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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Whether XXXXXXXXXX company can exclude from income XXXXXXXXXX delivered to customers, which are returned in the first 90 days of the following year
Reasons: No reserve can be claimed because at year end the liability to credit customers for XXXXXXXXXX returned is contingent. Also, where title to the XXXXXXXXXX passes to the customer, and the customer has an absolute, but not necessarily immediate, obligation to pay for them, the sale price included in income cannot be retroactively adjusted for goods returned in a subsequent year.
XXXXXXXXXX Wayne Antle, CGA
November 14, 2002
Re: Advance Income Tax Ruling Request-XXXXXXXXXX
This is further to your request for an advance income tax ruling dated March 18, 2002. We also acknowledge the additional information received on June 24, 2002 and September 3, 2002, as well as our meeting of July 24, 2002 and our various telephone conversations.
Since we cannot provide the advance income tax ruling that you requested, we are considering the request to have been withdrawn. We will, however, provide you with the following comments explaining our position in this regard.
XXXXXXXXXX. Under the terms of sale, virtually all sales by XCo are made with a right of return, which provides that active titles bought on a returnable basis can be returned at any time. For accounting purposes, XCo includes the XXXXXXXXXX shipped to customers in its sales and records an annual allowance for returns, which has been treated as a non-deductible reserve for income tax purposes. XCo is now requesting that it be allowed to exclude from its sales XXXXXXXXXX that have been returned in the first 90 days after its year-end in accordance with our policy set out in paragraph 13 of Interpretation Bulletin IT-215R Reserves, Contingent Accounts and Sinking Funds.
Paragraph 13 of IT-215R essentially states that no reserve may be claimed for possible returns of items sold because the reserve would be contingent and therefore not deductible by virtue of paragraph 18(1)(e) of the Income Tax Act (the "Act"). However, in situations where goods are sold on consignment or on a "sale or return" basis where title to the goods has not yet passed to the purchaser, we recognize that income therefrom need not be reported unless and until title to the goods has passed from the vendor.
The issue of whether an amount could be excluded from income with respect to goods sold to customers, with a right of return, was dealt with by the courts in two leading cases. The Supreme Court considered the matter in the case of Sinnott News Company Ltd. v. MNR (56 DTC 1047). In this case, the appellant was a wholesaler that sold magazines to retailers. The retailers had the right to return periodicals that they did not wish to retain. The company sought to deduct a reserve for the magazines expected to be returned. The Court found that, being deliveries on sale or return, Rule 4 of section 19 of the Ontario Sale of Goods Act applied, and that title to the goods did not pass to the retailers, nor were they liable to pay for the goods delivered, other than for goods sold by them or not returned within the agreed period. While the Court agreed that a reserve for goods expected to be returned could not be claimed, the same result was achieved by the appellant. The Court ruled that the appellant's taxable income be restated by deleting from revenue the accounts receivable that had been set up in respect of the goods subject to sale or return remaining in the hands of the retailers at the appellant's fiscal year end.
The second case, heard by the Federal Court of Appeal, was Harlequin Enterprises Limited v. M.N.R (77 DTC 6634). Harlequin published paperback novels, which it marketed throughout Canada and the United States. In Canada, the marketing was done by a distributor, whereby the distributor became owner of the books upon delivery but would be entitled to claim full credit for the books returned unsold. In the U.S., the distributor was given a licence to print the books and was required to pay royalties on the net sales to Harlequin. Harlequin was legally liable to give the U.S. distributor full credit for unsaleable books. Harlequin claimed a reserve for expected returns of unsold books, which was disallowed by the Canada Customs and Revenue Agency ("CCRA"). The Federal Court of Appeal affirmed the Trial Division's ruling that no reserve could be claimed. While the company was obliged to give credits for the unsaleable books there was no liability to do so until the books were returned. The liability was, therefore contingent and the amounts set aside to pay the credits were a contingent account and not deductible pursuant to paragraph 12(1)(e) of the former Act. The case was distinguished from Sinnott News in that title to the goods had passed to the distributor when the books were delivered, and were therefore properly included in sales.
In our view, it is clear from the judgments in the Sinnott News and Harlequin cases that proceeds from the sale of goods can only be excluded from revenue when they are sold on consignment, or on a true "sale or return" basis where title to the goods does not pass to the buyer, and there is no liability to pay for the products, until the goods are either sold by the buyer, or a certain period of time has expired.
Our position in this regard, is set out in Interpretation Bulletin IT-170R Sale of Property-When Included in Income Computation. Paragraph 5 states that the sale price of property sold should be included in income when the vendor has an absolute, but not necessarily immediate, right to be paid. The bulletin goes on to say in paragraph 19 that where goods are reacquired (unless section 79 applies), this reacquisition does not retroactively nullify the effects of the original disposition for income tax purposes, even if the agreement restores the vendor and purchaser to their relative positions before the sale took place.
While it is clear that XCo has a legal obligation to credit customers for XXXXXXXXXX returned, the facts indicate that this obligation does not arise until customers return the XXXXXXXXXX, or otherwise satisfy the conditions for credit. Until this time, it is our view that the liability is contingent and therefore not deductible pursuant to paragraph 18(1)(e) of the Act.
Furthermore, our review of the terms of sale submitted indicates that title to the goods passes to the purchaser upon delivery. This is further corroborated by the fact that XCo records the items delivered in sales for accounting purposes. Therefore, consistent with the principles set down in the above cases, and our comments in IT-170R, it is our opinion that sales in one year cannot be retroactively adjusted for goods returned in the following year.
We trust that our comments will be of assistance.
We have closed our file concerning this matter. An invoice for the time spent considering this advance income tax ruling request will be forwarded to you under separate cover.
John Oulton, CA
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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