Judgments

Decision Information

Decision Content

T-1671-72
Mister Muffler Limited (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Walsh J.—Montreal, October 17; Ottawa, November 15, 1974.
Income tax—Deductions—Sale of automobile mufflers— Certificate with each muffler sold—Customer entitled to obtain second new muffler during ownership of car—Tax- payer setting aside reserve of part of purchase price relating to replacement—Whether reserve deductible from income— Income Tax Act, R.S.C. 1952, c. 148, ss. 3(a), 4, 12(1)(a),(e), 8 5B(1)(a),(c),(4)•
The appellant promoted its sale of automobile mufflers by giving with each purchase a certificate entitling the purchas er, during ownership and possession of his car, to obtain a free replacement "should this muffler become defective through no fault of your own". The muffler was replaced about every 22 months, so that in the years subsequent to the sale of the original muffler, a certain quantity of muf flers was used for replacement. The sale price of the original mufflers, including an allowance for replacement, was included in gross income, in respect of which a reserve was established of that part of the purchase price relating to the replacement mufflers. The plaintiff made deductions from income for the taxation years 1967 and 1968 as a reserve in respect of such mufflers as were reasonably anticipated as having to be delivered after the end of the year. The Minister added the amounts in question to the plaintiff's income for the relevant years. The plaintiff appealed.
Held, the deductions were not reasonable amounts deductible as reserves under sections 85B(1)(a) and (c) of the Income Tax Act, as it then applied. An exception was introduced by section 85B(4) so as to forbid deductions with respect to "guarantees, indemnities or warranties". These words were intended to be comprehensive enough to include all types of guarantees, indemnities or warranties, which the Act meant to exclude from immediate deduction by way of reserves, because of their contingent and uncertain value. The replacement expense of a muffler could clearly be claimed as an expense in the year of its actual replacement. The plaintiff's alternative argument was that the amounts constituted fixed, substantial, continuing and current liabili ties to deliver goods as determined by proper accounting practice and hence were deductible under sections 3(a), 4 and 12(1)(a). But section 12(1)(e) forbade deductions except as expressly permitted "by this Part". Since section 85B of the Act was in the same Part of the Act as section 12, this returned the argument to the question, decided above, of whether the deduction of the reserve was permitted by section 85B(1)(c) or prohibited by section 85B(4).
Time Motors Limited v. M.N.R. [1969] S.C.R. 501; J. L. Guay Ltée v. M.N.R. [1971] F.C. 237 affirmed [1972] F.C. 1441; Kenneth B. S. Robertson Limited v. M.N.R. [1944] Ex.C.R. 170; Western Vinegars Limited v. M.N.R. [1938] Ex.C.R. 39; Edward Collins & Sons Ltd. v. Commissioners of Inland Revenue (1924) 12 T.C. 773; Associated Investors of Canada Ltd. v. M.N.R. [1967] 2 Ex.C.R. 96; Capital Transit Limited v. M.N.R. (1952) 7 Tax A.E.C. 19; McManus Motors Limited v. M.N.R. 53 DTC 255; M.N.R. v. Atlantic Engine Rebuilders Limited [1967] S.C.R. 477; Dominion Stores Limited v. M.N.R. [1966] Ex.C.R. 439 and Dominion Taxicab Association v. M.N.R. [1954] S.C.R. 82, considered.
INCOME tax appeal. COUNSEL:
Claude Thivierge and Brian Crane for plaintiff.
Roger Roy and A. Garon, Q.C., for defendant.
SOLICITORS:
Duquet, MacKay & Co., Montreal, for plaintiff.
Deputy Attorney General of Canada for defendant.
