A-397-74
Harlequin Enterprises Limited (Appellant)
v.
The Queen (Respondent)
Court of Appeal, Urie J., MacKay and Kerr
D.JJ.—Toronto, March 16; Ottawa, April 4, 1977.
Income tax Deductions — Unsold books returned to
publisher for credit — Whether reserve in respect of same
deductible Appeal Income Tax Act, R.S.C. 1952, c. 148,
ss. 11(1)(e), 12(1)(e).
Appellant, a Canadian publisher, sold its books through
distributors in Canada and the United States. The distributors
dealt, through wholesalers, with retail outlets, and directly,
with large retailers. Provisions for return of unsold books were
made in agreements between the appellant publisher and the
distributors. Appellant claimed deductions for the 1969 taxa
tion year in respect of the following items: (1) about $125,000,
representing appellant's gross profits on books on hand at
Canadian wholesalers as of December 31, 1969, the end of
appellant's fiscal year; (2) about $220,000 for goods which
could reasonably be expected to be returned in accordance with
the terms of the agreement for sale. These deductions were
disallowed by the Minister. The Trial Division dismissed the
appeal. Appellant launched this appeal in respect of the second
issue.
Held, the appeal is dismissed. The reserve established con
stituted a "contingent account" within the meaning of section
12(1)(e), and is therefore not deductible. The further conten
tion of appellant that the amount should be deductible under
section 11(1)(e) as a reserve for bad debts is not supported by
the facts, as there is no history of uncollectable accounts
between appellant and its distributors. Even if there had been
such a history, the proposed deduction of more than one-third
of the accounts receivable could not be considered realistic.
Sinnott News Company Limited v. M.N.R. [1956] S.C.R.
433; M.N.R. v. Atlantic Engine Rebuilders Limited
[1967] S.C.R. 477 and Time Motors Limited v. M.N.R.
[1969] S.C.R. 501, distinguished. Western Vinegars Lim
ited v. M.N.R. [1938] Ex.C.R. 39, disagreed with.
INCOME tax appeal.
COUNSEL:
Ronald J. Rolls, Q.C., D. A. Ward, Q.C., and
R. S. Harrison for appellant.
Derek Aylen, Q.C., and A. Butler for
respondent.
SOLICITORS:
Davies, Ward & Beck, Toronto, for appellant.
Deputy Attorney General of Canada for
respondent.
The following are the reasons for judgment
rendered in English by
URIE J.: This is an appeal from a judgment of
the Trial Division' dismissing with costs the appel
lant's appeal from the respondent's re-assessment
in respect of its 1969 taxation year. In its 1969
income tax return the appellant, a book publisher,
deducted from its income the sum of $125,040
representing its "Gross profit on books on hand at
wholesalers". This, it was alleged, related to books
sold by the appellant to distributors, still in their
hands or those of the wholesalers who purchased
from them at the end of the fiscal period, on the
assumption that all unsold books would be
returned to the appellant. The re-assessment disal
lowed the deduction.
Briefly the facts are these. The appellant mar
kets its books both in Canada and the United
States through distribution chains to what are
described as the wholesale and direct markets. In
the wholesale market the appellant deals with a
distributor in Canada and one in the United
States, which, in turn, sell to a number of whole
salers. The wholesalers then sell to retail outlets in
their territories which then sell to retail customers.
In the direct market, there is no wholesaler
intervention. The distributor deals directly in this
market with large retailers, such as chain stores,
which then sell to retail customers.
In Canada, distribution to both wholesale and
direct markets is made by Curtis Distributing
Company Limited (herein called "Curtis Cana-
da") under a written agreement dated March 22,
1949. The most important provisions in that agree
ment for purposes of understanding the issue in
this appeal are:
(a) "Title to books and risk of loss thereof shall
remain in publisher [the appellant] until deliv
ery to wholesalers", and
1 [1974] 2 F.C. 877.
(b) "Books which are considered unsaleable
shall be fully returnable . .. Curtis shall be
entitled to credit on its monthly statements for
all returns, at the price charged Curtis for books
hereunder."
