17 November 2003 Internal T.I. 2003-0046787 - SOFTWARE MAINTENANCE PLANS

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:

Follow-up inquiry on 2003-003794, specifically whether subsection 20(7) of the Act applies to deny a paragraph 20(1)(m) reserve for a software maintenance.

Position: Yes.

Reasons:

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.

									November 17, 2003

	XXXXXXXXXX  TSO						HEADQUARTERS
XXXXXXXXXX 						Income Tax Rulings
Verification & Enforcement Division 			  Directorate
			Randy Hewlett, B.Comm
613-957-8973	

2003-004678

Application Of Subsection 20(7) - Software Maintenance Plans

We are writing in response to your e-mail of November 3, 2003, wherein you provided us with a copy of a letter from XXXXXXXXXX (the "Taxpayer"), submitted to you in response to our memorandum of October 7, 2003 (our file 2003-003794).

The issue concerns whether paragraph 20(7)(a) of the Income Tax Act (the "Act") prohibits the deduction of a reasonable reserve by the Taxpayer under paragraph 20(1)(m) in respect of amounts included in income under paragraph 12(1)(a) for software maintenance plans. We concluded, on the basis of the facts as set out in our letter of October 7, 2003, that:

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). 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 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.

In the Taxpayer's view, the Maintenance Plan does not indemnify customers and therefore, it should not be denied a reserve under 20(1)(m) of the Act by virtue of paragraph 20(7)(a). The Taxpayer does not believe the Sears decision is relevant because the case involved "defective or broken products", whereas the Taxpayer's Maintenance Plan provides customers with "major and minor enhancements to the functionality of the software". The Taxpayer is of the opinion that the income it receives in respect of the Maintenance Plan should be treated the same as any prepayment for goods to be delivered or services to be rendered after the end of a taxation year.

Our Comments

We have reviewed the Taxpayer's letter and remain of the view that paragraph 20(7)(a) of the Act precludes a deduction for a subsection 20(1)(m) reserve for certain elements of the Maintenance Plan. We acknowledge the Taxpayer's position that the Sears case dealt with prepaid maintenance contracts for appliances, and in that respect differs from its situation. In our view, however, the legal principle enunciated in the Sears decision is relevant in determining whether the Maintenance Plan is in the nature of an indemnity. By undertaking to service and maintain software as required under the terms of the Maintenance Plan agreement, we are of the view that the Taxpayer obliged itself to bear expenses that customers would otherwise have incurred to service and maintain their software. In our opinion, this is the very essence of an indemnity for purposes of paragraph 20(7)(a) of the Act, as described by the FCA in Sears.

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