4 December 2001 External T.I. 2001-0110895 - PROVISION OF SERVICES (TEI)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Would CCRA consider permitting the taxpayer to prorate the payments received, based on the length of a maintenance contract, and include in income only the portion of the payments that relates to the contract period that pertains to the current taxation year?

Position: No

Reasons: If the payments received are included in income under subparagraph 12(1)(a)(i), no reserve can be taken in respect of a portion of the amount included because of the combined effects of subsection 20(7) and paragraph 20(1)(m) considering the indemnity nature of the maintenance contract. If the amount received is included in income under section 9, paragraph 18(1)(e) would not permit a reserve because of the contingent nature of the obligation.

TEI Conference
December 4, 2001

Question 5 Provision of Services

Under most hardware and software maintenance agreements provided by a vendor, payments are received by the vendor in advance of the taxable period where services will be rendered. Paragraph 12(1)(a) of the Act requires an income inclusion in the period when the payment is received. Unless the taxpayer can reasonably anticipate that services will be provided after year-end, no reserve can be established under paragraph 20(1)(m) of the Act.

Under most software maintenance agreements, the taxpayer can usually demonstrate that software code fixes, updates, or upgrades will be provided; the only question is the timing of the service or upgrade. Similarly, most equipment maintenance agreements include a clause requiring the vendor to provide preventive or routine maintenance on a predetermined schedule in order to ensure that the customer's business operations continue in an uninterrupted fashion. Preventive maintenance schedules for equipment are generally based on the passage of time, level of usage, historical failure rates, or some combination of these variables. It is not certain that, during those visits, preventive or routine maintenance will be required. Most software maintenance agreements generally do not provide for scheduled releases of upgrades, updates, or code fixes. Rather, these services are provided on an "as required basis".

In contrast with the tax treatment, Canadian GAAP requires the revenue from these agreements to be deferred and included in income over the period of the contract.

Would CCRA consider permitting the taxpayer to prorate the payments received, based on the length of the maintenance contract, and include in income only the portion of the payments that relates to the contract period that pertains to the current taxation year?

CCRA's Position

Subsection 9(1) provides that a taxpayer's income from a business or property is the profit from that business or property subject to the rules in Part I of the Act. The Canadian GAAP are often viewed as a reference for the profit, subject to other tax rules. In Her Majesty The Queen v. Foothills Pipe Lines (Yukon) Ltd., 90 DTC 6607, Westcoast Petroleum Ltd. v. Her Majesty The Queen, 89 DTC 5153 and Burrard Yarrows Corporation v. Her Majesty The Queen, 86 DTC 6459, the courts found that amounts received in advance were income for the purposes of section 9 based on the principle that if a taxpayer has a right to an amount, absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment, the amount received in advance would be considered as having been earned in the year of the receipt. In determining whether a payment received in advance should be included in income under the basic principles of determining income from a business or property for the purposes of subsection 9(1), a thorough review of all agreements or contracts must be made. This review would generally reveal whether paragraph 12(1)(a) applies or whether subsection 9(1) applies because the amount can be considered as having been earned in the year of the receipt.

In particular, subparagraph 12(1)(a)(i) states that there shall be included in computing the income of a taxpayer for a taxation year:

(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).....

In the present situation, while some services could be viewed as not rendered before the end of the year, it is unclear whether the amount received by the vendor has not been earned in the year of the receipt. If the vendor has a right to an amount, absolute and under no restriction as mentioned in the above court decisions, section 9 would apply because the amount would be considered earned and subparagraph 12(1)(a)(i) could not apply.

If we assume that section 9 applies, it is the CCRA's view that receipt of maintenance agreement fees creates contingent obligations for the vendor. Due to the contingent nature of obligations, paragraph 18(1)(e) would apply to disallow any reserve in respect of the fees included in income unless expressly permitted.

If the amount received is included in income under subparagraph 12(1)(a)(i), subparagraph 20(1)(m)(ii) expressly permits a reasonable amount as a reserve in respect of:

(ii) services that it is reasonably anticipated will have to be rendered after the end of the year,

However, subsection 20(7) states that paragraph 20(1)(m) does not apply to allow a deduction as a reserve in respect of guarantees, indemnities or warranties. In our view, maintenance agreements for software and hardware would be considered as a form of indemnity provided to the purchasers to secure them against certain repair costs or costs of acquiring any updates.

This view is based on Sears Canada Inc. v. Her Majesty The Queen, 86 DTC 6304 (upheld at the FCA 89 DTC 5039), in which the court found that the Sears maintenance agreement for appliances should be characterized as indemnities to secure customers against maintenance and repair.

In view of the above, the CCRA would not allow taxpayers to prorate the receipt of maintenance agreement fees, based on the length of the maintenance contract since no reserve can be taken in respect of a portion of the amount included in income under subparagraph 12(1)(a)(i) because of the combined effects of subsection 20(7) and paragraph 20(1)(m) considering the indemnity nature of the maintenance contract. Alternatively, if the amount received is included in income under section 9, paragraph 18(1)(e) would not permit a reserve because of the contingent nature of the obligation.

Author: L. Vermette
Division: Business and Partnerships Division
Phone number: 957-2092