The following are the reasons for judgment delivered in English by
WALSH J.: Plaintiff appeals from income tax assessments for the taxation years ending November 30, 1967, December 31, 1967 and December 31, 1968. Its declaration sets forth that it operates a chain of retail automotive exhaust system installation shops and that as of May 1, 1964 with a view to promoting its sales to the public, it introduced a special plan where by a customer, when purchasing a muffler, was given a certificate presentable at any of plain tiff's shops entitling him to obtain a second new muffler and subsequent additional replacements for as long as he retained possession and owner ship of his automobile. Plaintiff claims that, in effect, the cost of the additional mufflers was included in the purchase price of the original mufflers and that experience has shown that the muffler was replaced on the average of every 22 months so that in the years subsequent to the sale of the original muffler, a certain quantity of
mufflers had to be used to replace same. The purchase prices of the original mufflers which, according to plaintiff, included an allowance for replacement, were included in gross income in respect of which a reserve of that part of the purchase price which related to the replacement mufflers was established. For the fiscal year ended November 30, 1967, this amounted to $118,622.96 which plaintiff deducted from its income as a reserve in respect of such mufflers as it was reasonably anticipated would have to be delivered after the end of the year. From November 30, 1967, the fiscal year end of plaintiff was changed to December 31 and in computing its income for the month of Decem- ber 1967 an amount of $364.30 was deducted as a similar reserve, while for the fiscal year ended December 31, 1968 an amount of $16,235.09 was deducted. These amounts were added back by the Minister in computing plaintiff's income for the periods in question. Plaintiff claims that these constitute reasonable amounts deducted as reserves and that they are deductible under the provisions of paragraphs (a) and (c) of sub section (1) of section 85B of the Income Tax Act' as it then applied, and were not amounts deducted as reserves in respect of guarantees, indemnities or warranties as set forth in subsec tion (4) of section 85B. Alternatively, plaintiff claims that such amounts constitute fixed, sub stantial, continuing and current liabilities of plaintiff to deliver goods as determined by good and proper accounting practice and accordingly are deductible from plaintiff's taxable income for the years in question under the provisions of paragraph (a) of section 3, section 4, and para graph (a) of subsection (1) of section 12 of the Act and should not under good accounting prac tice be credited to a contingent account as set forth in paragraph (e) of subsection (1) of section 12.
Defendant in assessing plaintiff based itself on the terms of the document given customers on whose cars plaintiff's muffler has been installed, which document is entitled "Guaran-
' R.S.C. 1952, c. 148.
tee", and reads as follows:
For the life of your car, that is as long as you will own and possess the vehicle on which MR. MUFFLER'S muffler has been installed, we guarantee the free replacement of this muffler without labor charges should this muffler become defective through no fault of your own. This guarantee is valid in any of MR. MUFFLER'S shops upon presentation of this certificate.
and contends that the amounts in question had been put by plaintiff in a reserve or a contingent account but that they were not amounts received on account of services not rendered or goods not delivered before the end of the rele vant fiscal periods, but rather were reserves by the plaintiff in respect of guarantees, indemni ties or warranties. Sections 12(1)(e) and 85B(4) are relied on.
Section 85B(1)(a) and (c) read in part as follows:
85B. (1) In computing the income of a taxpayer for a taxation year,
(a) every amount received in the year in the course of a business
(i) that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, or
shall be included;
(c) subject to subsection (3), where amounts of a class described in subparagraph (i) or (ii) of paragraph (a) have been included in computing the taxpayer's income from a business for the year or a previous year, there may be deducted a reasonable amount as a reserve in respect of
(i) goods that it is reasonably anticipated will have to be delivered after the end of the year,
(ii) services that it is reasonably anticipated will have to be rendered after the end of the year,
In brief, sums received in payment for goods not delivered during the year or that have not been fully earned in the year or previous year shall nevertheless be included, subject to the deduction of a reserve to the extent that it is reasonably anticipated that the goods or ser vices for which payment has been made will have to be delivered or rendered after the end of the year. The deduction of this reserve, how-
ever, is subject to the exception provided in subsection (4) which reads as follows:
85B. (4) Paragraph (c) of subsection (1) does not apply to allow a deduction as a reserve in respect of guarantees, indemnities or warranties.
