13 October 2000 Internal T.I. 2000-0034027 - REWARD POINTS IN PROMO. PROGRAM

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Whether the Taxpayer is entitled to a reserve under subparagraph 20(1)(m)(i) of the Act for the cost of merchandise it anticipates will have to be delivered after the end of the year on the redemption of its customers' reward points in its promotional program where the reward points relate to XXXXXXXXXX .

Position: While we agree that the Taxpayer may not claim a 20(1)(m)(i) reserve in respect of reward points XXXXXXXXXX , since this paragraph indicates that the reserve is only available for amounts that have been included in computing the taxpayer's income from a business in the year or in a previous year under in paragraph 12(1)(a), we are inclined to the view this item may give rise to a deductible expense in computing the Taxpayer's profit for the year under subsection 9(1) of the Act.

Reasons: Based on the relevant caselaw, the fact that the Taxpayer's liability in respect of unredeemed reward points is based on an estimate does not make the liability a contingent one. Further, the fact that the customer has the option of redeeming the reward points or not redeeming them does not change the nature of the liability. Accordingly, it is our view that paragraph 18(1)(e) does not apply to deny the deduction of a reserve for unredeemed reward points on credit sales. Finally, in accordance with the principles set out by the Supreme Court in Canderel Limited, a taxpayer is free to adopt any method for computing profit which is consistent with the provisions of the Income Tax Act, established case law principles or "rules of law," and well-accepted business principles.

		October 13, 2000

	XXXXXXXXXX  Tax Services Office	HEADQUARTERS
	Large File Section	J. Gibbons
(613) 957-2135
	Attention: XXXXXXXXXX
		2000-003402

XXXXXXXXXX (the "Taxpayer")

We are replying to your memorandum of June 22, 2000, in which you requested our views on whether the Taxpayer is entitled to a reserve under subparagraph 20(1)(m)(i) (hereinafter referred to as the "20(1)(m)(i) reserve") of the Income Tax Act for the cost of merchandise it anticipates will have to be delivered after the end of the year on the redemption of its customers' XXXXXXXXXX ("reward points").

Facts

• XXXXXXXXXX.
• XXXXXXXXXX.
• XXXXXXXXXX.
• XXXXXXXXXX.
• The cost of merchandise in inventory which is to be delivered to the client is not expensed until it has actually been delivered.
• The Taxpayer estimates a reserve for the cost of merchandise it anticipates will have to be delivered after the end of the year on the redemption of reward points.
• The reserve established by the Taxpayer is used for tax and accounting purposes.
• The reserve is expensed on the profit and loss statement and is approximately $XXXXXXXXXX for the XXXXXXXXXX taxation year.
• The Taxpayer sells the unpaid balance of its customer credit accounts receivables to an affiliated company ("Affiliateco").
• For the taxation year ended XXXXXXXXXX, the balance of the customer accounts receivable was approximately $XXXXXXXXXX .
• Sales of customer accounts receivables from persons resident in XXXXXXXXXX are made with recourse.
• For all accounts sold with recourse, an allowance for doubtful accounts is provided in accrued expenses, since the Taxpayer reimburses Affiliateco for the uncollectible balance.
• The Taxpayer's parent ("Parentco") undertakes on behalf of Affiliateco to collect the receivables.
• Affiliateco receives service charges on the receivables and reimburses Parentco for the collection costs.
• Parentco pays various amounts to Affiliateco to adequately service the receivables.
• There is a XXXXXXXXXX% transfer of the customer accounts receivable from the Taxpayer to Affiliateco. However, there has never been a sale of customer accounts receivable for cash. That is, no funds are exchanged, but rather the accounts are tracked through intercompany accounts on a monthly basis.
• Collections, sales, service charges, bad debt write-offs and provision for doubtful accounts are recorded monthly in general ledger accounts.

Auditor's position

It is the auditor's view that a reserve under subparagraph 20(1)(m)(i) is not available XXXXXXXXXX since no amount is included into income by virtue of paragraph 12(1)(a). Further, the auditor expressed the view that the fact that the Taxpayer transfers its customers' accounts receivable to Affiliateco at year-end does not affect the issue since the transfer fits within the Agency's criteria for not being treated as a sale. These criteria are:

(1) The parties do not deal at arm's length: (i) Parentco acts as the collection agent, (ii) debtors are not notified, and (iii) no gain or loss (i.e., discount) is recorded on the transfer of accounts receivable to Affiliateco.

