Citation: 2009TCC324
Date: 20090615
Docket: 2007-3069(IT)G
BETWEEN:
DOTEASY TECHNOLOGY INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent,
Docket: 2007-3077(IT)G
AND BETWEEN:
IN2NET NETWORK INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
V.A. Miller, J.
[1]
Prior to the hearing of
these appeals, the parties reached the following agreement with respect to two
issues raised by the Appellant, In2Net Network Inc. (“In2Net “):
a)
In2Net is allowed to
deduct motor vehicle expenses in the amounts of $7,031.54 and $10,105.43 for
the 2002 and 2003 taxation years, respectively.
b) In 2002, the amount
of $13,187.17 became a bad debt and In2Net is entitled to a deduction in
accordance with subparagraph 20(1)(p)(i) of the Income Tax Act
(“the Act”).
[2]
The only issue that was
litigated in these appeals is whether the Appellants were entitled to claim a
reserve pursuant to paragraph 20(1)(m) of the Act. The net reserves
claimed by In2Net were $258,674.93 and $82,828.78 in the 2002 and 2003 taxation
years respectively. The net reserves claimed by Doteasy Technology Inc.
(“Doteasy”) were $2,826,047, $819,370 and $420,642 in the 2003, 2004 and 2005
taxation years respectively.
[3]
The appeals proceeded
by way of a Statement of Agreed Facts. A summary of the material facts is as
follows:
a)
The Appellants are British Columbia corporations. Mr. Kevin Tang is the sole shareholder and
director of both companies.
b)
The year end for each
Appellant is June 30.
c)
The Appellants are in
the business of providing internet website hosting services and domain name
registration services (“the Services”).
d)
In order to provide the
website hosting services during the years under appeal, the Appellants operated
and maintained computer servers. Customers were given space on these servers to
create and maintain their own internet websites and files. The customers were
also given space on the servers to maintain their email addresses under their
domain name. This allowed the customers to send and receive emails.
e)
The Appellants also
entered into contracts with their customers whereby they acquired and
registered domain names on their customers’ behalf. Throughout the term of each
contract for domain registration, the Appellants were obligated to maintain the
customers’ domain presence by complying with the ongoing obligations required
by the applicable Registry. In addition, the Appellants sent their customers
annual emails with up-to-date information for their domain name records.
f)
The Appellants’
customers registered online for these Services and entered into service
contracts ranging from several months to several years. Many contracts extended
beyond the June 30 year end.
g)
Upon registration, the
Appellants required their customers to consent to the terms and conditions of
the service contracts. These terms and conditions provided, among other things,
that none of the fees paid for Services were refundable.
h)
The customers were
required to pay the full contract price for the entire service term at the time
of registration.
i)
The service contracts
were automatically renewed. The Appellants required renewing customers to pay
for the entire service term up front, and they terminated the Services if
payment was not received within 45 days.
j)
The Appellants, at
their discretion and on a case-by-case basis, did provide refunds of website
hosting fees to certain customers within 45 days of registration. The Appellants
never refunded domain name registration fees.
k)
Doteasy sometimes
provided refunds, in the form of in-store credits, outside the 45 day time
period.
l)
The Appellants provided
on-going customer service including customer support, technical support and bandwidth
management.
m)
The Appellants operated
out of an office of approximately 10,000 square feet and had a combined staff
of 30 employees who were engaged in customer service, domain name service,
server operations and maintenance, programming, billing, computer networking
and marketing.
n)
In each of the taxation
years in issue, each of the Appellants included in its income the full contract
price received for customer registrations for the Services during the taxation
year.
o)
In each of the taxation
years in issue, each of the Appellants claimed a reserve under paragraph 20(1)(m)
in respect of the Services. The reserve claimed in a particular taxation year
was brought back into income in the following year in accordance with
subparagraph 12(1)(e)(i). The claiming of the reserve is a timing issue.
(p) These reserves were reported in the same manner
on the Appellants’ financial statements.
[4]
At the hearing of these
appeals, counsel for the Respondent conceded that certain of the assumptions
made by the Minister of National Revenue (“the Minister”) were incorrect. It
was conceded that the Appellants did provide Services to its customers in the
subsequent taxation year into which a customer’s service term extended. The
Services provided in each month of the service term were substantially
identical. The Services were not substantially performed upon a customer’s
initial service activation.
[5]
The Respondent agreed
that if a reserve is available to the Appellants, then their calculation of the
reserve on a straight-line basis is reasonable.
Appellants’ Position
[6]
It is the Appellants’
position that the amounts received for the Services and included in income,
were amounts described in paragraph 12(1)(a) of the Act. They further
stated that they were entitled to claim the reserves under paragraph 20(1)(m)
as the statutory conditions specified therein were satisfied. More
specifically, the amounts were received by the Appellants in each taxation year
in the course of a business and some of the Services were to be provided to
their customers beyond the end of each taxation year.
