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: (a) Whether subsection 9(1) or paragraph 12(1)(a) includes in income a prepayment in respect of a software maintenance agreement. (b) If paragraph 12(1)(a) applies, whether subsection 20(7) of the Act will apply to deny a paragraph 20(1)(m) reserve because of the indemnity nature of the agreement.
Position: (a) Paragraph 12(1)(a) applies. (b) Yes, but the prepayment may have to be allocated amongst the elements of the maintenance plan that indemnify the customers.
Reasons: (a) As a general rule, paragraph 12(1)(a) should apply; the circumstances in this case are such that subsection 9(1) is not appropriate. (b) There are elements of the software maintenance agreement that are in the nature of an indemnity. However, there are also elements where services will likely have to be rendered by the taxpayer.
October 7, 2003
XXXXXXXXXX HEADQUARTERS
Verification & Enforcement Division Randy Hewlett, B.Comm
XXXXXXXXXX Tax Services Office 613-957-8973
2003-003794
Deductibility of 20(1)(m) Reserve - Software Maintenance Plans
We are writing in response to your memorandum of September 5, 2003, wherein you asked for our opinion on the deductibility of a reserve by XXXXXXXXXX (the "Taxpayer") under paragraph 20(1)(m) of the Income Tax Act (the "Act") in respect of a software maintenance plan.
Facts
Our understanding of the relevant facts is as follows:
1. The Taxpayer is a distributor of accounting software in Canada.
2. The Taxpayer also sells a maintenance plan for the accounting software that it distributes (the "Maintenance Plan").
3. The Maintenance Plan has XXXXXXXXXX levels of support, described as follows:
XXXXXXXXXX.
4. Approximately XXXXXXXXXX% of all software maintenance provided by the Taxpayer relates to customers who purchase Level One support. The cost of Level One is XXXXXXXXXX% of the suggested retail price of the software, and is mandatory for all new customers for a period of XXXXXXXXXX months.
5. The Maintenance Plan is available for terms of XXXXXXXXXX years. The fee paid is non-transferable and non-refundable, even in the event that the customers cancel coverage or do not fully avail themselves of the services provided, or in the event that the Taxpayer does not issue any software upgrades.
6. If customers do not purchase the Maintenance Plan, service packs will still be received to fix bugs, but without advance notification. Further, if those customers want to upgrade their software they would have to purchase a new version each time.
7. Level One customers who do not have access to the telephone help for technical support issues, or Level Two customers who have access to only XXXXXXXXXX telephone technical support issues, may purchase XXXXXXXXXX technical support issues for a set annual fee. The fee paid for these technical support issues is non-refundable and expires within a year.
8. The Taxpayer typically upgrades the software XXXXXXXXXX times per year and issues a new version every XXXXXXXXXX months.
9. In its XXXXXXXXXX income tax returns, the Taxpayer deducted a reserve in respect of each Maintenance Plan agreement under 20(1)(m) of the Act. The reserve was calculated by multiplying the fee paid for each Maintenance Plan by the proportion that the number of months remaining in the contract term at the end of the taxation year was of the total contract term.
Your Position
In your view, the Taxpayer is not entitled to a reserve under paragraph 20(1)(m) of the Act. Your primary position is that the fee received by the Taxpayer in respect of a Maintenance Plan is not included in income under paragraph 12(1)(a) of the Act but subsection 9(1), on the basis that it has the "quality of income". A reserve is not available under paragraph 20(1)(m) of the Act for an amount included in income under subsection 9(1). Alternatively, it is your view that if the amount were included in income under paragraph 12(1)(a) of the Act, subsection 20(7) would preclude the deduction of a reserve under paragraph 20(1)(m), on the basis that the customer who purchased a Maintenance Plan is being "indemnified". Pursuant to paragraph 20(7)(a) of the Act, paragraph 20(1)(m) does not apply to allow a deduction "as a reserve in respect of guarantees, indemnities or warranties".
We outline below our comments on both your primary and alternative positions:
(a) Primary Position: Subsection 9(1) Includes The Fees In Income
The CCRA's position on the issue of whether subsection 9(1) or paragraph 12(1)(a) of the Act applies to include prepaid amounts in income, was recently discussed by this Directorate at the 2003 Canadian Tax Foundation Conference. The CCRA's general position is that paragraph 12(1)(a) of the Act will apply to include in income amounts received by a taxpayer in respect of services not rendered or goods not delivered before the end of the year or that, for any reason may be regarded as not having been earned in the year or a previous year.
There may, however, be situations where an "upfront inclusion approach" under subsection 9(1) of the Act is more appropriate. The following examples were given:
A. Where the actions required to be done by the taxpayer and/or its obligations under the agreement are substantially performed at the time of receipt of the prepayment, or shortly thereafter; or
B. Where the agreement between the taxpayer and its client lawfully provides that the taxpayer is allowed to retain the prepayment in any event, regardless of whether or not services will be rendered or goods provided.
In view of the above, we are of the opinion that the fee received by the Taxpayer from a customer in respect of the purchase of a Maintenance Plan is included in income under paragraph 12(1)(a) of the Act. In our view, the Taxpayer is required to provide services under the terms and conditions of the Maintenance Plan, notwithstanding the fact that the fee paid is "nontransferable and non-refundable". Further, the Taxpayer has demonstrated through past performance that it subsequently incurs expenses in respect of the provision of services specified in the Maintenance Plan. Consequently, we are of the view that the example in A above is not analogous to this situation. Further, we doubt whether the Taxpayer could lawfully retain the fee without performance of its obligations, especially in view of the wording of paragraphs XXXXXXXXXX of the Maintenance Plan agreement. Therefore, we are also of the view that the example in B above is not analogous to this situation.
(b) Alternative Position: Subsection 20(7) Denies The Paragraph 20(1)(m) Reserve
The CCRA's position on whether a taxpayer can claim a reserve under paragraph 20(1)(m) of the Act in respect of a fee received for a software maintenance program was discussed at the 2001 Tax Executives Institute Conference (our file 2001-0010895). In general terms, software and hardware maintenance agreements are considered a form of indemnity provided to purchasers to secure them against certain repair costs or the costs of acquiring updates. In accordance with paragraph 20(7)(a) of the Act, a taxpayer is not permitted to claim a deduction under paragraph 20(1)(m) for a reserve in respect of an indemnity (See the decision of the Federal Court of Appeal in Sears Canada Inc. v. Her Majesty The Queen, 1989 DTC 5039).
In view of the above, we are of the opinion that a respectable argument can be made that the Taxpayer is not entitled to a reserve under subsection 20(1)(m) of the Act because of the indemnity nature of certain elements of the Maintenance Plan. For example, the software upgrades protect customers from having to purchase new versions of the accounting software. It is also our view, however, that other elements of the Maintenance Plan do not indemnify customers. For example, this would include the telephone technical support service, which the Taxpayer must provide to customers should they choose to avail themselves of the service. Consequently, we are of the view that consideration should be given to pro-rating the fee amongst all elements of the Maintenance Plan and allowing a reasonable reserve in respect of those amounts relating to elements of the plan that do not relate to the indemnification of customers.
We trust our comments are of assistance.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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