Paul Burden LTD v. Minister of National Revenue, [1981] CTC 2847, 81 DTC 651

M J Bonner:—This is an appeal from an assessment of income tax for the 1978 taxation year. On assessment the respondent included in income certain service contract revenue received during the year. The appellant, in its domestic financial statements, had deferred recognition of that revenue by setting up a balance sheet liability in the amount of $47,574.85. That amount represented fees unearned at year end calculated on a basis of prorating by time. It did not reverse that entry in the statement entitled “reconciliation of net income per financial statements with net income for income tax purposes” forming part of its income tax return.

The appellant is a retailer of office machines and supplies. It operates a service department, the function of which is to maintain and repair office machines. It offers its customers service contracts. Under those contracts the appellant agrees that it will make, at its expense, all repairs necessitated by normal wear and tear to those machines described in the contract. Most of these contracts are for a term of twelve months. All are renewable. All are in consideration of a payment to the appellant of a comprehensive fee determined prior to entry into the contract. Work done under the service contracts forms about 25% of the work of the service department. The remainder is done, I gather, on a job-by-job basis and the customer is charged at the then current hourly rate for the number of hours spent in performing the service.

Exhibit A-1, a service contract, was identified as being essentially similar to the contracts entered into during the 1978 taxation year. It is an extremely imprecise document drawn more in the style of an advertising brochure than in an apparent attempt to create identifiable legal obligations. It provided in part:

We pledge and dedicate the skills and technological knowledge of our Customer Engineering Service Organization to guarantee the performance of your equipment.

Our personalized service performed by factory trained servicemen will: Maintain your equipment at peak performance. Extend the efficient life of your equipment. Reduce the consumption of costly supplies. Minimize “Lost Time” due to machine malfunction.

EXTENDED WARRANTY AGREEMENT PROVIDES:

NO HIDDEN CHARGES

Your equipment will be maintained for a period of one (1) year at the prevailing extended warranty rate, and will remain in force until cancelled by written notice by either party. All necessary shop repairs, including a repair loaner if available at no charge.

The evidence indicated that no pre-arranged regular pattern of preventive maintenance was laid down. What happened was that when a serviceman visited a customer’s premises in answer to a call to repair a machine which had broken down, he repaired that machine and, as well, he did maintenance work on the other machines covered by the agreement which were on the premises.

The evidence of Paul O Barrett, comptroller of the appellant, was that the liability figure used was the amount of “unearned” service contract fees at the end of the 1978 fiscal year. As I understand it, the figure was calculated as that portion of total fees paid for service contracts in effect at, but expiring after, the end of the 1978 taxation year which the remaining terms of such contracts were of the total terms of such contracts.

Mr Barrett produced a copy of a letter in which he had calculated, for the 1980 fiscal year, the revenues earned under service contracts and the costs of earning such revenues. He found that for that year the costs were $63,311 and the revenues earned were $60,133. The 1980 result was, he said, representative of experience over the years. Costs and revenues had consistently been almost equal.

Charles E Scott, the acountant who was responsible for the audit of the appellant’s financial statements, testified that it was “common practice” in situations of this kind to categorize service contract income as earned and as unearned by prorating on the basis of the unexpired months of the contracts. Further, he expressed the view that in determining a reasonable reserve in respect of future costs, it was proper to look to historical experience in estimating the costs expected to be incurred. He admitted, however, that what was done here was not the creation of a reserve against full contract revenues in respect of anticipated costs, but rather was a deferral of part of those revenues.

It was the appellant’s position that:

(a) The Income Tax Act, by implication, permits the deduction of the amount in question as a reserve in respect of services to be rendered after the year end. The line of reasoning here was that the deduction of the cost of such post year end services was in accordance with generally accepted accounting principles and may thus be made in the computation of profit for purposes of section 9;

(b) The Income Tax Act, by paragraph 20(1 )(m), permits the deduction of a reserve in the amount in question. Counsel argued that if the amount of $47,574.85 is properly included in income under the provisions of subparagraph 12(1 )(a)(i), then a corresponding deduction of that amount is permitted by paragraphs 18(1 )(e) and 20(1 )(m);

(c) the paragraph 20(1 )(m) deduction permitted here is not prohibited by subsection 20(7).

It was the respondent’s position that:

(a) the inclusion in income of the $47,574.85 was required by paragraph 12( 1 )(a) of the Act;

(b) the sum of $47,575 exceeded a reasonable amount as a reserve under paragraph 20(1 )(m), a provision which relates the reserve to the cost of providing the services or goods;

(c) subsection 20(7) precludes any deduction under paragraph 20(1 )(m) in the circumstances of this case; and

(d) if the deduction sought is not one permitted by paragraph 20(1 )(m), then it is prohibited by paragraph 18(1 )(e).

