T. Marcogliese (613) 957-2095
JAN 27 1988
Dear Sirs:
This is in reply to your letters of October 15, 1987 and December 22, 1987 wherein you request our views on the deductibility under the Income Tax Act (the "Act") of warranty obligations assumed on the acquisition of a business. Specifically, you have asked that we further consider the comments outlined in our letter of August 24, 1987. In that letter, we indicated that, in our opinion, the warranty obligations represent outstanding liabilities of the transferor of the business and their assumption by the purchaser would be part of the consideration paid upon acquisition of the business. Accordingly, since the taxpayer's expenditures are on account of the acquisition cost of the business, the amounts paid to honour warranty obligations would not be deductible expenses to the purchaser but rather would be on capital account.
In your view, the case of Lawrence H. Mandel (78 DTC 6518 Federal Court of Appeal), wherein it was determined that the cost of an asset (i.e. a film) could not include a liability which was contingent upon a future event that was by no means certain to occur, precludes the addition of warranty obligations to the cost of the asset acquired. Accordingly, you believe, that the warranty payments would be deductible in computing the taxable income of the taxpayer only when actually incurred by the purchaser.
Although, the situation you describe and the Mandel case appear to both be contingent liabilities, we believe that the facts involved are dissimilar. In Mandel the amount of the liability was certain, however, the requirement to pay the full capital cost of the asset was contingent upon the unlikely occurrence that the film would produce future profits. In the situation you describe relating to the sale of a business, an estimate of the outstanding warranty obligations to be transferred is necessary since the assumption of these obligations by the purchaser will reduce the amount of other consideration that he is willing to pay for the business. In this situation, the warranty obligation is a liability which is contingent upon the occurrence of a future defect in a product. Although, it may not be possible to determine the precise future cost to honour the warranty obligations, the liability is, unlike that in Mandel, subject to reasonably accurate estimates based upon the history of the product's performance. Without reasonable confidence in the amount of the warranty provision transferred, the purchaser cannot accurately calculate a purchase price for the business.
We are unable to agree with your view, that the warranty obligations assumed upon acquisition by the purchaser would be a deductible expense for purposes of section 9 and paragraph 18(1)(a) when incurred.
In our view the warranty obligations assumed upon the acquisition of the business are in respect of capital and therefore by virtue of paragraph 18(l)(b) of the Act, would not be a deductible expense to the taxpayer.
Our conclusion would remain unchanged even if the principles established in the Mandel case had application to your situation.
We regret that a more favourable response could not be provided.
for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch