17 September 1999 Internal T.I. 9920647 - PENALTIES (INCOME SUBJECT TO RESERVE)

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 Department.

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

September 17, 1999

	Halifax Tax Services Office	HEADQUARTERS
	Audit Services	C. Tremblay
		957-2139

Attention: Brian Munroe. Technical Advisor

		992064

Application of penalties pursuant to subsection 163(2) of the Income Tax Act (the "Act") for income subject to reserve under subsection 34.2(4) of the Act

This is in reply to your memorandum of July 7, 1999, concerning the application of a penalty to unreported business income subject to an available reserve.

You indicate that pursuant to sections 34.1 and 34.2 of the Act, a proprietorship formerly with a fiscal period ending June 30 switches to a December 31 calendar year end in 1995 because after 1994, paragraph 249.1(1)(b) of the Act deems that a fiscal period beginning in a calendar year cannot end after the end of that same calendar year. Thus, unless a person elects to retain an off-calendar fiscal year end, December 31 automatically becomes the fiscal year end. According to the rules in section 34.2(1) of the Act, the individual claims a reserve in 1995 equal to 95% of the income for the period from July 1 to December 31, 1995.

An income tax audit reveals unreported business income with respect to the July to December 1995 stub period. Penalties under subsection 163(2) of the Act are being applied. The assessment will necessitate changes to the 1995 reserve and amounts which will be brought into income in subsequent years. You question whether the penalty under subsection 163(2) of the Act is applied entirely in 1995 on the total unreported income even though subsections 34.2(4) and 34.2(5) of the Act will include the amount over ten years or whether the penalty is applied in each of the next ten years based on the amount of business income reserve brought into taxable income each year.

In your opinion, the penalty provided by subsection 163(2) of the Act should be calculated entirely in 1995 since logistically there is no way in the present system to self assess such a penalty. Besides, each of the next 7 years would have to be followed-up and adjusted for the penalty. You base this reasoning on the fact that the reserve allowed under subsection 34.2(4) of the Act is a deduction that can be made at the discretion of the taxpayer.

Our Comments:

Subsection 34.2(1) of the Act defines, among others, "December 31, 1995 income” for the purposes of calculating the reserve from the business under subsection 34.2(4) of the Act. In our opinion the income for the year from the business is the income reported at the time the income tax return was filed as well as the additional unreported income. Accordingly, a greater reserve would be available as a result of the additional unreported business income.

Subsection 163(2.1) of the Act defines the expression understatement of income" for a year of a person to mean the amount by which the aggregate of amounts not reported by the taxpayer and required to be included in computing income for the year exceeds amounts deductible under paragraph 163(2.1)(a)(ii) of the Act which permits a deduction for amounts as are wholly applicable to the unreported amounts that has not been deducted by the taxpayer in computing income for the year as reported.

In our opinion, the provision of subsection 34.2(4) of the Act allowing a reserve in respect of "December 31, 1995 income” is a reserve wholly applicable to the unreported income and should thus be allowed as a deduction against that income. Accordingly, the penalty to be applied pursuant to subsection 163(2) of the Act is calculated on the net unreported income after deducting the reserve under subsection 34.2(4) of the Act wholly applicable to the unreported income.

Further, in all subsequent years, provided the taxpayer reports his income for the year pursuant to subsection 34.2(5) by including the prior year's reserve into income, in our view, he will not be subject to the penalty under subsection 163(2) of the Act in that year. We refer you to the directives under TOM 13(163)2.(26) 2 (4).

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Request for this latter version should be made by you to Jackie Page at (819) 994-2898. The severed copy will be sent to you for delivery to the client.

Jim Wilson
Manager
Business, Property and Employment Section II
Business and Publications Division
Policy and Legislation Branch
Income Tax Rulings and
Interpretations Directorate