T-1671-72
Mister Muffler Limited (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Walsh J.—Montreal, October 17;
Ottawa, November 15, 1974.
Income tax—Deductions—Sale of automobile mufflers—
Certificate with each muffler sold—Customer entitled to
obtain second new muffler during ownership of car—Tax-
payer setting aside reserve of part of purchase price relating
to replacement—Whether reserve deductible from income—
Income Tax Act, R.S.C. 1952, c. 148, ss. 3(a), 4,
12(1)(a),(e), 8 5B(1)(a),(c),(4)•
The appellant promoted its sale of automobile mufflers by
giving with each purchase a certificate entitling the purchas
er, during ownership and possession of his car, to obtain a
free replacement "should this muffler become defective
through no fault of your own". The muffler was replaced
about every 22 months, so that in the years subsequent to
the sale of the original muffler, a certain quantity of muf
flers was used for replacement. The sale price of the original
mufflers, including an allowance for replacement, was
included in gross income, in respect of which a reserve was
established of that part of the purchase price relating to the
replacement mufflers. The plaintiff made deductions from
income for the taxation years 1967 and 1968 as a reserve in
respect of such mufflers as were reasonably anticipated as
having to be delivered after the end of the year. The
Minister added the amounts in question to the plaintiff's
income for the relevant years. The plaintiff appealed.
Held, the deductions were not reasonable amounts
deductible as reserves under sections 85B(1)(a) and (c) of
the Income Tax Act, as it then applied. An exception was
introduced by section 85B(4) so as to forbid deductions with
respect to "guarantees, indemnities or warranties". These
words were intended to be comprehensive enough to include
all types of guarantees, indemnities or warranties, which the
Act meant to exclude from immediate deduction by way of
reserves, because of their contingent and uncertain value.
The replacement expense of a muffler could clearly be
claimed as an expense in the year of its actual replacement.
The plaintiff's alternative argument was that the amounts
constituted fixed, substantial, continuing and current liabili
ties to deliver goods as determined by proper accounting
practice and hence were deductible under sections 3(a), 4
and 12(1)(a). But section 12(1)(e) forbade deductions except
as expressly permitted "by this Part". Since section 85B of
the Act was in the same Part of the Act as section 12, this
returned the argument to the question, decided above, of
whether the deduction of the reserve was permitted by
section 85B(1)(c) or prohibited by section 85B(4).
Time Motors Limited v. M.N.R. [1969] S.C.R. 501; J. L.
Guay Ltée v. M.N.R. [1971] F.C. 237 affirmed [1972]
F.C. 1441; Kenneth B. S. Robertson Limited v. M.N.R.
[1944] Ex.C.R. 170; Western Vinegars Limited v.
M.N.R. [1938] Ex.C.R. 39; Edward Collins & Sons Ltd.
v. Commissioners of Inland Revenue (1924) 12 T.C.
773; Associated Investors of Canada Ltd. v. M.N.R.
[1967] 2 Ex.C.R. 96; Capital Transit Limited v. M.N.R.
(1952) 7 Tax A.E.C. 19; McManus Motors Limited v.
M.N.R. 53 DTC 255; M.N.R. v. Atlantic Engine
Rebuilders Limited [1967] S.C.R. 477; Dominion Stores
Limited v. M.N.R. [1966] Ex.C.R. 439 and Dominion
Taxicab Association v. M.N.R. [1954] S.C.R. 82,
considered.
INCOME tax appeal.
COUNSEL:
Claude Thivierge and Brian Crane for
plaintiff.
Roger Roy and A. Garon, Q.C., for
defendant.