(2) The accounts are transferred with recourse in the case of XXXXXXXXXX provinces (i.e., there is no transfer of risk), and the Taxpayer claims an allowance for bad debts and writes off bad debts.

(3) The transfer takes place on a non-cash basis. That is, the Taxpayer customer accounts receivable are replaced with intercompany receivables.

Our views

Under paragraph 12(1)(a), an amount received by a taxpayer in the course of business for services not rendered or goods not delivered is included in income from a business, notwithstanding the fact that the amount has not been earned. Paragraph 20(1)(m) provides for an offsetting deduction of a reserve in respect of goods that it is reasonably anticipated will have to be delivered after the end of the year or services that it is reasonably anticipated will have to be rendered after the end of the year.

We agree with your view that paragraph 20(1)(m) may not be used as support to allow the Taxpayer to claim a deduction for reward points XXXXXXXXXX. The preamble to paragraph 20(1)(m) indicates that the reserve is only available for amounts that have been included in computing the taxpayer's income from a business in the year or in a previous year under paragraph 12(1)(a). Further, as you correctly stated, the position in paragraph 5 of

IT-154R that a 20(1)(m)(i) reserve is available for the cost of prizes that it is anticipated will have to be delivered after the end of the year in respect of the redemption of trading stamps or other tokens of exchange is based on Dominion Stores Limited, which involved cash sales.

While we agree with you that the Taxpayer may not claim a 20(1)(m)(i) reserve in respect of reward points XXXXXXXXXX, we are inclined to the view this item may give rise to a deductible expense in computing the Taxpayer's profit for the year under subsection 9(1) of the Act. In this regard, we refer to the decisions in Time Motors Limited (69 DTC 5149), Féderation Des Caisses Populaires Desjardins De Montréal Et De L'Ouest-Du Québec (99DTC 1275), Canadian Pacific Limited (99 DTC 5286), and Newfoundland Light and Power (90 DTC 6166).

In Time Motors Limited, the Supreme Court considered whether the appellant company was entitled to a deduction for credit notes issued by it to its customers. Time Motors was a car dealer which purchased used cars from individuals and paid for them partly with credit notes, which could be applied by the holder within a stipulated time against the purchase price of some other car of stated minimum value. The Minister disallowed the deductions claimed by the Company in respect of the credit notes outstanding based on the view that the Company's obligations under the credit notes were conditional and were thus prohibited under paragraph 12(1)(e) of the Act (now paragraph 18(1)(e)). The Appeal Board allowed the Company's appeal, but the Exchequer Court reversed this decision. The Supreme Court, in deciding in favour of the Company, indicated that the note could not be considered apart from the transaction out of which it arose, i.e., the purchase of used cars by the Company. The credit note was evidence of the obligations of the Company vis à vis these purchases, and the obligation subsisted until satisfied or expired, and the company's customers had an enforceable right for the balance due.

In Canadian Pacific Limited, the Court of Appeal for Ontario considered the appellant company's method of accounting for Workmen's Compensation Board (the "Board") awards. Canadian Pacific was a Schedule 2 employer under the Workmen's Compensation Act and, as such, was liable to reimburse the Board for benefits payable by the Board to the Company's workers. Upon receipt of a notice of award made by the Board, the Company calculated the amount of the award based on the life expectancy of the worker. It added this amount to its "Deferred Liabilities - Workmen's Compensation" account, and expensed it for income tax purposes. The Minister of Ontario disallowed the deductions in the Company's 1981 to 1984 taxation years, on the basis that, for any given award, the only amounts that could be deducted in a taxation year were the actual payments made to a worker during the year. The Ontario Court (General Division) dismissed the Company's appeal on the basis that the amounts were not deductible under paragraph 18(1)(a) of the Act, since they had not been incurred to produce income from its business. Further, the Court felt that the amounts were not deductible under paragraph 18(1)(e) of the Act because they represented total estimated amounts which in fact might never be paid. In deciding in favour of the Company, the Court of Appeal referred to the expert testimony given on behalf of the Company, stating: "From Mr. Hawkins testimony, it is clear according to proper accounting practice, that the fact that an estimate is involved will not, in itself, lead to a finding that an account is contingent within the meaning of paragraph 18(1)(e)." Further, the Court went on to say: "To conclude this part of my reasons, 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, uncertainties surrounding the amount which will ultimately be paid will not per se result in the liabilities being classed as contingent, not the account being classed as a contingent account."

