In order to be entitled to a reserve under paragraph 20(1)(m), an amount in respect of the reserve must be included in income under paragraph 12(1)(a). There does not appear to be a direct income inclusion under paragraph 12(1)(a); however, one could take the view that a portion of the purchase price for the merchandise actually represents payment by the customers for these points which are in respect of goods that may be delivered after year end.
The case of Dominion Stores Limited v. MNR, 66 DTC 5111,  CTC 97 (Ex. Ct.), dealt with a similar issue. In that case, Dominion Stores issued free trading stamps to customers when they purchased merchandise from one of the stores in which a trading stamp plan was in effect. These trading stamps could be exchanged for premiums listed in a catalogue or could be redeemed for groceries sold in the stores. The company attempted to claim a reserve for a certain percentage of these unredeemed trading stamps at year end. The Minister denied the deduction and argued in the case that there was no evidence of an increase in price of the merchandise that was sold in the normal course of business to cover the cost of the trading plans when introduced and there was no segregation or allocation of the revenue received to the merchandise sold, on the one hand, and to the trading stamps distributed on the other. The trading stamps were free as they were described in Dominion’s advertising. Dominion did not receive any amounts in respect of these trading stamps, therefore, no amounts were included in income and a reasonable reserve not permissible as a deduction under paragraph 20(1)(m) of the current Act.
The Court concluded that in exchange for the purchase price of merchandise, the customer received merchandise and trading stamps. Dominion was legally obligated to make the redemption. Just because no specific amount was allocated to the stamps, did not mean that they were free. As the Court stated:
“… a portion of each amount received by the appellant from its customers was received on account of goods to be delivered on presentation of the trading stamps or tapes for redemption. All amounts received by the appellant in respect of such goods were included in the appellant’s income in the year of receipt whether or not the trading stamps or tapes were redeemed in that year. Such amounts, with respect to trading stamps which remained outstanding at the end of each taxation year, were on account of goods not delivered before the end of the year. From this it follows that by virtue of section 85B [now paragraph 20(1)(m)], the appellant is entitled to deduct a reasonable amount for each of the two years in question as a reserve in respect of goods that it is reasonably anticipated will have to be delivered upon the redemption…”
Not only is there a requirement that there be an income inclusion under paragraph 12(1)(a), but the reserve must be reasonable in order to be deductible under paragraph 20(1)(m). .
CRA’s view is that a 20(1)(m) reserve is not available on the basis of Dominion Stores Limited unless the reward points involve cash sales. However, the estimated cost of merchandise to be delivered after year end under the reward program may be deductible under Subsection 9(1). [See Technical Interpretation 2000-0034027 – Reward Points in Promotional Program].
GST is payable by the customer on the purchase of goods based on the full invoice price. No reduction or reserve is permitted for the value of the points issued or credited. When the points are redeemed for goods, either calculate GST on the value of the goods, in which case, it may claim an input tax credit of the value of the points, or alternatively, GST may be computed on the consideration received net of the points. In the latter alternative, there will be no GST payable as long as there is no consideration paid in addition to the points (subsection 181(3), Excise Tax Act).
Having decided that this amount must be included in income, it is necessary to determine whether a reserve for returned goods is permitted. The only reserves which may be appropriate are as follows:
- Paragraph 20(1)(l) - Reserve for doubtful debts
- Paragraph 20(1)(m) - Reserve for goods not yet delivered
- Paragraph 20(1)(n) - Reserve for amounts not due
None of these reserves can be claimed in respect of product returns. Note from the problem there is nothing to doubt the quality of the receivable which makes a reserve under paragraph 20(1)(l) inappropriate.
The issue of whether a reserve for returned goods could be deducted was considered in the case of Harlequin Enterprises Limited v. The Queen, 77 DTC 5164,  CTC 208 (FCA). The Court held the amount was undeterminable and contingent and could not be deducted under the then equivalent of paragraph 18(1)(e).
In ruling 2002-0129813, CRA stated that “in our view, it is clear from the Judgements in the Sinnott News and Harlequin cases that proceeds from the sale of goods can only be excluded from revenue when they are sold on consignment, or on a true “sale or return” basis where title to the goods does not pass to the buyer, and there is no liability to pay for the products, until the goods are either sold by the buyer, or a certain period of time has expired.”