SOLICITORS:
Duquet, MacKay & Co., Montreal, for
plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
delivered in English by
WALSH J.: Plaintiff appeals from income tax
assessments for the taxation years ending
November 30, 1967, December 31, 1967 and
December 31, 1968. Its declaration sets forth
that it operates a chain of retail automotive
exhaust system installation shops and that as of
May 1, 1964 with a view to promoting its sales
to the public, it introduced a special plan where
by a customer, when purchasing a muffler, was
given a certificate presentable at any of plain
tiff's shops entitling him to obtain a second new
muffler and subsequent additional replacements
for as long as he retained possession and owner
ship of his automobile. Plaintiff claims that, in
effect, the cost of the additional mufflers was
included in the purchase price of the original
mufflers and that experience has shown that the
muffler was replaced on the average of every 22
months so that in the years subsequent to the
sale of the original muffler, a certain quantity of
mufflers had to be used to replace same. The
purchase prices of the original mufflers which,
according to plaintiff, included an allowance for
replacement, were included in gross income in
respect of which a reserve of that part of the
purchase price which related to the replacement
mufflers was established. For the fiscal year
ended November 30, 1967, this amounted to
$118,622.96 which plaintiff deducted from its
income as a reserve in respect of such mufflers
as it was reasonably anticipated would have to
be delivered after the end of the year. From
November 30, 1967, the fiscal year end of
plaintiff was changed to December 31 and in
computing its income for the month of Decem-
ber 1967 an amount of $364.30 was deducted as
a similar reserve, while for the fiscal year ended
December 31, 1968 an amount of $16,235.09
was deducted. These amounts were added back
by the Minister in computing plaintiff's income
for the periods in question. Plaintiff claims that
these constitute reasonable amounts deducted
as reserves and that they are deductible under
the provisions of paragraphs (a) and (c) of sub
section (1) of section 85B of the Income Tax
Act' as it then applied, and were not amounts
deducted as reserves in respect of guarantees,
indemnities or warranties as set forth in subsec
tion (4) of section 85B. Alternatively, plaintiff
claims that such amounts constitute fixed, sub
stantial, continuing and current liabilities of
plaintiff to deliver goods as determined by good
and proper accounting practice and accordingly
are deductible from plaintiff's taxable income
for the years in question under the provisions of
paragraph (a) of section 3, section 4, and para
graph (a) of subsection (1) of section 12 of the
Act and should not under good accounting prac
tice be credited to a contingent account as set
forth in paragraph (e) of subsection (1) of
section 12.
Defendant in assessing plaintiff based itself
on the terms of the document given customers
on whose cars plaintiff's muffler has been
installed, which document is entitled "Guaran-
' R.S.C. 1952, c. 148.
tee", and reads as follows:
For the life of your car, that is as long as you will own and
possess the vehicle on which MR. MUFFLER'S muffler has
been installed, we guarantee the free replacement of this
muffler without labor charges should this muffler become
defective through no fault of your own. This guarantee is
valid in any of MR. MUFFLER'S shops upon presentation of
this certificate.
and contends that the amounts in question had
been put by plaintiff in a reserve or a contingent
account but that they were not amounts
received on account of services not rendered or
goods not delivered before the end of the rele
vant fiscal periods, but rather were reserves by
the plaintiff in respect of guarantees, indemni
ties or warranties. Sections 12(1)(e) and 85B(4)
are relied on.
Section 85B(1)(a) and (c) read in part as
follows:
85B. (1) In computing the income of a taxpayer for a
taxation year,
(a) every amount received 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
shall be included;
(c) subject to subsection (3), where amounts of a class
described in subparagraph (i) or (ii) of paragraph (a) have
been included in computing the taxpayer's income from a
business for the year or a previous year, there may be
deducted a reasonable amount as a reserve in respect of
(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,
In brief, sums received in payment for goods
not delivered during the year or that have not
been fully earned in the year or previous year
shall nevertheless be included, subject to the
deduction of a reserve to the extent that it is
reasonably anticipated that the goods or ser
vices for which payment has been made will
have to be delivered or rendered after the end
of the year. The deduction of this reserve, how-
ever, is subject to the exception provided in
subsection (4) which reads as follows:
85B. (4) Paragraph (c) of subsection (1) does not apply to
allow a deduction as a reserve in respect of guarantees,
indemnities or warranties.
In other words, a reserve can only be deducted
for goods to be delivered or services to be
rendered in future if this does not result from
guarantees, indemnities or warranties.