The purchase prices for books sold under this
agreement were invoiced monthly, for payment,
the Court was advised, within 60 days. The actual
unsold books were not returned. Rather, their
covers were ripped off and returned by the whole
salers to Curtis Canada which issued credit notes,
copies of which went to the appellant. The copies
of the credit notes served as invoices from Curtis
Canada to the appellant and were taken into
account for credit to Curtis Canada on the month
ly statements required by the contract.
In the United States, distribution to the whole
sale market was made by Curtis Circulation Com
pany (herein called "Curtis U.S.") pursuant to a
written agreement dated December 19, 1968. The
relevant provisions of that agreement for purposes
of this appeal read as follows:
(3) Harlequin agrees to sell and Curtis agrees to purchase the
books for resale in accordance with this Agreement .... The
purchase price shall become due and payable by Curtis sixty
days after shipment by Harlequin and Harlequin shall invoice
Curtis monthly. Books shall be shipped and delivered by Har
lequin or its agent to the wholesaler or other outlets as directed
by Curtis .... Curtis shall become the owner of the books
purchased on delivery of the same to such delivery points
specified by Curtis.
(4) Curtis shall sell Books to Customers subject to full return
privileges as hereinafter described. Books shall always be fully
returnable by Curtis to Harlequin for full credit. Curtis will
initiate computation of the Customers' credit for returns for
unsold Books via return authorizations issued by Curtis ....
Curtis shall give return credit to Customers upon receipt of
authorizations from Customers and shall receive credit from
Harlequin upon the giving of such credit to Customers ....
(6) Curtis shall pay Harlequin for shipments of books to Curtis
or to Customers within sixty days after shipment is made by
Harlequin. This payment shall be adjusted for return credits
(issued in accordance with paragraph 4 hereof) for previously
uncredited returns. [The underlining is mine.]
Returns were handled in much the same fashion
as that which prevailed in Canada.
Distribution in the direct market in U.S. was
made on an entirely different basis pursuant to an
agreement with Simon & Schuster, Inc., (herein
called "Simon & Schuster"). In essence it appears
to be a licensing agreement whereby the appellant
furnished Simon & Schuster with plates and nega
tives permitting the latter to print, in the United
States, the books the former published in Canada.
Royalties were to be paid on "net sales", which
term was defined as "copies shipped by Publisher
(Simon & Schuster) to retail chain store outlets
less returns." Simon & Schuster had "unlimited
and uncontrolled discretion in the matter of
accepting returns." The agreement also included
detailed provision for the accounting for and pay
ment of royalties and credits for returned books
against royalties already paid.
As I understand it, the appellant does not con
tend that the Minister erred in his re-assessment in
refusing the deduction of $125,040, calculated in
the manner in which it was. There was no such
argument advanced either on the appeal or in the
appellant's memorandum of fact and law. Rather
the appellant says that the deduction to which it is
entitled is the sum of $232,889 shown in its bal
ance sheet for the year ending December 31, 1969
under the heading "Provisions for returns or allow
ances", adjusted because of an error in its calcula
tion to the sum of approximately $220,000. That
sum was calculated by the application of percent
ages, based on historical data and interviews with
its distributors in regard to their actual experience
with returns, to annual gross sale figures and was
said to provide a more accurate estimate of the
value of returns at the end of a fiscal year.
Although shown in the appellant's balance sheet
for the fiscal year in issue it was not claimed as a
deduction in its 1969 tax return.
The appellant argued that:
(a) the sum of $220,000 ought to have been
allowed as a deduction from its accounts receiv
able or as a current liability, or
(b) the said sum ought to have been character
ized as a reserve for doubtful debts and allowed
under section 11(1) (e) 2 of the Income Tax Act
as it read in 1969 (hereinafter called the Act.)
The respondent on the other hand, argued that
the Trial Judge correctly found that the proposed
deduction was prohibited by section 12(1)(e) 3 of
the Act in that it was "an amount transferred or
credited to a ... contingent account ...".
