Paragraph 18(1)(e) - Reserves, etc.

The taxpayer ("Perron") made cash term deposits in connection with its potential liability for countervailing and anti-dumping duties imposed by American trade authorities on Canadian softwood lumber exports, to the Royal Bank and pledged them in favour of the bank as security for irrevocable letters of credit issued by the bank to Perron's insurance company, which in turn issued a bond guaranteeing Perron's potential liability to the U.S. government. When the U.S. decided not to levy duties in 2002, the bond was released, the letters of credit expired and Perron received back the term deposits. Perron deducted the full amount of the term deposit as an expense in computing its income for the 2001 taxation year and included the same amount in income for its 2002 taxation year.

After finding (at para. 29) that as Perron retained an interest in the term deposits, they did not constitute an outlay or expense for purposes of s. 18(1)(a), Pelletier JA went on to state (at para. 30):

Furthermore, the amounts paid to the Royal Bank were in the nature of a reserve, or a fund set up to cover a contingent liability, as was the case in Nomad. Perron had no liability for countervailing or anti-dumping duties until such time as a final determination was made. Until that time, Perron simply had an obligation to ensure that it was in a position to pay the duty owing in the event of an adverse final determination. If no adverse determination was made, the funds would be returned to Perron. On the facts, that is exactly what happened. I am therefore of the view that the amounts paid to the Royal Bank were not deductible because they were in respect of a contingent liability, as provided in paragraph 18(1)(e) of the Act.

The taxpayer disposed of a property and reported a business loss in his 1975 tax return. In computing the loss, the taxpayer deducted from the proceeds of sale of a property amounts paid into court in connection with outstanding liens placed on the property at the time a building was constructed on it, even though the amount remained in court for some time after 1975. In agreeing with the Minister's position that the amount was not deductible in the 1975 year, Strayer J stated (at pp. 5283-4):

The jurisprudence seems amply clear that a reserve for the possible future payment of liens is contingent because it is impossible to know, until matters are finally settled, how much will actually be owing and therefore money held in reserve for such purposes is not deductible as an expense until the amounts actually owing are ascertained... . Therefore even though some or all of the amount of $35,850.19 might be regarded as a business expense, and potentially part of a business loss, in some taxation year, it could not properly be so regarded in 1975.

A collective agreement between the taxpayer and the CAW, as amended by them following the decision of the Federal Court of Appeal for the earlier taxation year, continued to create only an absolute liability of the taxpayer to add to a notional fund an amount of $2 per overtime hour worked by all covered employees in excess of 5% of straight time hours, but without creating an absolute liability to pay those amounts. As the liability was thereby contingent, the taxpayer was not entitled to a deduction in respect of the addition to the notional fund.

The full purchase price of $100,000 for the acquisition by the taxpayer of seismic data represented Canadian exploration expense to him notwithstanding that $85,000 of the purchase price was satisfied by a promissory note for $85,000 which would be paid down during its term out of a portion of cash proceeds received from any future sales or licensing of technical assets and of production cash flow generated from petroleum rights from drilling programs. The note did not represent a contingent liability because it provided that should any amount be outstanding at maturity, the holder of the note would have recourse to specified security (in such event a trustee was to be appointed to sell seismic data with the proceeds of sale being allocated as 60% in reduction of the remaining amounts owing under the note). Rothstein J. stated (at para. 33):

"The Minister seemed to be saying that if there is risk to the value of the collateral security at maturity, liability is contingent because the creditor may not make full recovery of the total liability. If the Minister were correct, all liability would be contingent."

Under a collective agreement with its union, the taxpayer agreed to accrue $2 per every overtime hour worked by covered employees in excess of 5% of straight time, with the accrued amounts to be used to support childcare programs, legal services plans, a suplementary unemployment benefits plan "only if needed", or to fund jointly agreed initiatives with the union. The accrued amounts were not deductible in light of s. 18(1)(e) since they were not contributed to a qualified trustee or othewise segregated or set aside from ordinary working capital, and there was no identifiable creditor who could make a legally enforceable claim against the taxpayer with respect to the accrued amounts.

If the taxpayer paid a logging contractor in full upon delivery to it of cut wood, it would be subject to liability to the workers' compensation board to the extent of unpaid workers' compensation contributions of the contractor. Accordingly, pursuant to terms in its contracts with the contractors, the taxpayer withheld from the payments made to them amounts (e.g., $0.50 per metric tonne of cut wood) that were estimated to be at least equal to the contribution liabilities of the contractors.