The alternative argument depends on the
application to the taxpayer of section 12(1)(a)
of the Act which reads as follows:
12. (1) In computing income, no deduction shall be made
in respect of
(a) an outlay or expense except to the extent that it was
made or incurred by the taxpayer for the purpose off
gaining or producing income from property or a business
of the taxpayer,
and that section 12(1)(e) which reads:
12. (1) In computing income, no deduction shall be made
in respect of
(e) an amount transferred or credited to a reserve, contin
gent account or sinking fund except as expressly permit
ted by this Part,
is not applicable. I do not believe that plaintiff
can successfully contend that this reserve con
stituted an outlay or expense but it does con
tend that this was not a contingent account and,
in any event, that it was a reserve "expressly
permitted by this Part". Since section 85B of the
Act is in the same Part as section 12, this
appears to return the argument to the question
of whether this reserve was one permitted by
section 85B(1)(c) or prohibited by section 85B(4)
as being in respect of a guarantee, indemnity or
warranty.
Documentary proof was filed consisting of a
copy of the guarantee and the financial state
ments of plaintiff for the year ending November
30, 1967, the subsequent month ending Decem-
ber 31, 1967 when its fiscal year was changed,
and the year ending December 31, 1968.
Jean Paul St-Denis, C.A., the General Manag
er of plaintiff, testified that although the guaran
tee refers to free replacement of the muffler
without labour charges "should this muffler
become defective through no fault of your
own", in practice it is used for the replacement
of worn out mufflers which the company's
records indicate require replacement approxi
mately every 22 months on the average, less
than 2 per cent of the mufflers being replaced
because of being defective, and that it is also
rare to refuse a replacement because this has
become necessary through the fault of the car
owner. Their experience indicates that about
one out of every five mufflers they sell has to
be replaced. This is because the guarantee is
only valid as long as the purchaser remains
owner of the vehicle and not when he sells it or
trades it in. Some owners may also lose the
guarantee or neglect to avail themselves of it.
While the new muffler is installed without any
charge for labour, quite frequently some other
parts are sold at the same time such as a new
tail pipe which is often required but is not
covered by the guarantee.
Competition had forced the introduction of
this plan in the United States and from 1964 to
1966 plaintiff had a study made by a firm of
consulting engineers which determined the aver
age life of the muffler to be 22 months. The
average wearing out period of 22 months was
admitted in an agreed statement of facts. This
study also determined that about one out of 5
come back for replacement and the figures of
this study have been borne out by subsequent
experience which indicates that currently the
percentage of claims remains about the same
and the mufflers now last about 20 months on
the average. Since they had figures of their sales
during the preceding 22 months, knew one out
of five would have to be replaced, and what it
cost them for a replacement muffler, they could
calculate accurately how much had to be added
to the price of the muffler originally installed to
provide for this. This study was done between
1964 and 1966 and no reserves.. were set up
during those years but once they had the figures
they set up the reserve for the year ended
November 30, 1967. This initial reserve was, of
course, high because it covered sales over a 22
month period and not merely a one month
period or 12 month period as in subsequent
statements. Replacements made during any
given fiscal period are deducted from the
reserve and the foreseeable obligations created
by new sales during the same period are added
to it. Thus, for the period ended November 30,
1967 we have on the balance sheet under liabili
ties an amount of $118,622.96 as a reserve for
merchandise sold and not delivered and this
same amount is deducted from income as a
business expense in that period. For the one
month fiscal period for December 31, 1967
there is a reserve similarly shown as a liability
in the amount of $118,987.26, but in that year
only the sum of $364.30 is deducted from
income as a business expense, this representing
the increase in liability as a result of new sales
after deducting from the reserve the cost of the
mufflers replaced during the period. For the
year ended December 31, 1968 the reserve is
increased to $135,222.35 and the amount
deducted from income as a result of this reserve
is $16,235.09 which again represents the
increase in the reserve during the year.