The same submissions were made by each party
at trial. The learned Trial Judge rejected those of
the appellant and agreed with counsel for the
respondent that the appellant's obligations to its
distributors in respect of credits for books returned
to it pursuant to their contractual rights, constitut
ed a contingent liability to the appellant. In the
same way its obligation to repay certain royalties
received from its licensee Simon & Schuster, for
royalties paid by it to the appellant for books
printed and distributed by the licensee constituted
a contingent liability. Thus he said [at page 894]:
An account set up to provide for those contingent liabilities
whether by way of a provision for returns and allowances on its
balance sheet or a deduction from earnings in the calculation of
its taxable income was a contingent account within the meaning
of section 12(1)(e).
I agree with this conclusion and the reasoning of
the learned Trial Judge in reaching it. No useful
purpose would be served, in my view, in reviewing
and restating that reasoning particularly since the
appellant did not quarrel with the findings of fact
of the Trial Judge but only with the application of
211. (1) Notwithstanding paragraphs (a),(b) and (h) of
subsection (1) of section 12, the following amounts may be
deducted in computing the income of a taxpayer for a taxation
year:
(e) a reasonable amount as a reserve for
(i) doubtful debts that have been included in computing
the income of the taxpayer for that year or a previous year,
and
(ii) doubtful debts arising from loans made in the ordinary
course of business by a taxpayer part of whose ordinary
business was the lending of money;
3 12. (1) In computing income, no deduction shall be made
in respect of:
(e) an amount transferred or credited to a reserve, contin
gent account or sinking fund except as expressly permitted
by this Part,
the law to those findings. Specifically, I agree with
him that, on the evidence of the expert witness
called by the appellant, the appellant's practice of
making provision for book returns was in conform
ity with generally accepted accounting principles.
However, the fact of its acceptability in accounting
practice does not of itself make it a proper deduc
tion from income for tax purposes. Whether or not
it is must be found in some provision of the Act. I
agree that the provision for returns is contingent,
because in any fiscal period, although it was
known from experience that there would be
returns, the number and actual value thereof could
not be fully known until all returns on sales made
within that fiscal period had actually been received
which might not be until some considerable period
of time had elapsed after the end of the fiscal
period. Therefore, the provision falls within the
prohibition contained in section 12(1)(e).
Ample support for this conclusion is derived
from the evidence. As above indicated, the appel
lant at trial called, as an expert witness, a char
tered accountant, Mr. Scott, to testify with respect
to what constitutes generally accepted accounting
practice in setting up reserves or other provisions
in financial statements of a business for events
which may in the future occur and which should
be considered in the preparation of the financial
statements. During the course of his cross-exami
nation he was asked the question set out hereunder
and gave in the answer which follows, what, I
believe, is a most illuminating opinion confirming
both my view and that of the learned Trial Judge
that the "provisions for returns or allowances"
made by the appellant in its balance sheet was, in
fact, a contingent liability:
Q. No. What do you understand by the expression contin
gent account?
A. It is not the most meaningful expression I have ever
encountered. If I had to express a meaning for it in an
accounting sense, I would look to the literature and
thought of accountants which said--would illustrate to
me I think that accountants think about contingencies in
three different ways. They think about contingencies
where the possibility of occurrence of reasonably predict
ing the occurrence of something is too remote, it is too
difficult to do so. Strangely enough that type of thing, an
example—the classic example I think is when the man
agement of a company is concerned after a period of
rising prices, that the bottom is going to fall out of the
market and it wants to provide against the contingency of
a decline in inventory. The accountant says in response to
that, the only way you can do that is by providing a
reserve. As I defined it, appropriation of earnings. That
type of contingency he cannot, in accounting, enter into
the measurement of income for a period.
The other extreme, accountants talk about contingencies
where there is a reasonable basis for expecting that the
event will in fact occur and if the foundation for that
event occurred or was accounted for in a particular year,
let's say year one, and yet there is a good basis of
probability based on past experience to believe that the
event will occur in a subsequent period and it affects the
measurement of income in the first year, then accounting
says you must provide for that contingency in the
accounts and the provision for book returns here is a
classic example of that.
