Harlequin Enterprises Ltd. v. The Queen, 77 DTC 5164, [1977] CTC 208 (FCA)

Urie, J (concurred in by MacKay and Kerr, DJJ):—This is an appeal from a judgment of the Trial Division dismissing with costs the appellant’s appeal from the respondent’s reassessment in respect of its 1969 taxation year. In its 1969 income tax return the appellant, a book publisher, deducted from its income the sum of $125,040 representing its “Gross profit on books on hand at wholesalers’’. This, it was alleged, related to books sold by the appellant to distributors, still in their hands or those of the wholesalers who purchased from them at the end of the fiscal period, on the assumption that all unsold books would be returned to the appellant. The reassessment disallowed the deduction.

Briefly the facts are these. The appellant markets its books both in Canada and the United States through distribution chains to what are described as the wholesale and direct markets. In the wholesale market the appellant deals with a distributor in Canada and one in the United States, which, in turn, sell to a number of wholesalers. The wholesalers then sell to retail outlets in their territories which then sell to retail customers.

In the direct market, there is no wholesaler intervention. The distributor deals directly in this market with large retailers, such as chain stores, which then sell to retail customers.

In Canada distribution to both wholesale and direct markets is made by Curtis Distributing Company Limited (herein called “Curtis Canada’’) under a written agreement dated March 22, 1949. The most important provisions in that agreement for purposes of understanding the issue in this appeal are:

(a) “Title to books and risk of loss thereof shall remain in publisher [the appellant] until delivery to wholesalers’’, and

(b) “Books which are considered unsaleable shall be fully returnable. . . . Curtis shall be entitled to credit on its monthly statements for all returns, at the price charged Curtis for books hereunder’’.

The purchase prices for books sold under this agreement were invoiced monthly, for payment, the Court was advised, within 60 days. The actual unsold books were not returned. Rather, their covers were ripped off and returned by the wholesalers to Curtis Canada which issued credit notes, copies of which went to the appellant. The copies of the credit notes served as invoices from Curtis Canada to the appellant and were taken into account for credit to Curtis Canada on the monthly statements required by the contract.

In the United States distribution to the wholesale market was made by Curtis Circulation Company (herein called “Curtis US’’) pursuant to a written agreement dated December 19, 1968. The relevant provisions of that agreement for purposes of this appeal read as follows:

(3) Harlequin agrees to sell and Curtis agrees to purchase the books for resale in accordance with this Agreement . . . The purchase price shall become due and payable by Curtis sixty days after shipment by Harlequin and Harlequin shall invoice Curtis monthly. Books shall be shipped and delivered by Harlequin or its agent to the wholesaler or other outlets as directed by Curtis . . . Curtis shall become the owner of the books purchased on delivery of the same to such delivery points specified by Curtis.

(4) Curtis shall sell Books to Customers subject to full return privileges as hereinafter described. Books shall always be fully returnable by Curtis to Harlequin for full credit.* [1] Curtis will initiate computation of the Customer’s credit for returns for unsold Books via return authorizations issued by Curtis. . . . Curtis shall give return credit to Customers upon receipt of authorizations from Customers and shall receive credit from Harlequin upon the giving of such credit to Customers . . .

(6) Curtis shall pay Harlequin for shipments of books to Curtis or to Customers within sixty days after shipment is made by Harlequin. This payment shall be adjusted for return credits (issued in accordance with paragraph 4 hereof) for previously uncredited returns.

Returns were handled in much the same fashion as that which prevailed in Canada.

Distribution in the direct market in US was made on an entirely different basis pursuant to an agreement with Simon & Schuster, Inc (herein called Simon & Schuster). In essence it appears to be a licensing agreement whereby the appellant furnished Simon & Schuster with plates and negatives permitting the latter to print, in the United States, the books the former published in Canada. Royalties were to be paid on “net sales’’, which term was defined as “copies shipped by Publisher [Simon & Schuster] to retail chain store outlets less returns’’. Simon & Schuster had ‘unlimited and uncontrolled discretion in the matter of accepting returns’’. The agreement also included detailed provision for the accounting for and payment of royalties and credits for returned books against royalties already paid.