Respondent’s Position
[7]
It is the Respondent’s
position that the amounts received by the Appellants for Services not rendered
in the particular taxation year are Prepayments which are included in
calculating the Appellants’ profits under section 9 of the Act and are not
amounts described in paragraph 12(1)(a) of the Act.
[8]
Counsel for the
Respondent explained that financial accounting principles allow a business to
treat income as not being “realized” when that income is received for services
not yet rendered. This rule is commonly known as the “realization principle”.
The income is deferred to a later date when the services are performed. This
deferral of income is the “matching principle” of accounting.
[9]
Counsel stated that the
Act incorporates the realization and matching principles of accounting only to
a limited extent. Tax law principles take precedence over accounting principles
when interpreting the Act. One such tax principle is that a taxpayer’s “profit”
under section 9 is a question of law and, accounting principles must yield to
legal principles where those legal principles provide a “truer” picture of a
taxpayer’s income[1].
[10]
Counsel submitted that
the Appellants’ entitlement to the Prepayments was absolute. After setting up
the Services, the Appellants were not obligated to meet any further conditions
before they became entitled to retain the fees received from their customers.
He argued that because the Prepayments were non-refundable, they had the
quality of income[2]
and the Prepayments were earned for tax purposes.
[11]
Paragraphs 12(1)(a)
and 20(1)(m) are aimed at allowing reserves only in respect of amounts
that are not earned for tax purposes but which the Act includes in income
regardless. Amounts that have the quality of income are included in income by
virtue of the calculation for profit in section 9 and no reserve can be claimed
for these amounts.
Analysis and Conclusion
[12]
The crux of the Crown’s
argument rests on its interpretation of the decisions in Robertson Ltd.
and Ikea Ltd. v. Canada[3]. Counsel relied on Robertson Ltd. to state that
because the Prepayments have the “quality of income”, they are earned and they
must be included in income when received.
[13]
It is my opinion that Robertson
Ltd. does not stand for the principle that if an amount has the “quality of
income”, then it is earned. At page 660 of his decision Thorson, J. stated that
amounts received in a taxation year may have the “quality of income” regardless
of whether they have been earned or unearned:
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.
[14]
It must be remembered that Robertson
Ltd. was decided under the Income War Tax Act which did not contain
paragraph 12(1)(a) or any comparable provision which dealt specifically
with unearned amounts[4].
[15]
Counsel for the
Respondent also contended that the Supreme Court of Canada’s decision in Ikea
Ltd. v. Canada[5]
supported his position that income was earned when it attained the “quality of
income”.
[16]
Iacobucci, J., speaking
for the court in Ikea Ltd., stated:
37
The combined effect of these
passages is to confirm what in the law of income tax has become known as the
“realization principle”, given that an amount may have the quality of income
even though it is not actually received by the taxpayer, but only “realized” in
accordance with the accrual method of accounting. The ultimate effect
of this principle is clear: amounts received or realized by a taxpayer, free of
conditions or restrictions upon their use, are taxable in the year realized, subject
to any contrary provision of the Act or other rule of law.
The TIP received by Ikea in the present case fits this description
perfectly. The tenant inducement agreement made it clear that the sole
condition precedent to receipt of the payment was the assumption of Ikea’s
obligations under the lease agreement, and further stipulated that the payment
was to be made within seven days of Ikea’s commencing business in the premises,
pursuant to the lease. Thus, Ikea’s right to the payment became absolute
at that time. There were no further strings attached such as to postpone
actual realization or receipt into a subsequent taxation year, and the payment
was received in full by Ikea in 1986. Therefore, I conclude that the
entire amount was taxable in that year. (emphasis added)
…
40 …The
consideration for the TIP is not the future payment of rent, but rather, the
immediate assumption of the contractual obligations. In such a case,
unless otherwise specified by the inducement agreement, then, and in the
absence of statutory or case law authority to the contrary, the realization
approach commends itself as that which will give a more accurate picture of the
taxpayer’s income. (emphasis added)
[17]
In Ikea Ltd.,
the inducement payments were taxable in the year they were realized because
there was no contrary provision in the Act or other rule of law and the
inducement payments did not relate to future obligations or expenditures. In
the present appeal, the Prepayments are for future services and there is a
provision of the Act that is contrary to the Prepayments being taxable in the
year they are received. Therefore, the fact that the Appellants have the
unrestricted right to use or dispose of the amounts is immaterial given that
the Prepayments are amounts described in paragraph 12(1)(a) and a
reserve is permitted under paragraph 20(1)(m).