Mr. St-Denis testified that in their pricing
they include an amount to provide for these
replacements. For a Chevrolet, for example, the
muffler costs them $5 but the customer pays
$16.95 which includes installation which repre
sents about half the price, and profit. Since they
estimate one out of five mufflers will have to be
replaced the price includes $1 as a reserve. If
the customer does not want the guarantee the
price is reduced by $1.
Mr. Henri Paul Ouellette, C.A., was called as
an expert witness, his affidavit being taken as
read. He is an experienced auditor and had
acted as such for plaintiff from 1960 to 1972. In
his affidavit he states:
[TRANSLATION] Assuming that these sums, after deciding
amounts set aside as reserves, were received by Mister
Muffler Limited to be applied to the cost of mufflers to be
delivered in the future by Mister Muffler Limited to replace
used mufflers I am of the opinion that in accordance with
the practice and accounting principles recognized and gener
ally accepted, such sums constitute a real liability of the
company and, as such, should be deducted from the income.
My opinion is based on the fact that financial statements
should faithfully reflect the financial position of the
company.
Referring to recommendations of the
Research Committee of the Institute of Char
tered Accountants dated December 1968, he
stated that he considers these sums to represent
a contractual obligation as they do not meet the
definition of reserves accepted by the Institute,
whereas the financial statements should provide
a summary exposition of all important contrac
tual engagements with regard to the actual
financial situation or future exploitation of the
business. Moreover, all eventual debts which do
not appear on the balance sheet should be
shown in one manner or another in the financial
statements. He referred to Finney and Miller,
Principles of Accounting, 5th ed., at page 436
where, under the heading "Operating Reserves
Classified as Current Liabilities" the following
statement appears:
Operating reserves are those which are set up by charges
to income to reflect provisions for prospective cash dis
bursements, the costs of which should be matched against
revenues that have been taken into income. If goods are sold
with guarantees of performance or with agreements to give
free service for a stated period, a proper matching of
revenue and expense requires the creation of an operating
reserve for the prospective disbursements. Although there
may be no present liability to any specific person, and
although the amount of the reserve may be an estimate, such
reserves are properly shown among the liabilities. The
reserve represents a current liability if there is an obligation
to make a cash disbursement in the near future.
Evidence as to what constitutes proper
accounting practice has been recognized in a
number of cases including the Supreme Court
judgment in Time Motors Limited v. M.N.R. 2 in
which Pigeon J. stated at pages 505-06:
2 [1969] S.C.R. 501.
Respondent's second contention is that because appel
lant's obligation was conditional it should not, until the
condition was realized, be treated for purposes of income
tax as a current liability but as an amount properly to be
entered in a contingent account. As a result, the deduction
would be prohibited by s. 12(1)(e) of the Income Tax Act:
12. (1) In computing income, no deduction shall be made
in respect of
(e) an amount transferred or credited to a reserve, contin
gent account or sinking fund except as expressly permit
ted by this Part,
The wording of that provision clearly refers to accounting
practice. The only expression applicable to the present case
is not "contingent liability" but "contingent account". This
means that the provision is to be construed by reference to
proper accounting practice in a business off the kind with
which one is concerned. In the present case, the only
evidence of accounting practice is that off appellant's audi
tor, a chartered accountant. His testimony shows that in
appellant's accounts credit notes are treated according to
standard practice as current liabilities until they are
redeemed or expired. They are not classed as contingent
liabilities. When asked why he considered the obligation
under a credit note as current liability and the obligation
under a warranty as contingent, he said:
... the credit note, while it is a liability, is also an
existing obligation today. A warranty may be a liability
in the future. It may be determinable in the future but
isn't an existing obligation until the future. At least, this
is my interpretation of the difference.
With respect, Gibson J. was in error in holding that
whether or not appellant's financial statements were drawn
up according to generally accepted accounting principles
could be disregarded. On the contrary, the wording of the
relevant provision off the Income Tax Act implies that this is
the essential question.
