Date: 20010507
Docket: 90-159-IT
BETWEEN:
REDHEAD EQUIPMENT LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Beaubier, J.T.C.C.
[1] These appeals were heard at Regina, Saskatchewan, on April 20, 2001. Gary Redhead, owner and president of the Appellant ("Redhead"), was the only witness. At all material times Redhead was the Saskatchewan distributor for Champion Road Machinery Limited.
[2] In 1986 Champion Road Machinery Limited ("Champion") introduced the Uptime warranty 5/5 (5 years or 5,000 hours) extended powertrain warranty. It is summarized in Champion's "Recommendations and Suggestions..." which it sent to the Appellant (Exhibit A-2). Paragraphs 5 and 6 of Exhibit A-2 read:
5. The Warranty is spelled out in detail on Form CW002. Champion warrants a new Grader, delivered to a Governmental/Municipal Power, for 5 Years or 5000 Hours, whichever comes first, for all the powertrain as listed in para. 3. Cummins warrants the Engine, and this is detailed on the forms in the Kit. The Customer has paid $5,000.00 for this protection. One Dollar per operating hour.
6. You will be making UPTIME 5/5 Inspections every six months. It is recommended that you spend time in advance studying this form before going to do your first Inspection. You will probably find it helpful to do a dry run Inspection on a used Grader in your yard.
The issue is whether the Appellant could claim a reserve on account of the inspection program.
[3] Mr. Redhead testified that upon this being introduced the Appellant reviewed its Champion Grader pricing and created five pricing components for sales purposes:
1. The cost of the grader;
2. $5,000 payable to Champion for its 5/5 program;
3. $5,000 inspection cost to Redhead;
4. Salesman's commission; and,
5. Redhead's profit.
The sales in question were to municipalities, and usually involve a trade-in. All of the sales were by negotiation, not tender. None of these components were identified to the customers because Redhead expected that the end result of negotiations would occur when the customer finally said "Well, I will buy your grader if you throw in the inspection program". The Court finds this to be a logical and sensible expectation by Redhead respecting negotiated sales deals.
[4] The result was that Redhead fixed an anticipated inspection cost to it of $5,000, which was the same figure as the one Champion identified as its fixed costs of the 5/5 program. It then calculated a reserve at the end of 1986 consisting of 4/5 of $5,000 x 56, the number of Champion graders which it sold with the 5/5 program. That reserve was not allowed and this appeal ensued.
[5] The portions of Section 20 of the Income Tax Act ("Act") upon which the appeal is centred are the following:
20(l) Deductions permitted in computing income from business or property – Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto;
...
(m) reserve in respect of certain goods and services – subject to subsection (6), where amounts described in paragraph 12(1)(a) have been included in computing the taxpayer's income from a business for the year or a previous year, 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,
(iii) periods for which rent or other amounts for the possession or use of land or chattels have been paid in advance, or
(iv) repayments under arrangements or understandings of the class described in subparagraph 12(l)(a)(ii) that it is reasonably anticipated will have to be made after the end of the year on the turn or resale to the taxpayer of articles other than bottles;
...
20(7) Exception – Paragraph (1)(m) does not apply to allow a deduction
(a) as a reserve in respect of guarantees, indemnities or warranties; ...
[6] Thus the particular question is whether or not Redhead's reserve for inspections was a deduction forbidden by subsection 20(7) because it was on account of a guarantee, or indemnity or a warranty. Or, within the terms of Redhead's and Champion's agreement and the sale to the customer, was the inspection program a warranty by Redhead? A second question, which will be dealt with first, is whether 4/5's of $5,000 per grader was a "reasonable" reserve under paragraph 20(l)(m).
[7] The Uptime 5/5 program only applied to municipalities, which ranged from 25 to 300 miles away from Redhead's three Saskatchewan outlets. Redhead had to send a qualified staff member out to each grader every six months to perform the inspection. Redhead was advised by Champion of the sum Champion would contribute to each inspection, which ranged from $150 per inspection in year one, to $200 per inspection in year five. Redhead knew that this was not enough to pay the cost of sending a "technician", vehicle and proper equipment anywhere from 25 to 300 miles away and then do the inspection. The inspection was detailed respecting each of the fluid systems; the engine frame area; the air intake, exhaust and cooling system; the fuel supply system; the final drive; the circle and "moldboard" area; the operator station and hinge area; an operational checkout; the electrical system; "maintenance and adjustments" and the "blade" system. Both the owner and Redhead signed each inspection report (Exhibit A-3). This was no "drive-by" inspection. On the other hand, it was merely an inspection. Redhead did not have to maintain, replace or repair. A-3 is specific – maintenance and repair is the responsibility of the owner. But Redhead had to provide the skilled labour, equipment and time for such inspections, miles away from its premises, every six months.