[18]
The relevant provisions
of the Act are as follows:
12. (1) Income inclusions -- 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)
services, etc., to be rendered [or
goods to be delivered] -- 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,
20. (1) Deductions
permitted in computing income from business or property -- 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 be regarded as applicable thereto:
(m)
reserve in respect of certain
[future] goods and services --
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
….
(ii) services that it is reasonably anticipated
will have to be rendered after the end of the year
[19]
There are two
conditions that the Appellants must meet to be able to deduct a reserve for the
Prepayments pursuant to paragraph 20(1)(m). The Prepayments must be
described in paragraph 12(1)(a) of the Act and they must have been
included in the Appellants’ income from a business for the year or a previous
year. Both of these conditions have been met.
[20]
The Prepayments are
described in paragraph 12(1)(a) as they were received by the Appellants
in the years in issue in the course of business and they were on account of
services not rendered before the end of the taxation year.
[21]
Counsel for the
Respondent has argued that when one considers paragraphs 12(1)(a) and
20(1)(m) in light of the statutory scheme, it is clear that these
paragraphs are aimed at allowing reserves only for amounts that are not earned,
but which the Act includes in income nonetheless. Counsel referred to the
closing words in subparagraph 12(1)(a)(i) to support this conclusion.
Those words are: or that, for any other reason, may be regarded as not
having been earned in the year.
[22]
I agree with counsel
for the Appellants that the Respondent’s position disregards the words which
precedes the clause quoted in the above paragraph. When one considers all the
words in subparagraph 12(1)(a)(i), I interpret the subparagraph to mean that amounts that
are received on account of services not rendered or goods not delivered before
the end of the year, those amounts are regarded as not having being earned in
the year. It is because the services have not been rendered before the end of
the year that the amounts received for them in the particular year are regarded
as not having been earned. Richard
G. Tremblay explained it as follows in his article “The Meaning of Earned
Income in Subparagraph 12(1)(a)(i): Burrard Yarrows Corp. (Versatile
Pacific Shipyards Inc.)”:
Firstly, it is
submitted that the grammatically correct reading of para. 12(1)(a) is such that
the mere fact that an amount is received in the course of a business in respect
of services not rendered or goods not delivered is sufficient to bring the
provision into play and the entitlement to the reserve in para. 20(1)(m). The
use of the words “for any other reason” in subpara. 12(1)(a)(i) indicate that
the mere fact that services have not been performed or that goods have not been
delivered is sufficient to make the income unearned in the mind of Parliament[6].
[23]
The use of the words
“for any other reason” and “may be” in subparagraph 12(1)(a)(i) suggests
that if an amount is on account of services not rendered before the end of the
year, then the amount is statutorily regarded as “not having been earned in the
year”.
[24]
The Respondent also
contended that because the Appellants’ customers are not entitled to receive a
refund, the Prepayments are earned in the year they are received; they are brought
into income through the calculation of profit in section 9; and, therefore they
are not described in paragraph 12(1)(a).
[25]
This argument was made
before Rip, J., as he then was, in Ellis Vision Inc. v. The Queen[7].
He dismissed the argument as follows:
[45] Notwithstanding that the amounts the
appellant received in its 1996 and 1997 taxation years from broadcasters under
the licence agreements may have been included in computing the appellant's
profits for those years under subsection 9(1) of the Act, I cannot find
any prohibition in the Act that precludes the appellant from taking
advantage of paragraph 20(1)(m) and claiming a reserve.
[46] All amounts that are received or
receivable in a taxation year by a taxpayer in the course of a business are to
be included in the taxpayer's income for that year. However paragraph 20(1)(m),
among other provisions in the Act, recognizes that a taxpayer may have
been prepaid an amount that is or was required to be included in computing
income for the year or previous year. In such circumstances the recipient of
the amount may be eligible to deduct a reasonable reserve.
[47]
I do not agree with the respondent's position that if a taxpayer's
income from a business is its profits from that business pursuant to subsection
9(1), one is foreclosed from considering amounts described in subsection 12(1)(a).
Amounts included in income for purposes of subsection 9(1) may be described in
paragraph 12(1)(a): services not rendered or goods not delivered before
the end of the year or rent or other amounts for possession or use of chattels,
for example, paid in advance are amounts described in paragraph 12(1)(a).