The facts of that case were, however, quite
different from the present one as it dealt with
credit notes given by a used car dealer as partial
payment of used cars acquired by it which
although not transferable could be applied by
the holder within a stated time to purchase a car
from the dealer of not less than a specified
value. The credit notes were treated in appel
lant's accounts as current liabilities and if they
were not redeemed the amount at expiration
was removed from the accounts payable and
treated as profit. The provisions of section 85B
of the Act were not in issue in this case.
In the case of J. L. Guay Ltée v. M.N.R. 3 ,
affirmed by the Court of Appeal 4 and now
under appeal to the Supreme Court, Associate
Chief Justice Noel stated at pages 245-46:
In most tax cases only amounts which can be exactly
determined are accepted. This means that, ordinarily, provi
sional 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 the 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. In Southern Rly. of
Peru Ltd. v. Owen (supra), the company's auditor stated that
he could not have signed its financial statement if the
reserve for future debts had not been entered on the balance
sheet. The House of Lords was not influenced by this
statement, however, and decided nevertheless that the com
pany could not deduct the amounts payable until the
employees terminated their employment. However, South
ern Rly. of Peru Ltd. v. Owen (supra) concerned a reserve
made for uncertain amounts which the company might be
called upon to pay in the future. What is the situation when
the amounts involved are certain, but are not due until a
subsequent accounting period? Such amounts were involved
in Naval Colliery Co. v. I.R.C. (1928) 12 T.C. 1017, (H.L.)
and the Court decided nevertheless that they could not be
deducted so long as the outlay had not been made. In that
case, Lord Buckmaster indeed stated clearly that these
amounts could only be deducted in the period in which they
were actually spent:
According to the appellant's contention, however, it is
not the actual expenditure that is deducted, but the need
for making the expenditure which is to be measured in
their favour and brought into the account. This contention
would involve the conclusion that the subject could
choose which period he liked as the one in which the
3 [1971] F.C. 237.
4 [1972] F.C. 1441.
allowance is to be brought into account, either that when
the expenditure became necessary or that when it was
made (p. 1040).
As a general rule, if an expenditure is made which is
deductible from income, it must be deducted by computing
the profits for the period in which it was made, and not
some other period.
Some of the remarks of Thorson P. in the case
of Kenneth B.S. Robertson Limited v. M.N.R. 5 ,
although this case was decided before section
85B came into existence, are of interest here. In
commenting on the decision in Western Vine-
gars Limited v. Minister of National Revenue
([1938] Ex.C.R. 39) in which Angers J. in deal
ing with a reserve which had been set aside to
cover losses on return of containers had stated
at page 45:
The profits on the containers are not, as I conceive, a
reserve properly called; and the loss of these profits, on the
returns of the containers, is not merely a contingency but a
certainty. The only thing uncertain is the quantity of the
containers which will be returned and the time at which the
returns will be effected.
the learned President stated [at page 178]:
The deduction claimed by the appellant for losses on the
returns of the containers was allowed, although such losses
had not yet been sustained. While the importance of the
decision lies in the distinction drawn between a loss that is
certain and one that is merely contingent, I find it difficult to
reconcile the decision with the authorities that apply the
general rule that profits are to be taxed in the year in which
they are received and losses borne in the year in which they
are sustained.
At page 179 he refers to the English case of
Edward Collins & Sons, Ltd. v. the Commis
sioners of Inland Revenue ((1924) 12 T.C. 773)
in which it was held that the deduction for an
apprehended future loss was not permissible.
Lord President Clyde stated at page 781:
It is, however, quite consistent with this that a prudent
commercial man may put part of the profits made in one
year to reserve, and carry forward that reserve to the next
year, in order to provide against an expected, or (it may be)
an inevitable, loss which he foresees will fall upon his
business during the next year. The process is a familiar one.
But its adoption has no effect on the true amount of the
profits actually made, and does not prevent the whole of the
profits, whereof a part is put to reserve, from being taken
into computation in the year in question for purposes of
assessment. On the contrary, the balance of profits and
gains is determined independently altogether of the way in
5 (1944] Ex.C.R. 170.
which the trader uses that balance when he has got it; and, if
he puts part of it to reserve and carries it forward into the
next year, that has no effect whatever upon his taxable
income for the year in which he makes the profit.