As I understand it, the appellant does not contend that the Minister erred in his reassessment in refusing the deduction of $125,040, calculated in the manner in which it was. There was no such argument advanced either on the appeal or in the appellant’s Memorandum of Fact and Law. Rather the appellant says that the deduction to which it is entitled is the sum of $232,889 shown in its balance sheet for the year ending December 31, 1969 under the heading “Provisions for returns or allowances’’, adjusted because of an error in its calculation to the sum of approximately $220,000. That sum was calculated by the application of percentages, based on historical data and interviews with its distributors in regard to their actual experience with returns, to annual gross sale figures and was said to provide a more accurate estimate of the value of returns at the end of a fiscal year. Although shown in the appellant’s balance sheet for the fiscal year in issue it was not claimed as a deduction in its 1969 tax return.

The appellant argued that

(a) the sum of $220,000 ought to have been allowed as a deduction from its accounts receivable or as a current liability, or

(b) the said sum ought to have been characterized as a reserve for doubtful debts and allowed under paragraph 11(1)(e)* [2] of the Income Tax Act as it read in 1969 (hereinafter called the Act).

The respondent, on the other hand, argued that the trial judge correctly found that the proposed deduction was prohibited by paragraph 12(1 )(e)t [3] of the Act in that it was “an amount transferred or credited to a . . . contingent account . .

The same submissions were made by each party at trial. The learned trial judge rejected those of the appellant and agreed with counsel for the respondent that the appellant’s obligations to its distributors in respect of credits for books returned to it pursuant to their contractual rights, constituted a contingent liability to the appellant. In the same way its obligation to repay certain royalties received from its licensee Simon & Schuster for royalties paid by it to the appellant for books printed and distributed by the licensee constituted a contingent liability. Thus he said [p 849]:

An account set up to provide for those contingent liabilities whether by way of a provision for returns and allowances on its balance sheet or a deduction from earnings in the calculation of its taxable income was a contingent account within the meaning of paragraph 12(1)(e).

I agree with this conclusion and the reasoning of the learned trial judge in reaching it. No useful purpose would be served, in my view, in reviewing and restating that reasoning particularly since the appellant did not quarrel with the findings of fact of the trial judge but only with the application of the law to those findings. Specifically, I agree With him that, on the evidence of the expert witness called by the appellant, the appellant’s practice of making provision for book returns was in conformity with generally accepted accounting principles. However, the fact of its acceptability in accounting practice does not of itself make it a proper deduction from income for tax purposes. Whether or not it is must be found in some provision of the Act. I agree that the provision for returns is contingent, because in any fiscal period, although it was known from experience that there would be returns, the number and actual value thereof could not be fully known until all returns on sales made within that fiscal period had actually been received which might not be until some considerable period of time had elapsed after the end of the fiscal period. Therefore, the provision falls within the prohibition contained in paragraph 12(1)(e).

Ample support for this conclusion is derived from the evidence. As above indicated, the appellant at trial called, as an expert witness, a chartered accountant, Mr Scott, to testify with respect to what constitutes generally accepted accounting practice in setting up reserves or other provisions in financial statements of a business for events which may in the future occur and which should be considered in the preparation of the financial statements. During the course of his cross- examination he was asked the question set out hereunder and gave In the answer which follows what, I believe, is a most illuminating opinion confirming both my view and that of the learned trial judge that the “provision for returns or allowances’’ made by the appellant in its balance sheet was, in fact, a contingent liability:

Q. No. What do you understand by the expression contingent account? A. It is not the most meaningful expression I have ever encountered. If I had to express a meaning for it in an accounting sense, I would look to the literature and thought of accountants which said—would illustrate to me I think that accountants think about contingencies in three different ways. They think about contingencies where the possibility of occurrence of reasonably predicting the occurrence of something is too remote, it is too difficult to do. Strangely enough that type of thing, an example—the classic example I think is when the management of a company is concerned after a period of rising prices, that the bottom is going to fall out of the market and it wants to provide against the contingency of a decline in inventory. The accountant says in response to that, the only way you can do that is by providing a reserve. As I defined it, appropriation of earnings. That type of contingency he cannot, In accounting, enter into the measurement of income for a period.