In other words, a reserve can only be deducted for goods to be delivered or services to be rendered in future if this does not result from guarantees, indemnities or warranties.
The alternative argument depends on the application to the taxpayer of section 12(1)(a) of the Act which reads as follows:
12. (1) In computing income, no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose off gaining or producing income from property or a business of the taxpayer,
and that section 12(1)(e) which reads:
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 permit ted by this Part,
is not applicable. I do not believe that plaintiff can successfully contend that this reserve con stituted an outlay or expense but it does con tend that this was not a contingent account and, in any event, that it was a reserve "expressly permitted by this Part". Since section 85B of the Act is in the same Part as section 12, this appears to return the argument to the question of whether this reserve was one permitted by section 85B(1)(c) or prohibited by section 85B(4) as being in respect of a guarantee, indemnity or warranty.
Documentary proof was filed consisting of a copy of the guarantee and the financial state ments of plaintiff for the year ending November 30, 1967, the subsequent month ending Decem- ber 31, 1967 when its fiscal year was changed, and the year ending December 31, 1968.
Jean Paul St-Denis, C.A., the General Manag er of plaintiff, testified that although the guaran tee refers to free replacement of the muffler without labour charges "should this muffler become defective through no fault of your own", in practice it is used for the replacement of worn out mufflers which the company's records indicate require replacement approxi mately every 22 months on the average, less than 2 per cent of the mufflers being replaced because of being defective, and that it is also rare to refuse a replacement because this has become necessary through the fault of the car owner. Their experience indicates that about one out of every five mufflers they sell has to be replaced. This is because the guarantee is only valid as long as the purchaser remains owner of the vehicle and not when he sells it or trades it in. Some owners may also lose the guarantee or neglect to avail themselves of it. While the new muffler is installed without any charge for labour, quite frequently some other parts are sold at the same time such as a new tail pipe which is often required but is not covered by the guarantee.
Competition had forced the introduction of this plan in the United States and from 1964 to 1966 plaintiff had a study made by a firm of consulting engineers which determined the aver age life of the muffler to be 22 months. The average wearing out period of 22 months was admitted in an agreed statement of facts. This study also determined that about one out of 5 come back for replacement and the figures of this study have been borne out by subsequent experience which indicates that currently the percentage of claims remains about the same and the mufflers now last about 20 months on the average. Since they had figures of their sales during the preceding 22 months, knew one out of five would have to be replaced, and what it cost them for a replacement muffler, they could calculate accurately how much had to be added to the price of the muffler originally installed to provide for this. This study was done between 1964 and 1966 and no reserves.. were set up during those years but once they had the figures they set up the reserve for the year ended
November 30, 1967. This initial reserve was, of course, high because it covered sales over a 22 month period and not merely a one month period or 12 month period as in subsequent statements. Replacements made during any given fiscal period are deducted from the reserve and the foreseeable obligations created by new sales during the same period are added to it. Thus, for the period ended November 30, 1967 we have on the balance sheet under liabili ties an amount of $118,622.96 as a reserve for merchandise sold and not delivered and this same amount is deducted from income as a business expense in that period. For the one month fiscal period for December 31, 1967 there is a reserve similarly shown as a liability in the amount of $118,987.26, but in that year only the sum of $364.30 is deducted from income as a business expense, this representing the increase in liability as a result of new sales after deducting from the reserve the cost of the mufflers replaced during the period. For the year ended December 31, 1968 the reserve is increased to $135,222.35 and the amount deducted from income as a result of this reserve is $16,235.09 which again represents the increase in the reserve during the year.
Mr. St-Denis testified that in their pricing they include an amount to provide for these replacements. For a Chevrolet, for example, the muffler costs them $5 but the customer pays $16.95 which includes installation which repre sents about half the price, and profit. Since they estimate one out of five mufflers will have to be replaced the price includes $1 as a reserve. If the customer does not want the guarantee the price is reduced by $1.