Again, at page 180-81 Thorson P. states:
Nor was the appellant, no matter how sound its account
ing practice was, entitled to distribute the amounts received
by it as income during any fiscal year into the amounts
earned during such year and those that were not yet earned,
for the test of taxability of the income of a taxpayer in any
year is not whether he earned or became entitled to such
income in that year but whether he received it in such year,
and the taxpayer has no right to have income received by
him during a taxation year distributed for taxation purposes
over the years in respect of which he may have earned or
become entitled to such income.
And again at page 182:
It seems equally clear that if income is received in any
one year it is taxable in that year, even although it has not
yet been earned, and it follows that the appellant was not
entitled to make any deduction from income received by it
in any year on the ground that it was not earned in such
year.
While that case differs substantially from the
present one in that it dealt with funds held in
trust, further comments on page 184 are also
pertinent:
Where an amount is paid as a deposit by way of security
for the performance of a contract and held as such, it cannot
be regarded as profit or gain to the holder until the circum
stances under which it may be retained by him to his own
use have arisen and, until such time, it is not taxable income
in his hands, for it lacks the essential quality of income,
namely, that the recipient should have an absolute right to it
and be under no restriction, contractual or otherwise, as to
its disposition, use or enjoyment. [Italics mine]
In the present case the full amount initially paid
for the muffler, even if it did include an element
of $1, (although this is not specified in the
contract) for contemplated replacements, was
nevertheless the plaintiff's and under no restric
tion, contractual or otherwise, as to its disposi
tion, use or enjoyment.
In the case of Associated Investors of Canada
Limited v. M.N.R. 6 at page 105 Jackett P. stated
in two footnotes:
' ... an expenditure that is made in the carrying on of the
business and that may or may not result in an actual cost of
operation should only be charged against the receipts of the
business in the year when the contingency is realized, and
then only to the extent of the net outlay involved at that
time.
2 I am not concerned here with the question whether the
method adopted by the appellant in showing the deduction
in its accounts was the appropriate way of reflecting the
transaction in the accounts. I am only concerned with
whether the "profit" was correctly computed.
The Robertson case (supra) was referred to in
the Tax Appeal Board judgment of Capital
Transit Limited v. M.N.R. 7 which I refer to
because the facts closely resemble those of the
present case although, here again, it dealt solely
with section 6(1)(d) of the Income War Tax Act,
the predecessor of section 12(1)(e) of the
Income Tax Act, and section 85B was not in
effect at the time. In that case a reserve was set
up for tickets sold and not yet used. The judg
ment states at page 27:
There can be no doubt that to include, as part of the
appellant's income in any taxation year, the full amount of
the cash received for a ticket, when the ticket has not been
used and therefore the company has had no opportunity of
charging against the receipts for that ticket the proportional
necessary expenses applicable to it, will result in the appel
lant's being dealt with inequitably, because it will be subject
ed to income tax on the whole of the receipts in respect of
unused tickets as though they represented 100% profit
whereas, in fact, only a small portion of the price paid for a
ticket will represent profit in the appellant's hands. How
ever, if that is the effect of the legislation as presently
enacted, the remedy lies, not with this Board, but with
Parliament.
This decision was followed in another Tax
Appeal Board judgment of McManus Motors
Limited v. M.N.R. 8 which refused to allow
deduction of a reserve in respect of liabilities
outstanding for lubrication coupon books paid
for in advance, although the proceeds had been
taken into taxpayer's revenue at the time of
such payment.
6 [1967] 2 Ex.C.R. 96.
(1952) 7 Tax A.B.C. 19.
s 53 DTC 255.
The Supreme Court case of M.N.R. v. Atlan-
tic Engine Rebuilders Limited 9 , also decided
solely on the question of section 12(1)(e),
referred with approval to the case of Dominion
Taxicab Association v. M.N.R. ([1954] S.C.R.
82) where it was stated at page 85:
It is well settled that in considering whether a particular
transaction brings a party within the terms of the Income
Tax Act its substance rather than its form is to be regarded.
