T-3816-73
Harlequin Enterprises Limited (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Mahoney J.—Toronto, Septem-
ber 12; Ottawa, November 21, 1974.
Income tax—Books unsold or returned—Publisher's
claims for deduction—Income Tax Act, ss. 4, 11(1)(e)(i),
12(1Xe)—Finance Act, 1940 (U.K.) c. 29—Sale of Goods
Act, R.S.M. 1954, c. 233, ss. 19, 20—The Sale of Goods
Act, R.S.O. 1960, c. 358, ss. 18, 19.
The plaintiff, a Canadian publisher, sold its books through
distributors in Canada and the United States. The distribu
tors dealt, through wholesalers, with retail outlets, and
directly, with large retailers. Provisions for books unsold or
returned were made in agreements between the plaintiff
publisher and the distributors. The plaintiff claimed deduc
tions for the 1969 taxation year in respect of the following
sums: (1) $128,000, representing the plaintiff's gross profits
on books on hand at Canadian wholesalers on December 31,
1969, the end of the plaintiff'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
plaintiff appealed.
Held, dismissing the appeal, the claim for deduction of
gross profits on books on hand at Canadian wholesalers had
not been established. The books were sold subject to a
condition subsequent which, if claimed by the purchasing
wholesaler, would re-vest the property in the publisher. The
expert evidence supported a return of 10.5 per cent of
books delivered to Canadian wholesalers over a period of
nine months. The evidence failed to support any require
ment, under generally accepted accounting principles, that
the entire profit element attributable to all of the books in
the hands of Canadiar wholesalers at a given time, be
deducted from income in order to present a true, or at least
truer, financial measurement of its operations to that point
in time. On the second claim for deduction, it was certain
that the plaintiff would, in due course, be obliged to give
rebates or refunds of royalties on returns, but the plaintiff's
liability to do so, in accordance with the agreements, did not
arise until the plaintiff was presented with a demand for the
credit. The plaintiff's obligation to the distributors, in
respect of rebates and refunds of royalties, was a contingent
liability. An account set up to provide for a contingent
liability, whether by way of a provision for returns and
allowances on its balance sheet, or a deduction from earn
ings in the calculation of its taxable income, was a contin
gent account within section 12(1)(e) of the Income Tax Act.
No deduction in respect of that account, even to the extent
that generally accepted accounting principles required it,
was permitted in the calculation of the plaintiff's taxable
income. No provision could be made for deduction of doubt
ful debts within section 11(1)(e)(i), under which the collecta-
bility of such a debt must be attended by a doubt based on a
real consideration, not a mere speculation, that it will not
likely be established. There was no evidence to show that
the debt due from the distributors was doubtful at December
31,1969.
Sinnott News Company Limited v. M.N.R. [1956]
S.C.R. 433; M.N.R. v. Atlantic Engine Rebuilders Ltd.
[1967] S.C.R. 477; Time Motors Ltd. v. M.N.R. [1969]
S.C.R. 501 and Dominion Telegraph Securities Limited
v. M.N.R. [1947] S.C.R. 45, followed. Winters v. I.R.C.
[1963] A.C. 235, agreed with.
INCOME tax appeal.
COUNSEL:
D. A. Ward, Q.C., and L. Hepburn for
plaintiff.
M. R. V. Storrow and J. A. Weinstein for
defendant.
SOLICITORS:
Davies, Ward and Beck, Toronto, for
plaintiff.
Deputy Attorney General of Canada for
defendant.
The following are the reasons for judgment
delivered in English by
MAHONEY J.: Two amounts in respect of the
calculation of the plaintiff's 1969 taxable
income are in issue. One is the deduction from
income of $128,040 claimed by the plaintiff,
being "gross profits on books on hand at
wholesalers", disallowed by the Minister of Na
tional Revenue. The other amount is a deduc
tion from income, calculated at approximately
$220,000, to which the plaintiff claims it is
entitled in respect of goods sold which could
reasonably be expected to be returned in
accordance with the terms of the agreements
under which the goods were sold.
The plaintiff is a book publisher. In 1969, it
published only paperback novels of a light
romantic nature at the rate of eight new titles
per month. These were marketed in both
Canada and the United States of America
through distinct distribution chains to what are
known as the wholesale and direct markets.
