the citing of subsection 20(7) puts the taxpayer on notice that the assumption is being made with respect to the three conditions and again in the examination for discovery at page 18, the dialogue goes this way:

By Mr Nelson:

Q. You are stating then that the belief of the auditor was that this income of $101,456.00 was earned as a result of a warranty?

A. Assumed, yes.

Q. Pardon?

A. That’s it, that’s warranty, guarantee, indemnity.

Q. In using those words, you are referring to Section 20, Subsection 7 of the Income Tax Act, is that correct?

Then there was an interjection by counsel for the defendant.

On that same page, in a rather mixed up paragraph, the witness concludes: . . as such, should have been included in income because no allowance is made for the warranty, indemnity or guarantee.”

During the examination for discovery the witness undertook to secure the auditor’s report and the witness indicated that the assumptions in the auditor’s report were the basis for the assessment. This undertaking having been given to produce the auditor’s report, I allowed it to be tabled as Exhibit 8. Reading a portion of it shows the point counsel was endeavouring to make. On page 7 of the report, referring to Mr Wilson the chartered accountant and himself; the auditor wrote:

Mr. Wilson said that it was not a warranty reserve. I replied, “Yes, I agree, it is not a warranty reserve.” I further explained the amount received under service charge is to be brought to income pursuant to 12(l)(a) and no reserve is available because warranty reserve is not allowed under section 20(7) and the expenses incurred under warranty are allowed in the period when incurred.

On September 17/79, I called Mr. Wilson & inquired about his views. He said: “I don’t think it is a warranty reserve. For warranty reserve, we debit expense and credit reserve and this I have not done. As it is not a warranty reserve I don’t think it should be included in income.”

I replied, “I agree that it is not a warranty reserve.” I explained to him again that when the amount received under charges are to be brought to income under Section 12(1)(a). He replied that the service charges relate to three years and he has correctly apportioned it for tax purposes, i.e. one-third is income for 1978 and the remainder two-thirds as unearned income for 1978 and to be spread over the years 1979 and 1980.

Later, however, the auditor says, quote:

I think, as I explained to Mr. Wilson, that warranty reserve is not allowed under 20(7), he is confusing the issue by saying that it is not a warranty reserve therefore it should not be added on to income. However, when we ask him that the charging Section is 12(1)(a) and under this section full amount is to be brought to income in the year 1978, we have not been able to get a satisfactory answer to it. . . . We strongly feel that such a treatment for tax purposes is contrary to the provisions of Section 12(1)(a) and the total amount of service charge should be brought to the income in the year 1978.

In my view the Minister has indicated the assumptions upon which the assessment is based and includes warranty, guarantee or indemnity.

Also to be considered is the decision of the Exchequer Court in MNR v Minden, [1962] CTC 79; 62 DTC 1044. In that case, at 89 [1050] it reads:

I should refer to the fact that in the statements accompanying the Notices of Reassessment the Respondent was said to be “deemed to be in the business of lending money on the security of mortgages and agreements for sale”. This was erroneous. She did not lend any money on the security of mortgages or agreements for sale nor did Mr. Minden do so on her behalf. The agreements for sale and the interest in the mortgages were purchased outright. But the facts that there was this error in the statements accompanying the Notices of Reassessment does not affect the validity of the assessment. In considering an appeal from an Income Tax Assessment the Court is concerned with the validity of the Assessment, not the correctness of the reasons assigned by the Minister for making it. An assessment may be valid although the reason assigned by the Minister for making it may be erroneous. This has been abundantly established.

Paragraph 12(l)(a) of the Income Tax Act is quite clear about what must be included in computing the income of a taxpayer for a taxation year as income from a business. Section 18 buttresses this requirement to bring everything into income by stating situations where no deductions shall be made from income. The plaintiff believed that he was entitled to the relief pursuant to subparagraph 20(l)(m)(ii). In my view two legislative roadblocks prevent the plaintiff from securing this tax relief. The first one is paragraph 18(l)(e) which states:

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.

[Emphasis added]

In Harlequin Enterprises Limited v The Queen, [1974] CTC 838; 74 DTC 6634, confirmed in [1977] CTC 208; 77 DTC 5164, Mr Justice Mahoney states at 848 [6641] the following:

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 it 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.