Mr. Henri Paul Ouellette, C.A., was called as an expert witness, his affidavit being taken as read. He is an experienced auditor and had acted as such for plaintiff from 1960 to 1972. In his affidavit he states:
[TRANSLATION] Assuming that these sums, after deciding amounts set aside as reserves, were received by Mister Muffler Limited to be applied to the cost of mufflers to be delivered in the future by Mister Muffler Limited to replace used mufflers I am of the opinion that in accordance with the practice and accounting principles recognized and gener ally accepted, such sums constitute a real liability of the company and, as such, should be deducted from the income. My opinion is based on the fact that financial statements should faithfully reflect the financial position of the company.
Referring to recommendations of the Research Committee of the Institute of Char tered Accountants dated December 1968, he stated that he considers these sums to represent a contractual obligation as they do not meet the definition of reserves accepted by the Institute, whereas the financial statements should provide a summary exposition of all important contrac tual engagements with regard to the actual financial situation or future exploitation of the business. Moreover, all eventual debts which do not appear on the balance sheet should be shown in one manner or another in the financial statements. He referred to Finney and Miller, Principles of Accounting, 5th ed., at page 436 where, under the heading "Operating Reserves Classified as Current Liabilities" the following statement appears:
Operating reserves are those which are set up by charges to income to reflect provisions for prospective cash dis bursements, the costs of which should be matched against revenues that have been taken into income. If goods are sold with guarantees of performance or with agreements to give free service for a stated period, a proper matching of revenue and expense requires the creation of an operating reserve for the prospective disbursements. Although there may be no present liability to any specific person, and although the amount of the reserve may be an estimate, such reserves are properly shown among the liabilities. The reserve represents a current liability if there is an obligation to make a cash disbursement in the near future.
Evidence as to what constitutes proper accounting practice has been recognized in a number of cases including the Supreme Court judgment in Time Motors Limited v. M.N.R. 2 in which Pigeon J. stated at pages 505-06:
2 [1969] S.C.R. 501.
Respondent's second contention is that because appel lant's obligation was conditional it should not, until the condition was realized, be treated for purposes of income tax as a current liability but as an amount properly to be entered in a contingent account. As a result, the deduction would be prohibited by s. 12(1)(e) of the Income Tax Act:
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 permit ted by this Part,
The wording of that provision clearly refers to accounting practice. The only expression applicable to the present case is not "contingent liability" but "contingent account". This means that the provision is to be construed by reference to proper accounting practice in a business off the kind with which one is concerned. In the present case, the only evidence of accounting practice is that off appellant's audi tor, a chartered accountant. His testimony shows that in appellant's accounts credit notes are treated according to standard practice as current liabilities until they are redeemed or expired. They are not classed as contingent liabilities. When asked why he considered the obligation under a credit note as current liability and the obligation under a warranty as contingent, he said:
... the credit note, while it is a liability, is also an existing obligation today. A warranty may be a liability in the future. It may be determinable in the future but isn't an existing obligation until the future. At least, this is my interpretation of the difference.
With respect, Gibson J. was in error in holding that whether or not appellant's financial statements were drawn up according to generally accepted accounting principles could be disregarded. On the contrary, the wording of the relevant provision off the Income Tax Act implies that this is the essential question.
The facts of that case were, however, quite different from the present one as it dealt with credit notes given by a used car dealer as partial payment of used cars acquired by it which although not transferable could be applied by the holder within a stated time to purchase a car from the dealer of not less than a specified value. The credit notes were treated in appel lant's accounts as current liabilities and if they were not redeemed the amount at expiration was removed from the accounts payable and treated as profit. The provisions of section 85B of the Act were not in issue in this case.