In between, as I expect I think one gets a gray area where
very difficult judgments have to be made, sometimes
these expected future contingencies are recorded, some
times they are not, the requirement in that middle zone,
the minimum requirement in the middle zone is the
financial statement discloses the existence of such contin
gencies, possibly having an impact on the business. [The
emphasis is mine.]
In respect to the method adopted by the appel
lant in its calculation of taxable income in its tax
return, i.e., by deducting from its income the sum
of $125,040, I agree with the learned Trial Judge
[at page 890] "that the elimination of the entire
profit element, including that attributable to the
approximately nine of ten books that would not be
expected to be returned, [as the evidence discloses
was the historical experience] has no rational foun
dation." That, coupled with the expert evidence
that made no reference to such a practice being
generally acceptable from an accounting point of
view, leads to the conclusion that since it is neither
acceptable accounting practice nor does any provi
sion in the Act permit a deduction of such a kind,
it was properly disallowed by the respondent.
On the basis of this finding, therefore, it does
not appear that any of the four authorities relied
upon by the appellant is applicable on the facts of
this case. Primarily counsel relied on the judgment
of Kellock J. in Sinnott News Company Limited v.
M.N.R.
4
In that case the appellant claimed to be entitled
to deduct, in computing its taxable income for a
fiscal period, a "reserve" for loss on returns repre
senting the profit element in the sale price of
periodicals in the hands of dealers at its fiscal year
end unsold and expected to be returned to the
[ 1956] S.C.R. 433.
appellant. The Minister contended that this
reserve was prohibited by the terms of section
6(1)(d) of the Act, as it then read. Effectively it
was the same section as section 12(1)(e) with
which we are here concerned.
Kellock J. found that the periodicals were not
sold on a "sale or return" basis within the meaning
of Rule 4 of section 19 of The Sale of Goods Act
(Ontario) because, in his view, property passed to
the dealers upon delivery of the periodicals. How
ever, he held that they were sales "subject to a
condition subsequent", the result being that, in the
case of magazines actually returned, title re-vested
in the appellant. Therefore, he found that the
appellant was not entitled, as it had done, to set up
any "reserve" of profits. What it was entitled to
do, he said [at page 438], was "to deduct the
estimated sales value itself, subject, however, when
the actual figure is ascertained at the end of the
three months' period, to adjustment in the year in
which such returns are actually made." He, there
fore, allowed the appeal but on a different basis
from that upon which the appellant argued the
appeal.
On the other hand, the majority of the Court,
while reaching the conclusion that the appeal
should be allowed, did so on another basis. Locke
J. writing for the majority, found that the title to
the periodicals did not pass to the purchasers in
that case, and that the deliveries were made on a
"sale or return" basis. While setting up a reserve
as suggested was the wrong means of achieving
what it wanted to do, the appellant was entitled to
exclude from its total sales any amount referable
to periodicals delivered to and unsold in, the hands
of retailers at the end of the fiscal period.
In my respectful opinion, the case at bar differs
on its facts. The written agreements both explicitly
and implicitly stipulated when title was to pass in
respect of books distributed either to the wholesale
market or the direct market. The accounting
procedures of the appellant correctly reflected the
agreements. The sales clearly were, as it seems to
me, outright sales with an obligation on the appel
lant to repurchase any books which the distributor
might elect to return. Thus, they were not sales on
consignment or on a "sale or return" basis since
title passed to the purchasers before the returns
were made. I do not think that it matters whether
the view is taken that they were sales "subject to a
condition subsequent" or not, because, even if the
obligation to repurchase is viewed as a condition
subsequent in the case at bar, as I have already
held, it constituted a contingent liability within the
meaning of section 12(1) (e). Kellock J. made no
finding as to whether or not the reserve was a
contingent liability within the meaning of that
section's predecessor, section 6(1)(d). Rather he
held that the "estimated sales value" was properly
deductible from the gross sales during the fiscal
period. Therefore, the case is distinguishable from
this case whether the basis upon which the majori
ty reached their conclusion or the basis upon which
Kellock J. reached his conclusion, is used.
I agree, too, with the learned Trial Judge that
the decisions of the Supreme Court in M.N.R. v.