Reassessments that treated portion of contract payments that had been held back as not being deductible until paid, were ordered to be reversed. Sharlow J.A. found that a legal obligation to pay the full contract amounts came into existence when the contractual obligation (delivery of wood) had been performed. Before noting the evidence that in some cases contractors never claimed the holdback amounts, she stated that "an obligation to pay a certain amount does not become a contingent obligation merely because events may occur that result in a reduction in the quantum of the liability", and later also indicated that (notwithstanding statements of Desjardins J.A. in the Newfoundland Light case to the contrary), a "legal obligation to pay an amount may exist even if there is some risk that the actual payment may be set off against potential counter claims".

The taxpayer agreed with Air Canada that: Air Canada would develop a software program for a price of $2 million; for the first five years following the acceptance of the developed software by the taxpayer Air Canada would receive an amount of $0.05 per ticket sold by the taxpayer; if this resulted in repayment of the $2 million Air Canada would continue to receive that amount per ticket sold as an investment bonus during the five-year period; Ticketmaster would pay additional stipulated royalties to Air Canada; and if Air Canada did not receive payment of the $2 million, it would have an option to acquire the software for an amount equal to the unamortized balance. The arrangement was terminated by Air Canada after it had largely completed the software development and before the software was accepted by the taxpayer.

In rejecting a submission of taxpayer's counsel that the arrangement should be construed as a services contract coupled with an interest-free loan of $2 million by Air Canada to the taxpayer, Evans J. stated (at p. 5415) that "the terms of the contract do not impose on Ticketnet an unequivocal obligation to repay money lent, one of the defining legal characteristics of a loan". Respecting an alternative submission that the services agreement itself represented a debt, Evans J. stated (at p. 5417) that "the fact that Ticketnet would not be liable to pay if Air Canada failed to deliver the software, or the software that it delivered was not accepted by Ticketnet for good reason, is sufficient to make the debt contingent as defined in Samuel F. Investments Ltd. ...". Finally, although both the parties might "... have agreed that Ticketnet was liable to pay $2 million to Air Canada for services rendered, a liability that terminated on the good faith non-acceptance of the software ... this is not what the contract provide[d]". Accordingly, s. 18(1)(e) precluded the taxpayer's claim to a scientific research and development tax credit under ss.37(1) and 127(5).

Upon receipt of notice of an award by the Workman's Compensation Board, the taxpayer would calculate the amount of the award on the basis of the life expectancy of the worker (using actuarial tables), and add that amount to a deferred liability account. The amount so added was expensed in the year for tax and accounting purposes, with subsequent adjustments being made as estimates changed.

Borins J.A. found that at the time the account was set-up the taxpayer had a statutory obligation which "was to be considered as subsisting until satisfied, or an event occurred which resulted in its termination" (p. 619) and that "where a taxpayer has incurred a liability in a taxation year, and has placed money into an account to enable it to fulfill the liability, uncertainty surrounding the amount which will ultimately be paid will not per se result in the liabilities being classed as contingent" (p. 621). Accordingly, the amounts added to the account were currently deductible.

In finding that a corporate taxpayer was not entitled to deduct expenses incurred prior to its formation and pursuant to an alleged contract between it and an individual promoter, Marceau J.A. noted that s. 18(1)(e) prohibited the deduction of contingent liabilities, and here the obligation in the alleged contract was subject to a condition that the taxpayer be "up and running", a condition which was only realized months later.

The taxpayer, which had incurred various expenses in respect of the second phase of a pipeline project which had not yet been constructed, was permitted by the National Energy Board to levy a special charge to Alberta producers of natural gas in respect of those costs. The Board indicated that it intended to make changes to the applicable regulations that would have the effect of refunding the special charge to the Alberta producers, and in the meantime required the taxpayer to give an undertaking to the Canadian government to repay the special charges.

Urie J.A. found that given that the date of completion of the second phase was unknown (and that date must occur before the requirement to repay could be implemented), the obligation to repay the special charges was uncertain and therefore contingent.