In the case of J. L. Guay Ltée v. M.N.R. 3 , affirmed by the Court of Appeal 4 and now under appeal to the Supreme Court, Associate Chief Justice Noel stated at pages 245-46:
In most tax cases only amounts which can be exactly determined are accepted. This means that, ordinarily, provi sional amounts or estimates are rejected, and it is not recommended that data which are conditional, contingent or uncertain be used in calculating taxable profits. If, indeed, provisional amounts or estimates are to be accepted, they must be certain. But then it is always difficult to find a procedure by which to arrive at a figure which is certain. Accountants are always inclined to set aside reserves for unliquidated liabilities, for, if they do not do so, the financial statement will not reflect the true position of the client's affairs. The difficulty arises from the fact that making it possible to determine the taxpayer's tax liability is not the main purpose of accounting. The accountant's report is, in fact, intended to give the taxpayer a general picture of his affairs so as to enable him to carry on his business with full knowledge of the facts. To achieve this end, it is not necessary for the profit shown to be exact, but it must be reasonably close, while the Income Tax Act requires it to be exact, and it is thus necessarily arbitrary. In Southern Rly. of Peru Ltd. v. Owen (supra), the company's auditor stated that he could not have signed its financial statement if the reserve for future debts had not been entered on the balance sheet. The House of Lords was not influenced by this statement, however, and decided nevertheless that the com pany could not deduct the amounts payable until the employees terminated their employment. However, South ern Rly. of Peru Ltd. v. Owen (supra) concerned a reserve made for uncertain amounts which the company might be called upon to pay in the future. What is the situation when the amounts involved are certain, but are not due until a subsequent accounting period? Such amounts were involved in Naval Colliery Co. v. I.R.C. (1928) 12 T.C. 1017, (H.L.) and the Court decided nevertheless that they could not be deducted so long as the outlay had not been made. In that case, Lord Buckmaster indeed stated clearly that these amounts could only be deducted in the period in which they were actually spent:
According to the appellant's contention, however, it is not the actual expenditure that is deducted, but the need for making the expenditure which is to be measured in their favour and brought into the account. This contention would involve the conclusion that the subject could choose which period he liked as the one in which the
3 [1971] F.C. 237.
4 [1972] F.C. 1441.
allowance is to be brought into account, either that when the expenditure became necessary or that when it was made (p. 1040).
As a general rule, if an expenditure is made which is deductible from income, it must be deducted by computing the profits for the period in which it was made, and not some other period.
Some of the remarks of Thorson P. in the case of Kenneth B.S. Robertson Limited v. M.N.R. 5 , although this case was decided before section 85B came into existence, are of interest here. In commenting on the decision in Western Vine- gars Limited v. Minister of National Revenue ([1938] Ex.C.R. 39) in which Angers J. in deal ing with a reserve which had been set aside to cover losses on return of containers had stated at page 45:
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.
the learned President stated [at page 178]:
The deduction claimed by the appellant for losses on the returns of the containers was allowed, although such losses had not yet been sustained. While the importance of the decision lies in the distinction drawn between a loss that is certain and one that is merely contingent, I find it difficult to reconcile the decision with the authorities that apply 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 sustained.
At page 179 he refers to the English case of Edward Collins & Sons, Ltd. v. the Commis sioners of Inland Revenue ((1924) 12 T.C. 773) in which it was held that the deduction for an apprehended future loss was not permissible. Lord President Clyde stated at page 781:
It is, however, quite consistent with this that a prudent commercial man may put part of the profits made in one year to reserve, and carry forward that reserve to the next year, in order to provide against an expected, or (it may be) an inevitable, loss which he foresees will fall upon his business during the next year. The process is a familiar one. But its adoption has no effect on the true amount of the profits actually made, and does not prevent the whole of the profits, whereof a part is put to reserve, from being taken into computation in the year in question for purposes of assessment. On the contrary, the balance of profits and gains is determined independently altogether of the way in
5 (1944] Ex.C.R. 170.
which the trader uses that balance when he has got it; and, if he puts part of it to reserve and carries it forward into the next year, that has no effect whatever upon his taxable income for the year in which he makes the profit.