The other extreme, accountants talk about contingencies where there is a reasonable basis for expecting that the event will in fact occur and if the foundation for that event occurred or was accounted for in a particular year, let’s say year one, and yet there is a good basis of probability based on past experience to believe that the event will occur in a subsequent period and it affects the measurement of income in the first year, then accounting says you must provide for that contingency in the accounts and the provision for book returns here is a classic example of that.* [4]

In between, as I expect I think one gets a gray area where very difficult judgments have to be made, sometimes these expected future contingencies are recorded, sometimes they are not, the requirement in that middle zone, the minimum requirement in the middle zone is the financial statement discloses the existence of such contingencies, possibly having an impact on the business.

In respect to the method adopted by the appellant in its calculation of taxable income in its tax return, ie by deducting from its income the sum of $125,040, I agree with the learned trial judge “that the elimination of the entire profit element, including that attributable to the approximately nine of ten books that would not be expected to be returned [as the evidence discloses was the historical experience], has no rational foundation” [p 847]. That, coupled with the expert evidence that made no reference to such a practice being generally acceptable from an accounting point of view, leads to the conclusion that, since it is neither acceptable accounting practice nor does any provision in the Act permit a deduction of such a kind, it was properly disallowed by the respondent.

On the basis of this finding, therefore, it does not appear that any of the four authorities relied upon by the appellant is applicable on the facts of this case. Primarily counsel relied on the judgment of Kellock, J in Sinnott News Company, Limited v MNR, [1956] SCR 433; [1956] CTC 81; 56 DTC 1047.

In that case the appellant claimed to be entitled to deduct, in computing its taxable income for a fiscal period, a “reserve” for loss on returns representing the profit element in the sale price of periodicals in the hands of dealers at its fiscal year end unsold and expected to be returned to the appellant. The Minister contended that this reserve was prohibited by the terms of paragraph 6(1)(d) of the Act, as it then read. Effectively it was the same paragraph as paragraph 12(1 )(e) with which we are here concerned.

Kellock, J found that the periodicals were not sold on a “sale or return” basis within the meaning of Rule 4 of section 19 of The Sale of Goods Act of Ontario because, in his view, property passed to the dealers upon delivery of the periodicals. However, he held that they were sales “subject to a condition subsequent”, the result being that, in the case of magazines actually returned, title revested in the appellant. Therefore, he found that the appellant was not entitled, as it had done, to set up any “reserve” of profits. What it was entitled to do, he said, was “to deduct the estimated sales value itself, subject, however, when the actual figure is ascertained at the end of the three months’ period, to adjustment in the years when the returns are actually made”. He, therefore, allowed the appeal but on a different basis from that upon which the appellant argued the appeal.

On the other hand, the majority of the Court, while reaching the conclusion that the appeal should be allowed, did so on another basis. Locke, J, writing for the majority, found that the title to the periodicals did not pass to the purchasers in that case, and that the deliveries were made on a ‘sale or return” basis. While setting up a reserve as suggested was the wrong means of achieving what it wanted to do, the appellant was entitled to exclude from its total sales any amount referrable to periodicals delivered to and unsold in, the hands of retailers at the end of the fiscal period.

In my respectful opinion, the case at bar differs on its facts. The written agreements both explicitly and implicitly stipulated when title was to pass in respect of books distributed either to the wholesale market or the direct market. The accounting procedures of the appellant correctly reflected the agreements. The sales clearly were, as it seems to me, outright sales with an obligation on the appellant to repurchase any books which the distributor might elect to return. Thus they were not sales on consignment or on a “sale or return’’ basis since title passed to the purchasers before the returns were made. I do not think that it matters whether the view ts taken that they were sales “subject to a condition subsequent’’ or not, because, even if the obligation to repurchase is viewed as a condition subsequent in the case at bar, as I have already held, it constituted a contingent liability within the meaning of paragraph 12(1)(e). Kellock, J made no finding as to whether or not the reserve was a contingent liability within the meaning of that paragraph’s predecessor, paragraph 6(1 )(d). Rather he held that the ‘estimated sales value’’ was properly deductible from the gross sales during the fiscal period. Therefore, the case is distinguishable from this case whether the basis upon which the majority reached their conclusion or the basis upon which Kellock, J reached his conclusion is used.