The plaintiff's marketing strategy is based on
the desire for a wide exposure of its books to
the buying public, the fact of a very low actual
unit cost of the books themselves and the
assumption, confirmed by experience, that if a
particular title is not accepted by the public
within a relatively short time of its appearance
on the retailers' display racks, it is not going to
be accepted and should be removed to make
room for another title. Thus, each title is dis
tributed in sufficiently large quantities to
ensure, in the plaintiff's judgment, adequate
coverage of the retail outlets but on the basis
that unsold titles are fully returnable.
In the wholesale market the publisher deals
with a distributor who handles the product of a
number of publishers and, in turn, deals with a
number of wholesalers. The wholesalers deal
with a number of distributors on the one hand
and with numerous retail outlets in their territo
ry. The retailers put the product on display
where the consumer is invited to buy. In the
direct market, the wholesaler does not appear;
the distributor deals direct with large retailers
such as chain stores. There is provision at all
stages along both chains of distribution for the
return of unsold books. In this case, the relevant
arrangements are those between the plaintiff
publisher and its distributors.
The first item in issue, the $128,040 deduc
tion claimed and disallowed, relates only to the
wholesale market in Canada. It represents the
plaintiff's gross profit on books in the hands of
Canadian wholesalers on December 31, 1969,
the plaintiff's fiscal year end. Its deduction is
claimed on the basis that deliveries of books by
the plaintiff to its distributor did not constitute
outright sales but rather deliveries made on sale
or return and that the profit referable to such
deliveries is not properly to be included in com
puting the plaintiff's income until the right of
the distributor to return the books has expired.
In the alternative, it is said that even if the
deliveries to the distributor were not on a sale
or return basis, they were sales subject to a
condition subsequent and the profit element
thereof is properly deductible in computing
income.
The Supreme Court of Canada, in Sinnott
News Company Limited v. M.N.R.', considered
a similar situation that arose at a different level
of the distribution chain. There the appellant
taxpayer was a wholesaler and the transactions
in issue were deliveries of magazines, not
books, to retailers and returns by them to the
wholesaler. The appellant sought the right to
deduct from its income for the year a "reserve
for loss on returns" being the estimated loss of
profit on magazines not sold by retailers and
liable to be returned in the following year.
The judgment of the Court was delivered by
Locke J., and concurred in by Cartwright and
Fauteux JJ., as they then were. Kellock J. con
curred in the result but on the basis of a differ
ent finding of the facts than the majority. Locke
J. said, at page 439, that:
The arrangements made between the appellant and the
retailers to whom it delivers the publications for sale have
been found by the learned trial judge to constitute deliveries
on sale or return and, accordingly, Rule 4 of s. 19 of the
Sale of Goods Act (R.S.O. 1950, c. 345) applies.
and, at page 442, that:
While the learned trial judge found as a fact that the
deliveries made to the retailers were on sale or return, he
concluded that they were thereafter treated by the parties as
outright sales and that, accordingly, the amounts which
would become payable by the dealers if the goods in their
hands were all sold or retained should be treated as accounts
payable.
I am unable, with respect, to agree with the finding that in
the present matter these transactions became outright sales.
The judgment of the Court was that, being
deliveries on sale or return, Rule 4 of section 19
' [1956] S.C.R. 433.
of the Ontario Sale of Goods Act applied and
that property in 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.
The Court disallowed the reserve for loss on
returns which the appellant had originally
claimed but achieved the result desired by the
appellant by directing that its taxable income be
restated by deleting from revenue and expense
the accounts receivable and payable that had
been set up in respect to the goods subject to
sale or return remaining in the hands of the
retailers at the appellant's fiscal year end. The
plaintiff in this case, being at the inaugural,
rather than an intermediate, position in the dis
tribution chain, has only accounts receivable
and no comparable accounts payable and so
seeks to achieve the desired result by deducting
its profit on the books delivered by it and in the
hands of wholesalers. It may be conjectured
that the plaintiff did not seek the same deduc
tion in respect of books in the hands of retailers
because of the practical difficulty inherent in
ascertaining the quantities thereof at a given
time. The principle would appear to be no dif
ferent so long as the books were subject to
being sent back up the distribution chain to the
plaintiff.
The parties herein made no issue of whether
the deliveries were governed by the law of
Ontario, where the plaintiff was located at the
end of 1969, or of Manitoba where its printer,
who actually shipped the books on its behalf,
was located. The comparable provisions of the
Manitoba 2 and Ontario 3 Sale of Goods Acts in
1969 were, in their effect, identical to those of
the Ontario Act considered in the Sinnott News
case. The Ontario Act provided:
2 R.S.M. 1954, c. 233, sections 19 and 20, respectively.
3 R.S.O. 1960, c. 358, sections 18 and 19 respectively.
18. (1) Where there is a contract for the sale of specific
or ascertained goods, the property in them is transferred to
the buyer at such time as the parties to the contract intend it
to be transferred.