The dissenting judgment of Judson J. states at
page 483:
I also think that the company fails under s. 12(1)(e). This
amount, shown as a liability, is an amount transferred or
credited to a reserve. It may be good commercial or
accountancy practice to make provision for these liabilities
but this is subject to the express provisions of the Act and
the Act does make an express provision here.
Plaintiff relies strongly on the case of Dominion
Stores Limited v. M.N.R. 10 which dealt with
trading stamps. The customer on purchasing
merchandise was given trading stamps of a
value of 1 per cent of the price paid for the
merchandise purchased which stamps could be
accumulated and subsequently exchanged for
merchandise from a catalogue or for groceries
at the store. The receipt of the trading stamps
was a condition of the original purchase and,
unlike the present case, there was no reduction
in price if the customer did not wish to take the
stamps. The company set aside a reserve for
unredeemed stamps. 'The Minister contended,
and this would not apply in the present case,
that no additional sum was paid for the trading
stamps and therefore that no amounts were
included arising from their sale in computing the
appellant's income and hence no reserve could
be made under section 8513(c) in the year during
which the sales were made as a provision for
the expenses arising from their redemption. In
rendering judgment, Cattanach J. stated at page
446:
The arrangement between the appellant and its customers
is quite clear from the evidence. A customer paid the price
demanded by the appellant when he purchased merchandise
from the appellant; For this, he received the merchandise
9 [1967] S.C.R.477.
1 O [1966] Ex. C.R. 439.
and in addition he received or was entitled to receive trading
stamps which he was entitled to present to the appellant
later for redemption either by way of premiums or the
appellant's merchandise. The appellant was legally obligated
to make this redemption. There was only one transaction
and this was the only way in which the appellant would
conduct its business at the particular stores. It does not
follow that, because no specific amount is identifiable as
being allocated to the cost of distributing and redeeming the
stamps, the total amount is not attributable in part thereto.
When two articles are sold together for one price without a
price being put upon each separately, it does not follow that
one article is free and that the price is attributable exclusive
ly to the other article.
While the facts in that case are quite similar to
those in the present one, it must be remembered
that Cattanach J. did not have to consider the
effect of section 85B(4) which was not appli
cable as there was no question of a guarantee,
indemnity or warranty.
Applying the foregoing jurisprudence to the
facts of the present case the following conclu
sions can be reached:
1. The fact that plaintiff in its financial state
ments refers to the amounts set aside as:
[TRANSLATION] "reserve for merchandise sold
and not delivered" when it is perhaps not prop
erly speaking a true reserve in the sense in
which the use of this term is recommended by
accounting authorities is not too significant. It is
not the designation given to the amount which is
set aside but the purpose for which it was so set
aside that is important, and the question to be
decided is whether this is a reserve which the
Income Tax Act permits to be deducted from
income for taxation purposes.
2. While the setting aside of this reserve may
have represented sound accounting practice so
as to present a true picture of the company's
financial position, it does not necessarily follow
that the amount of this reserve is deductible
from taxable income in the years in question.
3. Even though the amount of such a reserve
can be calculated and foreseen with .consider-
able accuracy, there are nevertheless elements
in it such as the loss of the guarantee form by
the purchaser, his neglect to avail himself of it,
or the transfer by him of the car on which the
original muffler was installed to another owner
which introduce an element of contingency into
the calculation of it.
4. Whether the amount is properly a reserve
or whether it is a contingent account, the
amount of which can be calculated with consid
erable accuracy, section 12(1)(e) of the Act only
permits the deduction in cases where such
deduction is "expressly permitted by this Part".
Section 85B, under the heading of "Special
Reserves" which is in the same Part of the Act,
sets out what reserves can be deducted. Section
85B(1)(a)(i) sets out that an amount received on
account of services not rendered or goods not
delivered before the end of the year must never
theless be included in taxable income, but para
graph (c) permits the deduction of a reserve for
goods that it is reasonably anticipated will have
to be delivered after the end of the year, which
is what plaintiff contends its reserve is for and
the situation in which Cattanach J. rendered
judgment in favour of appellant in the Dominion
Stores case (supra). However, this deduction of
a reserve is subject to the exception set out in
subsection (4) of section 85B which expressly
excludes the deduction when the reserve is in
respect of "guarantees, indemnities or
warranties".
