On March 29, 2011, the Tax Court of Canada released its decision in Bernard Demeterio v. Her Majesty The Queen 2011 TCC 192. The case involved Bernard Demeterio, a life insurance agent, who received life insurance commissions in the 2002 and 2003 taxation years. Mr. Demeterio submitted that the commissions he received should not be taxable in the year of receipt (i.e. 2002 and 2003). He felt that the commissions were not income that had been earned but instead were loans advanced to him because they were required to be paid back if the life insurance policies that he sold were cancelled within two years. [This is a rather common remuneration feature amongst life insurance sales persons and life insurance companies and is often referred to as “chargebacks”]. Mr. Demeterio submitted that the commission income should be taxable once the life insurance premiums became non-refundable in the two immediate taxation years following the year of receipt.
The Court quickly dismissed Mr. Demeterio’s appeal and agreed with the Crown that the facts in Mr. Demeterio’s case were similar to those in another case, Destacamento v. Her Majesty The Queen 2009 TCC 242.
In Destacamento, the Crown submitted that the life insurance commissions received by the appellant were only called advances because there could be a chargeback. However, the possibility of a chargeback was a condition subsequent. In other words, the event had not yet happened and may never happen. Therefore the amounts received by the appellant had the “quality of income” and had to be included as income in his tax returns. If there was a chargeback, the Crown asserted that the appellant could deduct the reimbursement in the year that it was made. Ultimately, the Tax Court agreed with the Crown’s reasoning and dismissed the appellant’s appeal.
In Demeterio, the Tax Court also stated that even if the amounts received by Mr. Demeterio were advances, paragraph 12(1)(a) of the Income Tax Act (the “Act”) would include the amount in income given that paragraph 12(1)(a) reads as follows:
12(1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:
(a) any amount received by the taxpayer 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
(ii) under an arrangement or understanding that it is repayable in whole or in part on the return or resale to the taxpayer of articles in or by means of which goods were delivered to a customer; (Emphasis added)
A careful read of paragraph 12(1)(a) of the Act reveals that it captures many unearned amounts into taxable income. However, taxpayers and their advisors will often look for reserves to offset the amount captured under paragraph 12(1)(a). The reserves that are available mostly appear in section 20 of the Act, but life insurance sales persons are specifically prohibited from claiming reserves under section 20 given the language of paragraph 32(1)(a) of the Act, which reads as follows:
32. (1) — In computing a taxpayer’s income for a taxation year from the taxpayer’s business as an insurance agent or broker, no amount may be deducted under paragraph 20(1)(m) for the year in respect of unearned commissions from the business, but in computing the taxpayer’s income for the year from the business there may be deducted, as a reserve in respect of such commissions, an amount equal to the lesser of
(a) the total of all amounts each of which is that proportion of an amount that has been included in computing the taxpayer’s income for the year or a preceding taxation year as a commission in respect of an insurance contract (other than a life insurance contract) that (emphasis added) …
Accordingly, Mr. Demeterio was prevented from deferring tax on the commissions that he received in 2002 and 2003.
The decisions in Demeterio and Destacamento are not surprising and, in my opinion, are the right results. Accordingly, the cases should serve as a gentle reminder to life insurance commissioned sales persons to properly report their income and not get clever in trying to claim reserves or other deferrals in respect of possible chargebacks that might occur into the future.
Demeterio and Destacamento are also good reminders for other taxpayers who receive deposits or other amounts that are not yet earned. In many cases, accountants who prepare the financial statements for the businesses will correctly report the unearned amounts as liabilities (such as deferred revenue) instead of revenue. However, for income tax purposes, the unearned amounts that are reflected as liabilities on the balance sheet will more than likely be caught by the provisions of paragraph 12(1)(a). Accordingly, taxpayers and their advisors will need to ensure that such unearned amounts are reported as taxable income and efforts made to look for proper reserves (usually under section 20 of the Act) to ensure that a legitimate tax deferral is sought. We find that this is a common error made by non-tax specialist accountants when they compute taxable income and therefore such advisors should be aware of the traps of paragraph 12(1)(a) and the reserves under section 20.
The tax professionals at Moodys LLP Tax Advisors would be pleased to explore this topic with you in more detail.