(2) For the purpose of ascertaining the intention of the
parties regard shall be had to the terms of the contract, the
conduct of the parties and the circumstances of the case.
19. Unless a different intention appears, the following are
rules for ascertaining the intention of the parties as to the
time at which the property in the goods is to pass to the
buyer:
Rule 4.—When goods are delivered to the buyer on
approval or "on sale or return" or other similar terms, the
property therein passes to the buyer:
(i) when he signifies his approval or acceptance to the
seller or does any other act adopting the transaction;
(ii) if he does not signify his approval or acceptance to
the seller but retains the goods without giving notice of
rejection, then if a time has been fixed for the return of
the goods, on the expiration of such time, and, if no
time has been fixed, on the expiration of a reasonable
time, and what is a reasonable time is a question of fact.
Whether the books were delivered by the plain
tiff to its wholesaler "on sale or return" is a
question of fact to be determined from the
agreement between them, their conduct and the
circumstances surrounding the transaction.
Distribution in Canada to both the wholesale
and direct markets was done by Curtis Distribu
ting Company Limited (herein called "Curtis
Canada") under a written agreement dated
March 22, 1949 in which the plaintiff was desig
nated "publisher" and Curtis Canada was desig
nated "Curtis". It provided:
2. ... The number of titles and amount of copies of books
to be shipped in any one month hereunder will be deter
mined by mutual agreement. Shipment of titles in the quanti
ties so agreed upon shall be made by publisher f.o.b. such
wholesaler destination points as shall be specified by Curtis.
Title to books and risk of loss thereof shall remain in
publisher until delivery to wholesalers.
3. Books which are considered unsaleable shall be fully
returnable. Curtis and publisher shall, from time to time,
determine what books are unsaleable, but in any event,
books which have been on sale for twelve months shall be
conclusively presumed to be unsaleable, and shall be fully
returnable at the option of Curtis.... All returns shall be
shipped, return transportation collect, to such points as
publisher shall designate. Curtis shall be entitled to credit on
its monthly statements for all returns, at the price charged
Curtis for books hereunder.
' 4. ... Settlement shall be made hereunder by Curtis by the
10th of the month for books shipped during the second
preceding month.
In practice, the plaintiff, in Toronto, did not
itself ship the books. Its printer, in Winnipeg,
did so on its behalf. Also, in practice, books
returned were not physically returned to the
plaintiff or even to Curtis Canada or the whole
salers. The retailer stripped the front covers, or
perhaps just the portion of the front covers
showing the title, from returnable books. The
books were destroyed by the retailer and the
covers passed back up the distribution chain as
evidence of destruction. When they reached
Curtis Canada, it issued a credit note to the
wholesaler and transmitted a copy of the credit
note to the plaintiff. This served as an invoice
from Curtis Canada to the plaintiff and was
taken into account on the monthly statement as
required by clause 3 of the agreement.
It appears that, in theory, the return process
could be initiated by retailers at any time but, in
practice, books distributed through the whole
sale market in Canada usually remained on
retailers' shelves three or four months. Further,
the claims for return credit were delayed be
tween six and eight weeks at the wholesale level
because a wholesaler had to process claims
from numerous retailers in respect of products
delivered by many distributors and to break
down and allocate the claims to the proper
distributors. Once a claim was made on the
distributor, it was immediately allocated and
passed on to the publishers who were ultimately
liable to satisfy it.
The plaintiff acknowledges that the settle
ment pattern called for in the agreement was
generally adhered to by Curtis Canada through
out 1969 and into 1970 until Curtis Canada was
advised of the plaintiff's intention to terminate
the agreement. Termination was effective in
September, 1970. Thus, in practice, the plaintiff
would be paid for a book shipped in a given
month by Curtis Canada about 40 days after the
end of that month. If that book were returned,
the credit for its return would not normally be
given by the plaintiff to Curtis Canada until
between four and a half and six months after
shipment.
The agreement provided that books be
shipped "f.o.b." by the plaintiff and that "title
to books and risk of loss thereof" would remain
in the plaintiff "until delivery to wholesalers".