Atlantic Engine Rebuilders Limited' and Time
Motors Limited v. M.N.R. 6 are also distinguish
able on their facts. In each of those cases there
were existing, ascertained current liabilities in con-
tra-distinction to the case at bar where no such
ascertained liability existed unless and until the
retailers exercised their right to return unsold
books.
In so far as Western Vinegars Limited v.
M.N.R. 7 is concerned, upon which the appellant
relied heavily, doubt was expressed as to its cor
rectness by Thorson J. in Kenneth B. S. Robertson
Limited v. M.N.R. 8 , with which doubt I respect
fully agree. The Western Vinegars case was one in
which the appellant sold its products in barrels and
kegs, the value of which were charged to the
customer as additions to the price of the goods
contained in them. The customers were at liberty
to return the containers, and, if they were in good
condition, the amount charged for them was to be
credited to the customers. The containers so
returned then were put back into the company's
inventory of containers at inventory prices. It was
the contention of the appellant in the case at bar
that the return of books and the return of the
containers involved the same elements. At pages
45-6 of the report, Angers J. stated:
5 [1967] S.C.R. 477.
6 [1969] S.C.R. 501.
7 [1938] Ex.C.R. 39.
8 [1944] Ex.C.R. 170 at p. 178.
The profits on the containers are not, as I conceive, a reserve
properly called; and the loss of these profits, on the returns of
the containers, is not merely a contingency but a certainty. The
only thing uncertain is the quantity of the containers which will
be returned and the time at which the returns will be effected. I
believe that an allowance should be made for the containers
that are returned. If no allowance were made, it would mean
that the appellant would have to pay tax on profits which it has
not reaped. I do not think that this was the intention of the
Legislature in enacting the provision contained in paragraph
(d) of subsection (1) of section 6.
In this case it cannot be said that "the appellant
would have to pay tax on profits which it has not
reaped." In fact, as returns were made, as I under
stand it, the purchase price thereof was deducted
from the gross sales figures in the determination of
gross profit. To the extent that, toward the end of
a fiscal year, some books sold by the appellant in
the fiscal year might, at some future date, become
returnable by the distributor, there would be an
unascertained element in the gross sales figure
which, when it became ascertained would be prop
erly deductible in the fiscal period in which the
returns were made in the form of credits to the
distributor. When that is done, the gross profits
and consequently the taxable profits would be
proportionately reduced for that year.
This method of accounting for returns, (aside
from the question of the advisability of making
some sort of provision in the accounts in anticipa
tion of the returns for the company's own informa
tion, a subject which has already been dealt with),
accords not only with good accounting practice but
also with the general rule that profits are to be
taxed in the year in which they are received and
losses borne in the year in which they are sus
tained. That being so, we believe that the Western
Vinegars case is not only distinguishable on its
facts, but even if it is not, then, in my opinion, it
was wrongly decided and, in any event, is not
binding on this Court.
There is no merit in the further contention of
the 'appellant that, if the provision for returns is
not deductible, it should be treated as a reserve for
bad debts and thus properly deductible under sec
tion 11(1) (e) (i) of the Act. For the reasons given
by the Trial Judge, I am unable to agree that there
is any merit in this submission. As I understand it,
there had not been any history of uncollectable
accounts between the appellant and Curtis
Canada, Curtis U.S. or Simon & Schuster. Thus,
historically, there was no reason or basis for set
ting up a reserve for bad debts, nor in fact, was
such a reserve ever set up. Even if there had been
such a history, obviously when the 1969 financial
statement discloses accounts receivable in the sum
of $616,538 and it is proposed that a reserve of
more than one-third of that amount, namely
$220,000 be allowed, such reserve bears no rela
tionship to the reality of the situation between the
debtors and creditor and could not be considered a
realistic reserve permissible as a deduction under
section 11(1)(e)(î).
For all of the above reasons, therefore, the
appeal should be dismissed.
* * *
KERR D.J.: I concur.
* * *
MACKAY D.J.: I agree with the reasons and
conclusions of my brother Urie.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.