Although the taxpayer, as the subcontractor on various jobs, withheld 15% from the amounts it paid to the sub-subcontractors until, generally, the time that the work performed by the sub-subcontractors was approved by an engineer, McNair J. found that the sub-subcontractors were legally entitled to the full amount of the progress estimates at the time they submitted their invoices therefor. On this basis, it was found that the taxpayer's obligation in respect of the monies withheld from its sub-subcontractors was not contingent.

Before finding against the taxpayer on other grounds, the Court accepted that the reference to "contingent account" refers to accounting practice.

Northern Central Gas was followed. Teitelbaum J. noted (p. 5167) that although "where amounts are put into reserve accounts to cover liabilities which are legally binding and ascertainable on the taxation year but which may not be enforced until a later date, such amounts in certain circumstances may be deducted from income", here there was no legally binding obligation on the taxpayer to refund the amounts in question to third parties at the end of the taxation year.

At the end of its 1980 taxation year, the taxpayer (a common carrier) deducted $125,385 for the total of cargo claims which had been filed against it by its customers, and a further reserve of $50,000 as an estimate for potential claims of customers for damaged or lost goods. Since payment of any claim was something that might not happen, these reserves were non-deductible as contingent amounts.

Sears included in income amounts which it received from customers for its agreement to maintain and repair the sold products for a further year beyond the expiry of the one-year warranty period, and then deducted the same amounts from its income (to the extent that the agreement had not been terminated by the customer returning the product). It was found that in the absence of s. 20(1)(m) (before giving effect to s. 20(7)) the deductions would have been prohibited by s. 18(1)(e). The liability under a maintenance agreement was contingent in nature because "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." In addition, the amounts sought to be deducted were contingent because "the actual amount of the plaintiff's liability under the maintenance agreement was unascertained and unascertainable at the end of each of the taxation years".

It was anticipated by the taxpayer that in its 1978 taxation year it would be required by the Ontario Energy Board to pass along to its customers the amount of a gain on the sale of its inventory which it had realized in 1977 as the result of a rate increase. It was held that since there was no legal liability on the taxpayer at the end of 1977 to "refund" the amount of the gain to its taxpayers, that amount could not be deducted from its 1977 income.

Semble, that "insurance" premiums paid by the plaintiff to an arm's-length Canadian insurance company, which in turn re-insured various risks with a wholly-owned Bermudan subsidiary ("OI") of a wholly-owned Canadian subsidiary of the plaintiff "were in effect amounts transferred to a reserve fund and [were] therefore not deductible by virtue of paragraph 18(1)(e)". Strayer, J. stated that "the 'insurance program' must be seen as a device for channelling funds from the plaintiff to one of its own instrumentalities over which it had complete control, and to which it would have to look to pay losses on risks retained by OI ... . Any surplus OI might enjoy would ultimately be under the control of the plaintiff ... Any losses which OI did not have assets to cover would have to be borne by the plaintiff. The net result is similar to the establishment of a reserve fund ...".

A distributor of television sets charged dealers a flat fee of $30 per set in return for providing after-sales servicing of the sets under a three-year warranty, and credited 2/3 of the fees received to its "Unearned Income" account. It was held that the full amounts received were income to the distributor, and that no amount could be deducted for the "unearned" portion of the fees due to the prohibition in s. 18(1)(e) against the deduction in respect of an account for a contingency. The distributor "had no way of knowing which particular machine would break down or how many nor in what time frame".

Since the liability of the taxpayer at the end of its 1968 taxation year to pay $500,000 to a prospective tenant was contingent inter alia upon that tenant paying compensation to the landlord of the tenant's present premises for vacating (at the beginning of the 1969 taxation year) those premises, and since that contingency did not occur until after the 1968 year-end, the amount of that still-contingent liability was not deductible from its 1968 income. A claim against the taxpayer which was not settled until after the year-end also was non-deductible because of its contingent nature.

As at the end of each fiscal year a company accrued the amount of a management bonus, and during the following year the company's executive-shareholders would receive their sole remuneration by drawing against the amount that had been set up in the previous year. The fact that (as happened twice in the course of 22 years) the directors might, if they considered that business conditions so demanded, reduce or cancel the amount that had been set up, was not a contingency which negated the fact that the amount set up in the company's books constituted an existing liability.