Prima facie, where goods are sold f.o.b., the
moment property passes to the purchaser is the
moment of shipment, however it is open to the
parties to postpone that moment. The plain sig
nificance of the provision that title and risk
would remain in the plaintiff until delivery is
that, in this case, the parties did agree to post
pone the moment that property in the books was
to pass but only until delivery.
The Rules under section 19 of The Sale of
Goods Act govern "unless a different intention
appears". Having regard to the provision in the
agreement that property in the books was to
pass to Curtis Canada on their delivery to the
wholesalers designated by it and to the fact that,
in the ordinary course of events, a given book
would actually be paid for long before credit for
its return would be given, I find that Rule 4 has
no application.
The books were not delivered "on sale or
xreturn"; they were sold subject to a condition
subsequent which, if invoked by the purchaser,
Curtis Canada, would re-vest property in the
goods in the plaintiff. This, then, is the plain
tiff's alternative position and is also essentially
the factual situation found to exist in the Sinnott
News Case by Kellock J. Having found that
property in the magazines passed from the
appellant wholesaler to the retailer dealers on
delivery, he went on to say, at page 437:
This, however, does not end the matter, as the parties
were at one that there was a right on the part of the dealers
to return the magazines at any time.... This being so, while
the transactions between the appellant and its dealers were
sales and not deliveries on consignment, they were never
theless sales subject to a condition subsequent, the result
being that, in the case of magazines actually returned, the
property re-vested in the appellant; Head v. Tattersall (1),
per Cleasby B.; May v. Conn (2); Benjamin, 8th ed. 415. the
situation would be otherwise where there is a sale but the
vendor has bound himself to repurchase in certain events,
such as was considered to be the situation in The Vesta (3) 4 .
Accordingly, the appellant is not entitled to set up, as it
has done, any reserve of profits. The reserve sought to be
set up is made up of the profit element in the sale value of
goods delivered to dealers during each of the years in
question which the appellant estimated would be returned to
it during the three months following. This estimate, to quote
the appellant's factum, "was practical, reasonably accurate,
and arrived at on the basis of the actual experience of the
company with each magazine for a reasonable time prior to
the end of the year".
As deposed to by the witness Sinnott, at the end of the
three month period, the appellant would "know exactly" the
value of goods actually returned. Accordingly, instead of
deducting the above mentioned reserve from the sales figure
in respect of each of the years in question, the appellant
should be entitled, in its income tax returns, 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. ,
Kellock J. did not link his conclusion as to the
deductibility of the estimated sales value to any
provision of the Act. While the judgment does
not state expressly what is meant by the term
"sales value" the following remark, at page 438,
is helpful:
Although the appellant fails with respect to the basis upon
which it contested this litigation, the practical result is the
same.
"Sales value" is not "profit" but it is an amount
equal to "profit" and is the same as "profit
element" that the plaintiff, in this case, seeks to
deduct not from its profit after that has been
calculated but rather from its earnings prior to
the calculation of profit. The law to be applied
in determining whether that deduction should be
allowed is the same as the law to be applied in
determining whether the $220,000 deduction
should be allowed. It is therefore convenient
here to set out the facts relevant to that
deduction.
Distribution in both the wholesale and direct
markets in Canada was pursuant to the agree
4 The citations of the cases referred to in this quotation,
respectively, are: (1) [1871] L.R. 7 Ex. D. 7 at 14; (2) (1910)
23 O.L.R. 102; (3) [1921] 1 A.C. 774 at 782-3.
5 The emphasis is mine.
ment with Curtis Canada. Its material provisions
have already been recited. Distribution in the
United States of America to the wholesale
market only was done by Curtis Circulation
Company (herein called "Curtis U.S.") under a
written agreement dated December 19, 1968, in
which the plaintiff was designated "Harlequin"
and Curtis U.S. was designated "Curtis". It
provided:
(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 deliv
ered by Harlequin 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.
In practice, as under the agreement with Curtis
Canada, the books were actually shipped by the
printer and covers were stripped and books
destroyed rather than physically returned. The
terms of payment called for in the agreement
were generally observed until it, too, was about
to be terminated in September 1970.