Paragraph 20(1)(m) permits a reasonable reserve when amounts that are
"described" in paragraph 12(1)(a) have been included in
computing the taxpayer's income from a business for the year, or previous year,
and rents or other amounts have been paid in advance, or services may
reasonably be anticipated to be rendered in a future year. I agree with
appellant's counsel: the word "described" in paragraph 20(1)(m)
means just what it says it does. The word in the French version of the Act
is "visées", which, in the context of paragraph 20(1)(m), is
analogous to the words "referred to", or "directed at" in
English. The "amounts described in paragraph 12(1)(a)" do not
mean only amounts that were included in income "by virtue of"
paragraph 12(1)(a); the amounts may be included in income by virtue of
paragraph 12(1)(a) and the amounts may also be included in income as
profit from a business in accordance with subsection 9(1).
[26]
However, counsel for
the Respondent has further argued that his interpretation of paragraphs 12(1)(a)
and 20(1)(m) are supported by the Federal Court decision in Burrard
Yarrows Corporation v. The Queen[8].
It appears that this decision was not considered by Justice Rip.
[27]
In Burrard Yarrows,
the taxpayer was a shipbuilder who had a contract with the Government of Canada
to build two icebreakers and with the B. C. Ferry Corporation to construct two
ferries. The purchase price for both contracts was paid by progress payments.
The progress payments from the Government of Canada were calculated with
respect to the expenses incurred by the taxpayer, whereas those from the B. C.
Ferry Corporation were received upon completion of various stages of the
construction. Title to all the materials, parts, and finished work paid for by
each progress payment made under the icebreaker contract was said to vest in
the federal Crown. Under the contract for the ferries, property in the vessels
as well as all machinery, equipment, and materials vested in the purchaser as
soon as they were intended for use in the ferries.. The taxpayer claimed an inventory allowance
under paragraph 20(1)(gg). It also included in income the progress payments
received during the year and then claimed a reserve for the same amount
pursuant to paragraph 20(1)(m).
[28]
On finding that the Burrard
Yarrows was not entitled to claim a reserve for the progress payments,
Joyal, J. stated at paragraph 23:
23 I
agree with defence counsel that subparagraph 12(1)(a)(i) brings into income
only those which are received by the taxpayer in the year but which must be
regarded as being unearned.
[29]
It is my opinion that
this is the ratio decidendi of the Burrard Yarrows case as it
concerns the paragraph 20(1)(m) reserve issue. It stands for the
proposition that, on the facts of that case, there was no unearned amount.
There was no amount described in paragraph 12(1)(a). This is evident
from Joyal, J.’s conclusion with respect to the inventory allowance. He stated
at paragraph 17:
17 In the present case there can be no doubt but
that the property in the ships and the materials to be used therein was
intended to pass to the purchasers upon the payment of the first instalment and
throughout construction. I come to this conclusion after considering the
clauses of the contract which are set out above. The result is that the
property in the ships had already passed.
[30]
However, Joyal, J. did
state the following at paragraphs 23 and 25 of the decision:
23 …Further,
the availability of a paragraph 20(1)(m) reserve depends entirely on whether an
amount described in paragraph 12(1)(a) was included in computing the taxpayer's
income. Therefore, to determine whether a paragraph 20(1)(m) reserve is
available with respect to the progress payments in question, it must be
determined whether they were brought into income pursuant to subparagraph
12(1)(a)(i), which in turn requires a determination of when they were 'earned'
or, in other words, when they took on the quality of income. (emphasis
added)
…
25 In the present case, the plaintiff, upon
completing each of the various stages of construction, became absolutely
entitled to receive the progress payments which had been agreed upon. Its right
to those amounts was under 'no restriction, contractual or otherwise, as to its
disposition, use or enjoyment'. The contract did not even contain a provision
requiring refunding of the progress payments in the event of the plaintiff
defaulting. As a result, I find that the progress payments had the quality of
income when received and, hence, were earned amounts. It follows, therefore,
that subparagraph 12(1)(a)(i) does not operate to bring the payments into
income, and, further, that the Minister was correct in denying the plaintiff's
claim for a paragraph 20(1)(m) reserve. The plaintiff must bring the progress
payments into income in the year they are received.
[31]
It is my opinion that
this statement is obiter and is incorrect. It ignores the clear inference that
the drafters of the paragraph 12(1)(a) considered that amounts received
on account of goods not delivered or services not rendered constituted amounts
not earned.
[32]
In upholding the
decision in Burrard Yarrows, the Federal Court of Appeal only stated
that it was in agreement with the Trial Judge’s reasons.
[33]
The essential facts in
the present case and the arguments made before me are indistinguishable from
those in Ellis Vision. In Ellis Vision, Justice Rip, as he then
was, found that the paragraph 20(1)(m) reserve was available even though
the amount might be included in income under section 9 so long as it was
described in paragraph 12(1)(a). It is my opinion that Ellis Vision
has settled the law with respect to this issue.
[34]
For all of these
reasons, the appeals are allowed with costs.
Signed at
Ottawa, Canada, this 15th day of June 2009.
“V.A. Miller”
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