The decision in this case must therefore
depend on whether this reserve was set up in
respect of a guarantee, indemnity or warranty.
None of these terms is defined in the Act and
plaintiff referred to a great many definitions of
them from dictionaries and court cases in an
attempt to establish that its undertaking to
replace a defective muffler free of charge so
long as the purchaser remained owner of the car
on which it was installed, does not come within
the strict definition of any of these terms. In
brief, plaintiff points out that a guarantee is an
accessory contract whereby the promissor
undertakes to be answerable to the promissee
for the debt, default or miscarriage of another
person, whose primary liability to the promise
must exist or be contemplated. There was, of
course, no third party involved in the present
guarantee. An indemnity is usually defined as a
contract whereby one party agrees to save the
other harmless from loss and the widest sense
of the term will include most contracts of insur
ance and also contracts of guarantee. In the
strictest sense an indemnity denotes a contract
to save the promissee harmless against claims of
third parties, but it is also frequently used to
denote a contract by which the promissor
undertakes an original and independent obliga
tion to indemnify as distinct from a collateral
contract in the nature of a guarantee. A warran
ty is merely a promise that a proposition of fact
is true. In the present case there is no warranty
that the original muffler would not prove to be
defective or need to be replaced but merely an
undertaking to . replace it, which plaintiff con
tends was in the nature of a contract to make
the replacement. The attempt to determine what
is meant by these words by reference to diction
ary or judicial definitions is further complicated
by the fact that in French the word "warranty"
is translated by "garantie" which also translates
the word "guarantee". In fact the French ver
sion of section 85B(4) of the Income Tax Act
translates the words "guarantees, indemnities or
warranties" simply as "garanties ou indem-
nités".
Plaintiff attempts to make a distinction be
tween the sort of guarantee which a vendor
gives that the merchandise will not be defective,
in the case for example of a television set, to the
effect that if it becomes defective within a cer
tain time the defective part will be replaced.
Even though the vendor may know from experi
ence that a certain number of the objects sold
will become defective and have to be replaced,
this is still dependent upon an uncertain and
contingent future event and plaintiff contends
that this is the sort of guarantee contemplated
by section 85B(4) of the Act in refusing the
deduction of a reserve. Plaintiff contends, how
ever, that its guarantee is not really addressed to
defective mufflers, although these are included
in it, but is really an undertaking to replace the
original muffler from time to time, and that this
is an event which is bound to occur and is
foreseeable and not contingent, and that it
should therefore be treated as a contractual
obligation and not as a guarantee or warranty.
In this contention, however, it appears to me
that plaintiff is attempting to make a distinction
which the Act itself does not make. It appears
to be pointless to attempt to seek the meaning
of section 85B(4) in dictionaries or judicial defi
nitions. The scheme of the Act does not permit
deductions of reserves with respect to guaran
tees, 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 deduc
tion by way of reserves because of their contin
gent and uncertain nature. In the present case
the replacement of mufflers can clearly be
claimed as an expense in the year in which the
replacement takes place but the probability of
this being necessary in connection with one-
fifth of all the mufflers sold, and even the fact
that plaintiff has charged extra for the original
muffler to allow for this does not in my view
permit the deduction of a reserve in the year in
which the original sale was made even though
this may be good accounting practice. The very
wording of the undertaking itself, which is en
titled "Guarantee" and undertakes to "guaran-
tee" replacement "should this muffler become
defective" indicates the contingent nature of the
undertaking. The fact that it is carried out in
good faith and the muffler is replaced when it
wears out even though it is not defective can in
no way change the tax liability of plaintiff.
Plaintiff's appeal from its income tax assess
ments for the taxation years ending November
30, 1967, December 31, 1967, and December
31, 1968 is therefore dismissed, with costs.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.