Distribution in the direct market in the United
States was on an entirely different basis. It was
governed by an agreement in writing dated
December 31, 1968 between the plaintiff, there
in designated "Harlequin" and Simon & Schust-
er, Inc., therein designated "Publisher". Under
that arrangement Harlequin provided Publisher
with plates and negatives permitting Publisher
to print in the U.S. titles Harlequin had or
proposed to distribute in Canada. Publisher
undertook to cause a minimum number of
copies of each title to be printed within a speci
fied time of the provision of the plates and
negatives and to pay Harlequin royalties on net
sales. "Net sales" was defined as "copies
shipped by Publisher to retail chain store outlets
less returns" and it was provided that "Publish-
er shall have unlimited and uncontrolled discre
tion in the matter of accepting returns".
The material provisions relative to the
accounting for and payment of the royalties
follow:
10. (a) On the last day of each month, publisher will
render a written statement to Harlequin of the aggregate
sales and returns of Titles during the preceding calendar
month and will pay to Harlequin an amount on account of
royalties hereunder based upon 75% of the net sales during
such preceding ... .
(b) Publisher shall render royalty statements to Harlequin
on May 30 for the period from October 1 to March 31 and
on November 30 for the period from April 1 to September
30 .... Within 10 days thereafter, Publisher shall pay to
Harlequin the royalty applicable to the reported period .. .
less amounts paid on account thereof pursuant to subpara-
graph (a) of this paragraph, and less a reserve of 25% of net
sales during the last two months of the period accounted;
and plus the reserve so withheld in respect to the prior
period. If such statement shows an overpayment of royal
ties, promptly on receipt of the statement, Harlequin shall
make refund to publisher ... .
The return experience on books distributed in
each of the four distribution chains was differ
ent. As at December 31, 1969, the plaintiff
provided in its accounts a current liability of
$232,889 for returns of books then outstanding
in the distribution system. Omissions in the cal
culation at the time resulted in this amount
being more than the amount now claimed.
The calculation follows:
Canadian Sales
Wholesalers
Last 9 months sales of
$724,398 at 10.5% = $ 76,000*
Direct Book Accounts
Last 3 months sales of
$60,000 at 15% = $ 9,000
United States Sales
Last 6 months sales of
$554,000 at 20% _ $110,800
Conversion to Canadian
dollars at 1.073 = $ 8,000*
$203,800
Simon & Schuster royalty rebate
Expected returns of
528,894 books at $.055 $ 29,089
Total provision $232,889
*approx.
The omissions which render the $232,889 figure
inaccurate are the failure to convert the Simon
& Schuster rebate from U. S. to Canadian dol
lars and the failure to take into account that any
rebate to which Simon & Schuster became en
titled would, ipso facto, reduce the plaintiff's
liability to pay royalties to a third party. I am
not satisfied that the revised figure given at the
trial is necessarily correct and I see no need to
determine it. For convenience, I have assumed
it to be in the neighborhood of $220,000. If this
deduction were allowed to the plaintiff then the
similar provision made at the end of its previous
year and carried forward would have to be
added to income. The net result would be a
reduction in the provision of about $35,000
since the provision established, but not claimed
for tax purposes, was higher at December 31,
1968. Again I see no need to determine and,
indeed, on the evidence am not able to deter
mine accurately the amount of the reduction.
The expert evidence of Ronald Walker Scott
is to the effect that the provision for returns, in
the circumstances of the plaintiff's business,
conforms with generally accepted accounting
principles and is, in fact, fair and reasonable.
Mr. Scott is a chartered accountant, a partner in
the accounting firm, Clarkson, Gordon & Co.,
working in that firm's National Accounting
Standards Department. That is a service depart
ment within the firm responsible, inter alia, for
research into developments in accounting prin
ciples and standards. Clarkson, Gordon & Co.
are the plaintiff's auditors. I, accept Mr. Scott's
evidence that, having regard to the manner in
which it conducted its business, the plaintiff's
practice of making provision for book returns
was a necessary conformity to generally accept
ed accounting principles. On the evidence as to
the plaintiff's actual return experience before,
during and since 1969 the provision appears to
have been reasonably calculated in so far as
returns under the Curtis agreements were
concerned.
While decisions dealing with deposits and
credit notes can readily be distinguished on their
facts from the present case, the law applicable
is the same law and is not to be distinguished.
The decisions of the Supreme Court of Canada
in M. N. R. v. Atlantic Engine Rebuilders Ltd. 6
and Time Motors Ltd. v. M.N.R. 7 are author
ity for the proposition that generally accepted
accounting principles are most relevant in arriv
ing at a determination of the facts to which the
provisions of the Income Tax Act are to be
applied.