Again, at page 180-81 Thorson P. states:
Nor was the appellant, no matter how sound its account ing practice was, entitled to distribute the amounts received by it as income during any fiscal year into the amounts earned during such year and those that were not yet earned, for the test of taxability of the income of a taxpayer in any year is not whether he earned or became entitled to such income in that year but whether he received it in such year, and the taxpayer has no right to have income received by him during a taxation year distributed for taxation purposes over the years in respect of which he may have earned or become entitled to such income.
And again at page 182:
It seems equally clear that if income is received in any one year it is taxable in that year, even although it has not yet been earned, and it follows that the appellant was not entitled to make any deduction from income received by it in any year on the ground that it was not earned in such year.
While that case differs substantially from the present one in that it dealt with funds held in trust, further comments on page 184 are also pertinent:
Where an amount is paid as a deposit by way of security for the performance of a contract and held as such, it cannot be regarded as profit or gain to the holder until the circum stances under which it may be retained by him to his own use have arisen and, until such time, it is not taxable income in his hands, for it lacks the essential quality of income, namely, that the recipient should have an absolute right to it and be under no restriction, contractual or otherwise, as to its disposition, use or enjoyment. [Italics mine]
In the present case the full amount initially paid for the muffler, even if it did include an element of $1, (although this is not specified in the contract) for contemplated replacements, was nevertheless the plaintiff's and under no restric tion, contractual or otherwise, as to its disposi tion, use or enjoyment.
In the case of Associated Investors of Canada
Limited v. M.N.R. 6 at page 105 Jackett P. stated in two footnotes:
' ... an expenditure that is made in the carrying on of the business and that may or may not result in an actual cost of operation should only be charged against the receipts of the business in the year when the contingency is realized, and then only to the extent of the net outlay involved at that time.
2 I am not concerned here with the question whether the method adopted by the appellant in showing the deduction in its accounts was the appropriate way of reflecting the transaction in the accounts. I am only concerned with whether the "profit" was correctly computed.
The Robertson case (supra) was referred to in the Tax Appeal Board judgment of Capital Transit Limited v. M.N.R. 7 which I refer to because the facts closely resemble those of the present case although, here again, it dealt solely with section 6(1)(d) of the Income War Tax Act, the predecessor of section 12(1)(e) of the Income Tax Act, and section 85B was not in effect at the time. In that case a reserve was set up for tickets sold and not yet used. The judg ment states at page 27:
There can be no doubt that to include, as part of the appellant's income in any taxation year, the full amount of the cash received for a ticket, when the ticket has not been used and therefore the company has had no opportunity of charging against the receipts for that ticket the proportional necessary expenses applicable to it, will result in the appel lant's being dealt with inequitably, because it will be subject ed to income tax on the whole of the receipts in respect of unused tickets as though they represented 100% profit whereas, in fact, only a small portion of the price paid for a ticket will represent profit in the appellant's hands. How ever, if that is the effect of the legislation as presently enacted, the remedy lies, not with this Board, but with Parliament.
This decision was followed in another Tax Appeal Board judgment of McManus Motors Limited v. M.N.R. 8 which refused to allow deduction of a reserve in respect of liabilities outstanding for lubrication coupon books paid for in advance, although the proceeds had been taken into taxpayer's revenue at the time of such payment.
6 [1967] 2 Ex.C.R. 96. (1952) 7 Tax A.B.C. 19. s 53 DTC 255.
The Supreme Court case of M.N.R. v. Atlan- tic Engine Rebuilders Limited 9 , also decided solely on the question of section 12(1)(e), referred with approval to the case of Dominion Taxicab Association v. M.N.R. ([1954] S.C.R. 82) where it was stated at page 85:
It is well settled that in considering whether a particular transaction brings a party within the terms of the Income Tax Act its substance rather than its form is to be regarded.