I cannot accept the appellant’s first contention for several reasons. First, there was no evidence that the procedure adopted by the appellant was in accordance with generally accepted accounting principles. The evidence of Mr Scott was that such procedure was “common” in the case of businesses which enter into service contracts. There may well be a difference between practices which are common and those which are generally accepted. Furthermore, even if the appellant’s accounting practice is one which is “generally accepted”, it is when viewed as a bald deferral of revenues, contrary to an express provision of the Income Tax Act which must, of course, prevail. It must always be remembered that although income from a business is the profit therefrom, steps in the calculation of profit which are prohibited by the Income Tax Act must not be taken. Accounting practices, no matter how appropriate to the circumstances of the business and no matter how widely accepted or common they may be, will not govern for tax purposes when inconsistent with an express provision of the Act. In this case, paragraph 12(1 )(a) of the Act, which falls within Part I, specifically requires the inclusion of all contract revenues received by the appellant in the year. Counsel for the appellant did not suggest any basis on which the deduction, viewed as a reserve in respect of costs to be incurred after year end, could escape the paragraph 18(1 )(e) prohibition, save by virtue of express permission in paragraph 20(1)(m).

It is therefore necessary to consider whether the deduction of $47,575 reserve is the deduction of . . a reserve in respect of guarantees, indemnities or warranties .. .” or . . a reserve in respect of insurance . . within the meaning of subsection 20(7).

Some further facts are relevant to a consideration of this question. The service contract was called an “Extended Warranty Agreement”. That name was adopted prior to 1978, according to Mr Barrett, in order to overcome customer resistance to the same contract when marketed as a “service contract”. As to the name “Extended Warranty Agreement”, counsel for the appellant relied on Front & Simcoe Ltd v MNR, [1960] CTC 123; 60 DTC 1081, in which the following statement of Viscount Simon was referred to with approval at 132 [1085]:

It may be well to repeat two propositions which are well established in the application of the law relating to income tax. First, the name given to a transaction by the parties concerned does not necessarily decide the nature of the transaction. To call a payment a loan if it is really an annuity does not assist the taxpayer, any more than to call an item a capital payment would prevent it from being regarded as an income payment if that is its true nature. The question always is what is the real character of the payment, not what the parties call it.

While that proposition is undeniably correct, it should be remembered that the name or description adopted in the contract may not be inaccurate.

The only relationship between the contracts in question and the manufacturer’s warranty on new machines was that the contracts did not take effect on new machines until the manufacturer’s warranty had expired. However the appellant sold such contracts not only in relation to new machines which it had sold to its customers,but also in relation to any machine which a customer wanted to be covered. It is plain that the contracts were not warranties as to the freedom from defects of the machines or their suitability for any named use.

Appellant’s counsel referred to dictionary definitions and judicial interpretations of the words guarantee, indemnity, warranty and insurance. Not surprisingly, counsel for the respondent countered by referring to the decision of Walsh, J in Mister Muffler Limited v The Queen, [1974] CTC 813; 74 DTC 6615, and in particular to the passage at 824 [6623] where his lordship said: “It appears pointless to attempt to seek the meaning of subsection 85B(4) In dictionaries or judicial definitions.”

The decision in Mister Muffler appears to suggest that paragraph 20(7)(a) has application here. There the reserve was sought in respect of the appellant’s obligation to its customers to replace mufflers which it sold in the event that they became defective. His lordship in referring to subsection 85B(4), a provision identical to paragraph 20(7)(a), said at 824 [6623]:

The scheme of the Act does not permit deductions of reserves with respect to guarantees, 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 deduction by way of reserves because of their contingent and uncertain nature.

It is far from certain that the appellant would be called on to fulfil its obligation to repair under any particular contract or in respect of any particular machine. It was not suggested that the appellant’s obligation to maintain should be treated differently from the obligation to repair. The evidence showed that preventive maintenance was carried out not in accordance with any regular or predetermined schedule but rather when a serviceman happened, as a result of a repair call, to be in an area where other machines could conveniently be serviced. Elements of contingency and uncertainty are amply present here.

Counsel for the appellant argued that:

In order for a contract of indemnity to take effect, a party to the contract must have suffered a loss and prove the extent of the loss. Compensation would then be made for the extent of the proven loss.

The meaning suggested is, in my view, unduly restrictive. Nothing in the decsion or definitions relied on supports a suggestion that an obligation to indemnify cannot exist where the obligation is not to pay monetary compensation but rather is one to perform an act or provide a service. The contracts in question obliged the appellant to maintain in order to prevent breakdown and to repair in order to rectify breakdown. Those are the principal obligations for which the appellant is paid. By those contracts the customer is kept free from or secured against maintenance and repair costs. He is, in a word, indemnified. The reserve sought is therefore . . in respect of. . . indemnities . . .” within the meaning of paragraph 20(7)(a).

At the beginning of the hearing, counsel for the respondent consented to judgment allowing the appeal and referring the assessment back to the respondent for variation on the basis that the sum of $11,698.60 referred to in the pleadings does not form part of the appellant’s income for 1978. The appeal will therefore be allowed in accordance with that consent but no other relief will be granted.

Appeal allowed in part.