The first question is whether the deduction
claimed was required by generally accepted
accounting principles to be made in order to
ascertain the plaintiff's true profit for the year
ended December 31, 1969. If that is answered
in the negative, it is not necessary to inquire
further, but if the answer is affirmative, it
remains to be answered whether the deduction
is prohibited by a provision of the Act. The
expert evidence did not deal with the deduction
of the entire profit element attributable to books
in the hands of Canadian wholesalers as at
December 31, 1969. The expert evidence dealt
only with the provision, by way of a current
liability, for the rebates that might reasonably
be expected to be made in respect of returns of
6 [1967] S.C.R. 477.
7 [1969] S.C.R. 501.
books in the distribution system at the plaintiff's
year end.
It is not suggested that all of the books in any
particular part of the system, in this instance,
those in the Canadian wholesale chain still in
the hands of wholesalers, could reasonably be
expected to be returned. That basis of deduction
may have been selected with a view to tailoring
the deduction as closely as might be to the
judgment of Kellock J. in the Sinnott News
case. With the greatest respect, I cannot accept
that judgment as the judgment of the Court,
having regard to the very different finding of
facts by the majority, and must assess what the
plaintiff has done in the light of generally
accepted accounting principles. It is significant
that in the case of Sinnott News, the deduction
sought was part only of the profit reasonably
estimated on the basis of experience to be
attributable to publications likely to be returned
for credit. In this case, the plaintiff seeks to
deduct the entire profit element attributable to
all the publications at a certain point in one of
its distribution chains.
I accept that returns of some of those books
was a certainty and that the application of gen
erally accepted accounting principles requires
some provision for those returns. The provision
which the expert evidence supports was based
on 10.5 per cent of books delivered to Canadian
wholesalers over a nine-month period being
returned. It seems to me that the elimination of
the entire profit element, including that attribut
able to the approximately nine of ten books that
would not be expected to be returned, has no
rational foundation. The evidence in this case
does not support the proposition that generally
accepted accounting principles required that the
entire profit element attributable to all of the
books in the hands of Canadian wholesalers at a
given time be deducted from income in order to
present a true, or at least truer, financial meas
urement of its operations to that point in time.
With respect to books outstanding under the
Simon & Schuster agreement as at December
31, 1969, I am by no means satisfied on the
evidence that the plaintiff had actually received
royalty payments liable to be refunded. The
agreement appears to have been designed to
protect Simon & Schuster from overpaying the
plaintiff. The evidence is that the terms of the
agreement as to the accounting and payment
were observed. Thus, as at December 31, the
plaintiff would not have been paid or be entitled
to be paid 25 per cent of the royalty on net sales
during August and September, being the last
two months of the last accounting period, nor
October, November and December, being in the
then current accounting period.
1969 was the first year of the Simon &
Schuster agreement. Previously, the plaintiff
had acted as its own wholesaler in parts of the
United States and Simon & Schuster, handling
books printed in Canada, had been the whole
saler in other parts of the United States. The
provision for rebate of royalties was based on
that experience but does not appear to have
taken into account the holdback. The 25 per
cent holdback of the royalties in respect of the
last five months' net sales is well in excess of
the 16 per cent and 14 per cent respectively, of
the royalty on the last five months' net sales,
which the plaintiff did set up, on the basis of
actual experience, under the new arrangement
at the end of 1970 and 1971. I therefore find
that this provision in 1969 did not conform with
the requirements of generally accepted account
ing principles.
The balance of the provision for returns in the
total of approximately $203,800 did, on the
evidence, conform with the requirements of
generally accepted accounting principles. The
application of those principles in the determina
tion of the plaintiff's profit is to be allowed
unless the Act contains an express prohibition.
The relevant provisions of the Act are:
4. Subject to other provisions of this Part, income for a
taxation year from a business or property is the profit
therefrom for the year.
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 decision of the Supreme Court of Canada in
Dominion Telegraph Securities Limited v.
M.N.R. 8 held that three distinct accounts: (1) a
reserve, (2) a contingent account and (3) a sink
ing fund, are described in section 12(1)(e). In
order for it to be an account within the contem
plation of the section, the allocation of an
amount to it from another account must have
the effect of reducing income. This case is not
concerned with a sinking fund as I understand
that term.
The adjective "contingent" means "liable to
happen or not; of uncertain occurence or
incidence". 9 The term "contingent account"
taken literally would appear to be nonsense. An
account, once set up is itself not contingent; it
has, so to speak, happened and is not uncertain.