[8] Redhead had been in the business for 18 years in 1986. But there is no evidence that it had any experience with such an inspection program. However, ten elaborate inspections would cost considerably more than Champion would pay Redhead. To the Court, an estimate of an extra $500 per inspection under such circumstances is not unreasonable. The average mileage to and from a rough and mostly rural inspection site would exceed 300 miles and the actual cost of that would easily amount to $2.00 per mile for the equipment and an appropriate vehicle, even in 1986. To this there must be added the cost of the technician, his benefits and a possible overnight stay. A further factor is the general overhead cost. It should be noted that two inspections per year amounts to a possible average of 112 days for inspections each year. This is one-half a working man-year plus a vehicle and other equipment. $56,000 per year as a charge plus Champion's annual payment per inspection to Redhead then appears quite reasonable. In 1988, during the objection stage, the Appellant's chartered accountant had Redhead calculate its actual average costs of each inspection in 1986, presumably after Champion's payment was received. These were $3,734.40 per machine. Thereupon Redhead reduced its reserve claim to $3,734.40 x 56 x 4/5 = $167,301.12. Two things should be noted about this:
1. This was done after 1986, and based upon the 1986 experience.
2. Champion had estimated an increased cost as the years passed and each machine got older and required longer inspection time, and as costs of everything increased. Undoubtedly Champion's view is sensible. In the Court's view, Redhead's calculation of $5,000 per machine was reasonable and its revised claim is conservative respecting the remaining four years.
[9] The reserve itself was not for a guarantee or an indemnity. Nothing was guaranteed and no loss was protected. The contract was merely that Redhead would inspect.
[10] Moreover Redhead did not warrant. Champion itself warranted the 5/50 warranty in the letter of its agreement. Paragraphs 5 and 6 of Champion's agreement with Redhead (Exhibit A-5) reads:
5. The DISTRIBUTOR agrees to carry out, on a semi-annual basis and in the manner set out in the UPTIME REPORT, inspections of all GRADERS in respect of which the WARRANTY has been purchased (the "UPTIME INSPECTIONS") employing only fully trained and qualified technicians (the "TECHNICIANS"). The TECHNICIANS will prepare and present to the OWNER, obtaining a receipt, an UPTIME REPORT in respect of each such UPTIME INSPECTION, specifying the required repairs or replacement of parts. If unable to present the UPTIME REPORT to the Official as indicated in para. 18 of the WARRANTY, the DISTRIBUTOR will mail, using "Certified Mail" service, addressed to the Official.
6. The DISTRIBUTOR agrees, upon authorization by the OWNER, to carry out all repairs or replacement of parts covered by the WARRANTY ("WARRANTED REPAIRS") and specified in the UPTIME REPORT, as well as any other repairs or replacement of parts ("NON-WARRANTED REPAIRS") authorized by the OWNER (together, the "REQUIRED WORK"), REQUIRED WORK must be completed by the DISTRIBUTOR within fourteen (14) days of the UPTIME INSPECTION. All other WARRANTED REPAIRS must be completed by the DISTRIBUTOR within seven (7) days of the date on which the WARRANTY claim is made by the OWNER. All WARRANTED and NON-WARRANTED REPAIRS shall be carried out by TECHNICIANS only.
[11] The inspection and its consequent "Uptime Report" (the inspection report) was a prerequisite to Champion carrying out its warranty. Redhead, in turn, supplied the labour for the warranty separate and apart from the inspection program. In fact, Champion and the Owner were the signatories to the "Champion Extended Powertrain Warranty" (Exhibit A-4). Redhead was not a signatory. Paragraph 5 of Exhibit A-4, Champion's warranty agreement with the owner, makes the inspections a condition of the warranty, but not part of the warranty.
[12] The Court finds that Redhead did charge $5,000 per grader in question which it sold in 1986 for the inspection program and included that sum in its income pursuant to paragraph 12(1)(a) of the Act. 4/5's or more of this $5,000 was for inspection services to be rendered by Redhead in inspections after 1986. Redhead contracted to provide these inspections and the history of graders owned by municipalities is that they are all owned for more than five years and they are not destroyed by accident or for other reasons. Thus, there was to be an inspection every six months and there was no contingency involved. For this reason, the 4/5 fraction calculated was correct.
[13] The inspections did not constitute warranties, indemnities or guarantees. Their purpose was to verify that the graders were being maintained and operated properly. The inspection process also instructed the municipality's staff in proper maintenance. This served Champion to protect its warranty. It also served the municipality because it acted as a check on its staff and it was also a prerequisite to its contract with Champion for the warranty.
[14] For these reasons, the appeals are allowed and the matter is referred to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.
Signed at Ottawa, Canada, this 7th day of May, 2001.
"D. W. Beaubier"
J.T.C.C.