The dissenting judgment of Judson J. states at page 483:
I also think that the company fails under s. 12(1)(e). This amount, shown as a liability, is an amount transferred or credited to a reserve. It may be good commercial or accountancy practice to make provision for these liabilities but this is subject to the express provisions of the Act and the Act does make an express provision here.
Plaintiff relies strongly on the case of Dominion Stores Limited v. M.N.R. 10 which dealt with trading stamps. The customer on purchasing merchandise was given trading stamps of a value of 1 per cent of the price paid for the merchandise purchased which stamps could be accumulated and subsequently exchanged for merchandise from a catalogue or for groceries at the store. The receipt of the trading stamps was a condition of the original purchase and, unlike the present case, there was no reduction in price if the customer did not wish to take the stamps. The company set aside a reserve for unredeemed stamps. 'The Minister contended, and this would not apply in the present case, that no additional sum was paid for the trading stamps and therefore that no amounts were included arising from their sale in computing the appellant's income and hence no reserve could be made under section 8513(c) in the year during which the sales were made as a provision for the expenses arising from their redemption. In rendering judgment, Cattanach J. stated at page 446:
The arrangement between the appellant and its customers is quite clear from the evidence. A customer paid the price demanded by the appellant when he purchased merchandise from the appellant; For this, he received the merchandise
9 [1967] S.C.R.477.
1 O [1966] Ex. C.R. 439.
and in addition he received or was entitled to receive trading stamps which he was entitled to present to the appellant later for redemption either by way of premiums or the appellant's merchandise. The appellant was legally obligated to make this redemption. There was only one transaction and this was the only way in which the appellant would conduct its business at the particular stores. It does not follow that, because no specific amount is identifiable as being allocated to the cost of distributing and redeeming the stamps, the total amount is not attributable in part thereto. When two articles are sold together for one price without a price being put upon each separately, it does not follow that one article is free and that the price is attributable exclusive ly to the other article.
While the facts in that case are quite similar to those in the present one, it must be remembered that Cattanach J. did not have to consider the effect of section 85B(4) which was not appli cable as there was no question of a guarantee, indemnity or warranty.
Applying the foregoing jurisprudence to the facts of the present case the following conclu sions can be reached:
1. The fact that plaintiff in its financial state ments refers to the amounts set aside as: [TRANSLATION] "reserve for merchandise sold and not delivered" when it is perhaps not prop erly speaking a true reserve in the sense in which the use of this term is recommended by accounting authorities is not too significant. It is not the designation given to the amount which is set aside but the purpose for which it was so set aside that is important, and the question to be decided is whether this is a reserve which the Income Tax Act permits to be deducted from income for taxation purposes.
2. While the setting aside of this reserve may have represented sound accounting practice so as to present a true picture of the company's financial position, it does not necessarily follow that the amount of this reserve is deductible from taxable income in the years in question.
3. Even though the amount of such a reserve can be calculated and foreseen with .consider- able accuracy, there are nevertheless elements in it such as the loss of the guarantee form by the purchaser, his neglect to avail himself of it, or the transfer by him of the car on which the original muffler was installed to another owner
which introduce an element of contingency into the calculation of it.
4. Whether the amount is properly a reserve or whether it is a contingent account, the amount of which can be calculated with consid erable accuracy, section 12(1)(e) of the Act only permits the deduction in cases where such deduction is "expressly permitted by this Part". Section 85B, under the heading of "Special Reserves" which is in the same Part of the Act, sets out what reserves can be deducted. Section 85B(1)(a)(i) sets out that an amount received on account of services not rendered or goods not delivered before the end of the year must never theless be included in taxable income, but para graph (c) permits the deduction of a reserve for goods that it is reasonably anticipated will have to be delivered after the end of the year, which is what plaintiff contends its reserve is for and the situation in which Cattanach J. rendered judgment in favour of appellant in the Dominion Stores case (supra). However, this deduction of a reserve is subject to the exception set out in subsection (4) of section 85B which expressly excludes the deduction when the reserve is in respect of "guarantees, indemnities or warranties".