It exists. The term must be taken to mean
"account for a contingency". In other words, it
is not the account that must be found to be
contingent but rather the thing in respect of
which it was set up: in this case the liability to
pay or give credit for the refunds and rebates. I
have been unable to find Canadian authority
defining the term "contingent liability"; how
ever, in Winter v. I.R.C. 10 the House of Lords
did so in the context of the Finance Act, 1940."
The facts of that case were complicated by
the intervention of a company controlled by the
deceased. Accordingly, the law Lords were
looking through the corporate veil to arrive at
8 [1947] S.C.R.45.
9 The Oxford English Dictionary.
10 [1963] A.C. 235.
" 3 & 4 Geo VI, c. 29.
the value of shares for estate duty purposes by
ascertaining the true worth of the company.
Certain company assets, in respect of which
capital cost allowance had been claimed, had a
fair market value on the death of the deceased
well in excess of their written-down value on
the company's books. If sold for anything more
than the written-down value, a recapture of the
capital cost allowance would necessarily have
given rise to an adverse change in the compa-
ny's income tax situation. The legislation impos
ing the estate duty expressly required that "con-
tingent liabilities" be taken into account in
determining the dutiable value of the estate. The
executors contended successfully that the
notional tax on the recapture of depreciation
was a contingent liability at the moment of
death. Their Lordships held that the term "con-
ditional obligation" which is well defined in
Scots law has the same meaning as the term
"contingent liability". A number of their Lord
ships discussed the definition in their speeches,
Lord Reid most extensively. At page 248 et seq.
he said, in part:
It would seem that the phrase "contingent liability" may
have no settled meaning in English law ... But the Finance
Acts are United Kingdom Acts, and there is at least a strong
presumption that they mean the same in Scotland as in
England. A case precisely similar to this case could have
come from Scotland and your Lordships would then have
considered the meaning of this phrase in Scots law. So I
need make no apology for reminding your Lordships of its
meaning there. Perhaps the clearest statement of the Law of
Scotland is in Erskine's Institute, 3rd ed., vol. 2, Book III,
Title 1, section 6, p. 586, when he says: "Obligations are
either pure, or to a certain day, or conditional . . . . A
conditional obligation, or an obligation granted under a
condition, the existence of which is uncertain, has no obliga
tory force till the condition be purified; because it is in that
event only that the party declares his intention to be bound,
and consequently no proper debt arises against him till it
actually exists; so that the condition of an uncertain event
suspends not only the execution of the obligation but the
obligation itself .... Such obligation is therefore said in the
Roman law to create only the hope of a debt. Yet the granter
is so far obliged, that he hath no right to revoke or withdraw
that hope from the creditor which he had once given him".
So far as I am aware that statement has never been
questioned during the two centuries since it was written, and
later authorities make it clear that conditional obligation and
contingent liability have no different significance. I would,
therefore, find it impossible to hold that in Scots law a
contigent liability is merely a species of existing liability. It
is a liability which, by reason of something done by the
person bound, will necessarily arise or come into being if
one or more of certain events occur or do not occur. If
English law is different—as to which I express no opinion—
the difference is probably more in terminology than in
substance.
Then, after dealing with the other classes of
liability the statute required the Inland Revenue
Commissioners to take into account, he said:
The third class is "contingent liabilities" which must mean
sums, payment of which depends on a contingency, that is,
sums which will only become payable if certain things
happen, and which otherwise will never become payable.
There calculation is impossible, so the commissioners are to
make such estimation as appears to be reasonable.
The last class appears to me to cover exactly the condi
tional obligation dealt with by Erskine in the passage I have
quoted. I agree with the respondents' argument to this
extent, that this class can only include liabilities which in
law must arise if one or more things happen, and cannot be
extended to include everything that a prudent business man
would think it proper to provide against.
I see no reason not to accept the same meaning
in Canadian law.
Certain as it was that the plaintiff would, in
due course, be obliged to give rebates on royal
ties or on returns of books, the fact is the
plaintiff's liability to do so, under the terms of
the agreements which were, in practice,
observed, did not arise until the plaintiff was
presented with a demand for the credit. The
plaintiff's obligation to the distributors in
respect of credits for returns was a contingent
liability. So was its obligation to rebate royalties
to Simon & Schuster. An account set up to
provide for those contingent liabilities whether
by way of a provision for returns and allow
ances 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). No deduction in respect of that
account, even to the extent that generally
accepted accounting principles required it to be
set up, is permitted in the calculation of the
plaintiff's taxable income.