The cases cited above involved taxation years before the amendment to paragraph 18(1)(e) was in effect (the amendment became effective for taxation years beginning after June 1988). However, based on comments in Féderation des Caisses Populaires Desjardins de Montréal et de l'Ouest-du Québec, which dealt with the amended provision, it appears that Time Motors is still relevant . In this regard, the Tax Court stated: "With regard to the third criterion, the Supreme Court of Canada established in Time Motors, supra, that paragraph 18(1)(e) does not apply in the case of a liability that must be paid during a determined period of time in the future." [Translated] The Tax Court considered whether the employee contributions, which were referable to employees unused vacation leave, and which were required to be made by the taxpayer, could be deducted in the year the vacation leave was earned. The Minister had accepted the taxpayer's deduction for unused vacation leave. Although the Tax Court dismissed the taxpayer's appeal, since it concluded that the obligation for employee contributions was a potential future one and was therefore denied pursuant to paragraph 18(1)(e), its comments regarding vacation leave are relevant to the case at hand. It stated: "The employees acquire their vacation leave during the reference year, but cannot take that leave until after the reference period is over. However, it is during the reference year that the appellant becomes obliged to pay, and that obligation subsists until the amounts are paid in the year following the reference period. That is why the vacation pay, although estimated, is not a reserve within the meaning of paragraph 18(1)(e)." [Translated]

In Newfoundland Light and Power (90 DTC 6166), the Federal Court of Appeal interpreted Time Motors as follows: "My reading of this decision is that, while accepting the accounting practice followed, Pigeon J., more importantly, accepted the whole reasoning behind the accounting practice. By the same token, he rejected the notion that the credit notes represented a conditional or a contingent liability. The credit note reflected an obligation which was in existence till the note expired: it represented a value owed for a value received. The customer's option to present or not to present the note for redemption before its expiration never changed the nature of the liability. If claimed in time, the value owed was given. If not claimed in time, the value given turned out to be a profit."

Based on the cases cited above, it is our view that the fact that the Taxpayer's liability in respect of unredeemed reward points is based on an estimate does not make the liability a contingent one. Further, the fact that the customer has the option of redeeming the reward points or not redeeming them does not change the nature of the liability. In fact, the cases indicate that this is so even if the reward points were to be subject to a time limit. Accordingly, it is our view that paragraph 18(1)(e) does not apply to deny the deduction of a reserve for unredeemed reward points XXXXXXXXXX.

Finally, in accordance with the principles set out by the Supreme Court in Canderel Limited (98 DTC 6100), a taxpayer is free to adopt any method for computing profit which is consistent with the provisions of the Income Tax Act, established case law principles or "rules of law," and well-accepted business principles. The principles also state that once the taxpayer has adopted a method of computing profit that produces an accurate picture of profit for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture of income, or that another method of computation would provide a more accurate picture.

In conclusion, it is our view that the Taxpayer's method of accounting for unredeemed award points is not inconsistent with case law and the provisions of the Act, specifically paragraphs 18(1)(a) and 18(1)(e). Further, it appears that the Taxpayer's method is consistent with well-accepted business principles, since you indicated that this method was also adopted for accounting purposes. The onus is thus on the Agency to show that another method of computing income provides a more accurate picture of income. Accordingly, we would be inclined to accept that the Taxpayer is entitled to a deduction for unredeemed reward points XXXXXXXXXX. We also feel that the calculation of the Taxpayer' deduction should be reviewed for its reasonableness since it is an estimated amount related to a program that has been in existence for some time. In this regard, we believe that the amount claimed should bear some relation to the annual redemption rate experience of the Taxpayer's reward points program.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. If you wish to send a severed copy to the client, you may obtain one from Jackie Page at 613 957-0682.

John Oulton
for Director
Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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