Sales of books were made each year by the taxpayer to a distributor. The taxpayer was obligated to repurchase any books which the distributor might elect to return. The taxpayer at the end of each year was not entitled to deduct a reserve in respect of estimated returns. "[T]he provision for returns [was] 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" (p. 5166). The acceptability of the reserve and accounting practice did not make the reserve a proper deduction from income for tax purposes.

Insurance premiums were payable each year by the taxpayer pursuant to a Lloyds policy which established the premiums payable for each year in accordance with a formula which included "reserves, as estimated by the Insurers for outstanding losses, outstanding at the time of adjustment." The taxpayer was able to deduct the amount which it estimated at the end of each year to be what the adjustment would prove to be. For each year, its estimate was less than what it ended up paying to Lloyds. Dube, J. stated that "the amounts entered as expense were definitely owing and payable and were in fact paid."

Kerr, J. indicated, obiter, that s. 18(1)(e) would have applied to unpaid bonuses which the taxpayer sought to deduct: "When the decision to pay bonuses was taken in the fall of 1968 the amount that would be paid was uncertain, although a range of $25,000 to $30,000 was decided, and payment was contingent on necessary funds being available".

Reserves set up for a "guarantee" to replace mufflers installed by the taxpayer were implicitly treated as a contingent account.

The price of lumber declined after the taxpayer contracted to purchase lumber at a stipulated price for delivery in a subsequent taxation year. Since the taxpayer would not actually suffer a loss as a result of such a price decline until the time of delivery when it acquired the lumber, the accrual of a loss for undelivered inventory was prohibited.

It was noted that the lower of cost and market rule for inventory contained in s. 14(2) of the pre-1972 Act permitted the recognition of a "hidden reserve" whose deduction otherwise would have been prohibited by s. 12(1)(e) of the pre-1972 Act. However, the contract was not itself inventory.

A general building contractor in accordance with the terms of its contracts with its subcontractors withheld 10% of the amounts invoiced on a monthly basis to it by its subcontractors. The amounts withheld became due 35 days after a completion certificate was issued by the architect. Since it was far from certain that the withheld amounts would be paid in full (or even in part) to the subcontractors, they were not deductible in the year of withholding.

It was submitted on behalf of a mining stock promoter that he should be permitted to follow the "project" method of accounting in determining the cost of his speculative shareholding in a junior mining company, i.e., deducting the receipts from the sale of the shares against the cost of all his shares until the entire cost of the venture was recovered, and only recognizing income to the extent that the cumulative amount of the proceeds received by him exceeded the aggregate cost of his shares. Pigeon J., in finding that this method contravened what then was s. 12(1)(e) stated (p. 5158):

"What appellant is really trying to accomplish by this "project" method of accounting is to set up against the contingency that his inventory might drop in value, a reserve equal to his profit so far on the operation."

The taxpayer, which was a used car dealer, issued credit notes in partial payments of used cars acquired for resale. The notes were not transferrable, were valid only within a stated period of time (generally one or two years) and were good only for the purchase of a car of the taxpayer of not less than a stated value. Pigeon J. found that the issuance of the credit note gave rise to an immediate enforceable obligation rather than a contingent liability after noting that the wording of s. 12(1)(e) "clearly refers to accounting practice" (p. 5151).

Kearney J. rejected a submission that a retail sales tax liability of the taxpayer (whose payment had not yet been demanded by the Québec provincial government) was a contingent amount in light of an action in which the validity of the Retail Sales Tax Act (Québec) was being challenged. He relied on a statement in Mertens to the effect that "a condition precedent to the creation of a legal right to demand payment effectively bars the accrual of income until the condition is fulfilled, but the possible occurrence of a condition subsequent to the creation of a liability is not grounds for postponing the accrual" (p. 1008) in finding that there was no condition precedent to prevent the provincial authorities from bringing a claim against the taxpayer, and went on to state (p. 1008) that "the validity of a statutory law must be presumed until the contrary is proved."

Thorson J., before finding that the taxpayer could exclude unearned insurance premiums from its income on other grounds, stated, with respect to s. 6.1(d) of the Income War Tax Act (at pp. 658-659):

"The deductions prohibited by the paragraph under discussion would, in my opinion, not be permissible, even if the paragraph were not in the Act at all, for they really are dispositions of income after it has been received ... [E]very reserves set up out of profits or gains of whatever kind, which seeks to provide against the happening of uncertain future events, is excluded as a deduction, except insofar as the Act permits."