This case is to be distinguished from Sun
Insurance Office v. Clark 12 where it was
expressly found that no statutory prohibitions
against deductions applied 13 and the only issue
was that the deduction had, of necessity, to be
estimated. It is also to be distinguished from the
Atlantic Engine Rebuilders and the Time Motors
cases where, in each case, the uncertainty did
not pertain to the coming into existence of the
liability (it came into existence when the deposit
was accepted or the credit note issued, as the
case may be) but rather pertained to whether
the creditors would do what was necessary to
enforce the existing liability.
In this instance, it is neither the fact that an
estimate had necessarily to be made nor that it
might or might not have been called upon to
meet the liability that defeats the plaintiff.
Rather, it is the fact that the liability, as at the
pertinent date, was contingent and the account
set up to provide for it, whatever the mechanics,
was a contingent account.
The two Curtis agreements were terminated
in September, 1970. When they were advised of
the plaintiff's intention to terminate, sometime
in 1970, the Curtis companies both suspended
payment as required by the agreements until all
returns had been processed and credits ascer
tained. The Curtis companies then paid the
plaintiff the balances owing. This evidence was
adduced in support of the plaintiff's contention
that a portion at least of the provision for
returns and allowances was properly deductible
as a reserve permitted by section 11(1)(e)(î) of
the Act.
11. (1) ... 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
12 [1912] A.C. 443.
13 Per Viscount Haldane at p. 454.
(i) doubtful debts that have been included in computing
the income of the taxpayer for that year, ... .
The plaintiff had not experienced any problems
in collecting from either Curtis company prior
to intimating its intention to cancel. That
occurred subsequent to the year in question.
The plaintiff had not, in its financial statements
for that year, set up a reserve for that purpose.
This deduction was sought in an appeal to the
Income Tax Appeal Board in respect of its 1949
income tax assessment by a taxpayer with
which the present plaintiff may have had some
connection. In that case, 14 the learned member
of the Board, R.S.W. Fordham, Q.C., said, with
reference to the term "doubtful debts", that:
Those two words imply a definite financial indebtedness
that, for some identifiable reason, probably — but not, it
should be noted, certainly — will not be satisfied by the
debtor.
I agree with that interpretation. For a debt to be
doubtful within the contemplation of section
11(1)(e)(i), its collectability must be attended by
a doubt based on a real consideration, not on
mere speculation, that leads to the conclusion
that it will not likely be collected. A doubtful
debt and a slow debt are not the same thing.
There is nothing in evidence to support the
proposition that the debt due from either Curtis
company was doubtful as at December 31,
1969.
Finally, the defendant took objection, on the
basis of the pleadings, to the Court dealing with
any deduction except the $128,040 claimed by
the plaintiff in its return and the reserve for
doubtful debts. It was noted that the deduction
of the provision for returns and allowances had
not been claimed in the return and it was argued
that it was not pleaded in the statement of
claim.
The statement of claim is by no means crys
talline in its definition of the issues; however,
the time for rectification of that deficiency is
past when the trial begins. It is reasonably open
10. Harlequin Books Ltd. v. M.N.R. 54 DTC 453.
to construction, by virtue of various cross-refer
ences, as raising the deductibility of the provi
sion for returns and allowances other than as a
reserve for doubtful debts.
Understandably, in the circumstances, the
statement of defence did not raise the question
of whether the deduction could be sought at all
in this action in view of its not having been
claimed in the return and, hence, not having
been the subject of the assessment from which
this appeal is taken. Neither, however, did the
statement of defence raise the same objection
concerning the reserve for doubtful debts which
was sought for the first time in the statement of
claim. The provision for returns and allowances,
unlike the reserve for doubtful debts, at least
appeared in the financial statements that accom
panied the tax return even though it was washed
out in the accompanying reconciliation of earn
ings per financial statements with taxable
income.
While, in the result, a disposition of this
objection is not necessary, it does seem to me
that, the appeal being an appeal from an assess
ment, it is a moot question whether the Court is
entitled to consider, on appeal, a deduction that
was not even the subject matter of the assess
ment. I should not, however, be prepared to
express a view on such a question without the
benefit of comprehensive argument directed to
the point. I was not the beneficiary of such
argument in this instance.
The appeal is dismissed with costs.
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.