The decision in this case must therefore depend on whether this reserve was set up in respect of a guarantee, indemnity or warranty. None of these terms is defined in the Act and plaintiff referred to a great many definitions of them from dictionaries and court cases in an attempt to establish that its undertaking to replace a defective muffler free of charge so long as the purchaser remained owner of the car on which it was installed, does not come within the strict definition of any of these terms. In brief, plaintiff points out that a guarantee is an accessory contract whereby the promissor undertakes to be answerable to the promissee for the debt, default or miscarriage of another person, whose primary liability to the promise must exist or be contemplated. There was, of course, no third party involved in the present guarantee. An indemnity is usually defined as a contract whereby one party agrees to save the other harmless from loss and the widest sense
of the term will include most contracts of insur ance and also contracts of guarantee. In the strictest sense an indemnity denotes a contract to save the promissee harmless against claims of third parties, but it is also frequently used to denote a contract by which the promissor undertakes an original and independent obliga tion to indemnify as distinct from a collateral contract in the nature of a guarantee. A warran ty is merely a promise that a proposition of fact is true. In the present case there is no warranty that the original muffler would not prove to be defective or need to be replaced but merely an undertaking to . replace it, which plaintiff con tends was in the nature of a contract to make the replacement. The attempt to determine what is meant by these words by reference to diction ary or judicial definitions is further complicated by the fact that in French the word "warranty" is translated by "garantie" which also translates the word "guarantee". In fact the French ver sion of section 85B(4) of the Income Tax Act translates the words "guarantees, indemnities or warranties" simply as "garanties ou indem- nités".
Plaintiff attempts to make a distinction be tween the sort of guarantee which a vendor gives that the merchandise will not be defective, in the case for example of a television set, to the effect that if it becomes defective within a cer tain time the defective part will be replaced. Even though the vendor may know from experi ence that a certain number of the objects sold will become defective and have to be replaced, this is still dependent upon an uncertain and contingent future event and plaintiff contends that this is the sort of guarantee contemplated by section 85B(4) of the Act in refusing the deduction of a reserve. Plaintiff contends, how ever, that its guarantee is not really addressed to defective mufflers, although these are included in it, but is really an undertaking to replace the original muffler from time to time, and that this is an event which is bound to occur and is
foreseeable and not contingent, and that it should therefore be treated as a contractual obligation and not as a guarantee or warranty.
In this contention, however, it appears to me that plaintiff is attempting to make a distinction which the Act itself does not make. It appears to be pointless to attempt to seek the meaning of section 85B(4) in dictionaries or judicial defi nitions. The scheme of the Act does not permit deductions of reserves with respect to guaran tees, indemnities or warranties and I am of the view that it is intended that these words should be comprehensive enough to include all types of guarantees, indemnities or warranties, which the Act intended to exclude from immediate deduc tion by way of reserves because of their contin gent and uncertain nature. In the present case the replacement of mufflers can clearly be claimed as an expense in the year in which the replacement takes place but the probability of this being necessary in connection with one- fifth of all the mufflers sold, and even the fact that plaintiff has charged extra for the original muffler to allow for this does not in my view permit the deduction of a reserve in the year in which the original sale was made even though this may be good accounting practice. The very wording of the undertaking itself, which is en titled "Guarantee" and undertakes to "guaran- tee" replacement "should this muffler become defective" indicates the contingent nature of the undertaking. The fact that it is carried out in good faith and the muffler is replaced when it wears out even though it is not defective can in no way change the tax liability of plaintiff.
Plaintiff's appeal from its income tax assess ments for the taxation years ending November
30, 1967, December 31, 1967, and December
31, 1968 is therefore dismissed, with costs.
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