I agree, too, with the learned trial judge that the decisions of the Supreme Court in MNR v Atlantic Engine Rebuilders Ltd, [1967] CTC 230; 67 DTC 5155, and Time Motors Ltd v MNR, [1969] CTC 190; 69 DTC 5149, are also distinguishable on their facts. In each of those cases there were existing, ascertained current liabilities in contradistinction to the case at bar where no such ascertained liability existed unless and until the retailers exercised their right to return unsold books.

In so far as Western Vinegars Ltd v MNR, [1935-37] CTC 325; 1 DTC 390; [1938] 2 DLR 503 (Exch), is concerned, upon which the appellant relied heavily, doubt was expressed as to its correctness by Thorson, J in Kenneth B S Robertson Limited v MNR, [1944] Ex CR 170 at 178; [1944] CTC 75 at 87; 2 DTC 655, with which doubt I respectfully agree. The Western Vinegars case was one in which the appellant sold its products in barrels and kegs, the value of which were charged to the customer as additions to the price of the goods contained in them. The customers were at liberty to return the containers, and, if they were in good condition, the amount charged for them was to be credited to the customers. The containers so returned then were put back into the company’s inventory of containers at inventory prices. It was the contention of the appellant in the case at bar that the return of books and the return of the containers involved the same elements. At page 332 [509], Angers, J stated:

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. I believe that an allowance should be made for the containers that are returned. If no allowance were made, it would mean that the appellant would have to pay tax on profits which it has not reaped. I do not think that this was the intention of the legislature in enacting the provision contained in para (d) of subsection (1) of sec 6.

In this case it cannot be said that ‘the appellant would be taxed on profits which it has not reaped”. In fact, as returns were made, as I understand it, the purchase price thereof was deducted from the gross sales figures in the determination of gross profit. To the extent that, towards the end of a fiscal year, some books sold by the appellant in the fiscal year might, at some future date, become returnable by the distributor, there would be an unascertained element in the gross sales figure which, when it became ascertained, would be properly deductible in the fiscal period in which the returns were made in the form of credits to the distributor. When that is done, the gross profits and consequently the taxable profits would be proportionately reduced for that year.

This method of accounting for returns (aside from the question of the advisability of making some sort of provision in the accounts in anticipation of the returns for the company’s own information, a subject which has already been dealt with) accords not only with good accounting practice but also with 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. That being so, we believe that the. Western Vinegars case is not only distinguishable on its facts, but even if it is not, then, in my opinion, it was wrongly decided and, in any event, is not binding on this Court.

There is no merit in the further contention of the appellant that, if the provision for returns is not deductible, it should be treated as a reserve for bad debts and thus properly deductible under subparagraph 11(1)(e)(i) of the Act. For the reasons given by the trial judge, I am unable to agree that there is any merit in this submission. As I understand it, there had not been any history of uncollectable accounts between the appellant and Curtis Canada, Curtis US or Simon & Schuster. Thus, historically, there was no reason or basis for setting up a reserve for bad debts, nor in fact was such a reserve ever set up. Even if there had been such a history, obviously when the 1969 financial statement discloses accounts receivable in the sum of $616,538 and it is proposed that a reserve of more than one-third of that amount, namely $220,000 be allowed, such reserve bears no relationship to the reality of the situation between the debtors and creditor and could not be considered a realistic reserve permissible as a deduction under subparagraph 11(1)(e)(i).

For all of the above reasons, therefore, the appeal should be dismissed.

Kerr, DJ:—I concur.

MacKay, DJ:—I agree with the reasons and conclusions of my brother Urie.