Again, I think it is appropriate to refer to the decision of Mister Muffler Limited v The Queen, [1974] CTC 813; 74 DTC 6615. Mr Justice Walsh gives a comprehensive review of the case law and quotes Associate Chief Justice Noël from the case of J L Guay Ltée v MNR, [1971] FC 237 affirmed by the Court of Appeal [1972] FC 1441 where the Associate Chief Justice said at 245-246:

In most cases only amounts which can be exactly determined are accepted. This means that, ordinarily, provisional amounts or estimates are rejected and it is not recommended that data which are conditional, contingent or uncertain be used in calculating taxable profits. If, indeed, provisional amounts or estimates are to be accepted, they must be certain. But then it is always difficult to find a procedure by which to arrive at a figure which is certain. Accountants are always inclined to set aside reserves for unliquidated liabilities for if they do not do so the financial statement will not reflect a true position of the client’s affairs. The difficulty arises from the fact that making it possible to determine the taxpayer’s tax liability is not the main purpose of accounting. The accountant’s report is in fact intended to give the taxpayer a general picture of his affairs so as to enable him to carry on his business with full knowledge of the facts. To achieve this end it is not necessary for the profit shown to be exact, but it must be reasonably close, while the Income Tax Act requires it to be exact and it is thus necessarily arbitrary.

What then is the situation here. It is clear from the evidence that there are several contingencies. The distributor will have a liability to repair only if the dealer and the consumer have met certain preconditions. The obvious one of course is that the machine must break down and it must be established that the consumer and the dealer acted pursuant to the conditions established in the warranty. The repair work is only done if the breakdown is a result of a factory defect. Only the original owner can secure the benefit and he must have the bill of sale and of course make his application within three years. Again, if the machine is broken by the owner or if it has been earlier repaired by an agent not approved by the distributor then of course there is no liability. I am satisfied that the accountant and the company were close with their estimates based on their experience with the earlier one-year warranty but it is just that, an estimate. Again, it was of course obvious that the plaintiff had no way of knowing which particular machines would break down or how many nor in what time frame. On all of these facts, therefore, I am satisfied that the total amount of $152,184.66 received by the plaintiff in its 1978 taxation year must be brought into income, no part of the said amount was deductible, and the amount of $101,456 was not deductible pursuant to paragraph 18(l)(e) of the Income Tax Act. If I had determined that the plaintiff was entitled to its claim for a reserve pursuant to subparagraph 20(l)(m)(ii) of the Income Tax Act I am satisfied on the facts of this case that it should be disallowed pursuant to subsection 20(7) of the Income Tax Act. Having made my determination in this case pursuant to paragraph 18(l)(e) I do not feel it is necessary to belabour the point in these reasons for judgment. Suffice it to say that Panasonic and the dealer were clearly bound by the warranty and the ultimate consumer could in my view look to both of these sources as a means of realizing on the warranty. By the same token any dealer could look to the distributor and/or Panasonic to meet the obligations of the warranty assuming of course the preconditions had been met. In my view the distributor stands in the shoes of Panasonic and relieves Panasonic from all liabilities pursuant to the warranty. Any claim made by an authorized dealer or a consumer against Panasonic would find Panasonic claiming over against the distributor. Again, the whole basis for this fund was predicated upon the warranty, namely, the amount of money to be charged, the conditions to be met, the obligations to be fulfilled, and the time frame within which the $30 premium was applicable. Mr Hamre, at the very beginning of his evidence, stated: “We charged a service charge for warranty.” Again, the plaintiff had absolute control over who should do the repair work and again Mr Hamre’s evidence was to the effect that sometimes they would extend the warranty because it was good business practice or because it was the right thing to do and I believe he gave the example of a picture tube being replaced beyond the three- year warranty period as a case in point. The distributor was also able to impose conditions about what was to be included with the television set and that the green sticker was to be affixed to the bill of sale. For all of these reasons I am satisfied that the circumstances here clearly fall within the meaning of subsection 20(7) of the Income Tax Act.