10 October 2014 APFF Roundtable Q. 13, 2014-0538111C6 F - Boni suite à la signature d'un contrat d'appro -- translation

10 October 2014 APFF Roundtable Q. 13, 2014-0538111C6 F - Signing Bonus for supply agreement

Principal Issues: 1) Is the amount received by a client as a result of a multi-year supply contract taxable under section 9 even if a part of the amount has not been paid yet?

2) May the supplier deduct the full amount in the year which the agreement was entered into?

Position: 1) & 2) Question of facts

Reasons: 1) & 2) We do not have enough information to provide an answer to this question. General information provided.

ROUNDTABLE ON FEDERAL TAXATION October 10, 2014
2014 APFF CONFERENCE

Question 13

Signing bonus in a supply agreement

A company (hereinafter "Purchaser") negotiated an extension to a major supply agreement with one of its suppliers (the "Supplier") in respect of an important raw material in its manufacturing process. This negotiation was necessary because of the price fluctuation in the purchase market. The results of the agreement negotiations were:

• The supply agreement was extended for a period of six years;
• The discount granted by the supplier for the raw material in this period increased considerably;
• When signing the contract, Supplier granted to Buyer a bonus ("signing bonus") in the amount of $5 million. This amount is payable at the rate of $2.5 million the first year and $2.5 million the second year. It is specified in the agreement that this bonus is non-refundable;
• In the event Buyer should close its plant for a period of over 90 days during the first three years of the contract, except in a case of force majeure, it will be obliged to pay compensation to the Supplier in an amount equivalent to twice the signing bonus;
• If a plant closure occurs in the last three years of the contract, the buyer must pay compensation to the supplier in an amount equivalent to the total signing bonus;
• The agreement stipulated that such payment would be made as compensation and not as a penalty, and that the amounts are estimates of the damage that the Supplier would suffer in the event of the closure of the Buyer factory;
• For accounting purposes, Buyer records the amount received as income received in advance that will be recognized as income over the term of the agreement;
• Supplier records the amount in its books as an intangible asset. This asset will be amortized over a period equal to the term of the agreement.

The signing bonus of $5 million granted to Purchaser is an amount that is not refundable and Buyer concluded that it should be included in income under section 9 of the Act since it represents an amount earned. This tax treatment follows the conditions of the Ikea case, part of the Supreme Court trilogy of cases along with Canderel and Toronto College Park regarding the determination of income for tax purposes. The amount should be taxable in the first year of the contract even if a part is not yet paid since that amount is earned.

The Supreme Court in Canderel dictated six principles for determining profit for tax purposes. In that case, the Court concluded that a tenant inducement payment was a current expense which was not subject to the matching principle that would have dictated recognizing the expense over the lease term. Based on the principles of Canderel, Supplier concluded that the signing bonus was a current expense in the year of the signing of the agreement. This provided an “accurate picture” of profit for tax purposes for the year of signing the agreement, despite the fact that Buyer may have to pay compensation to Supplier.

Questions to CRA

a) Do you agree with the tax treatment of the signing bonus granted to Buyer?

b) Do you agree with the tax treatment of the signing bonus granted by Supplier?

CRA Response

Each return must be individually examined to determine if there is a return of income or of capital. It is the same for expenditures.

When it comes to a return or expenditure, the timing of recognition must be determined.

In the judgment Canderel Ltd. v. Canada (Footnote 1), the Supreme Court set out six principles to determine profit. It summarizes these principles as follows:

1. The determination of profit is a question of law.
2. The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income: M.N.R. v. Irwin, [[1964] S.C.R. 675], Associated Investors, [[1967] 2 R. C. Ex. 96].
3. In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer’s profit for the given year.
4. In ascertaining profit, the taxpayer is free to adopt any method that is not inconsistent with:

a) The provisions of the Income Tax Act;

b) established case law principles or “rules of law”; and

c) well-accepted business principles.

1. Well-accepted business principles, which include but are not limited to the formal codification found in GAAP, are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer’s financial situation.
2. On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture. (footnote 2)

Determination of profit for Buyer

According to the Supreme Court in Ikea Ltd. v. Canada (footnote 3):

[A]mounts received or realized by a taxpayer, free of conditions or restrictions upon their use, are taxable in the year realized, subject to any contrary provision of the Act or other rule of law. (footnote 4).

This is what is known as the "realization principle". Applying this principle to a specific situation can only be done by considering all relevant facts.

Determination of profit for the Supplier

The determination of profit for the payer must also be established on the principles stated in Canderel.

The competing concepts of running expenses and matching which appear to be involved in the wording of the question fall into the category of well-accepted business principles. They are “important interpretive aids which may assist, but are not determinative, in the illumination of an accurate picture of the taxpayer’s income.” (footnote 5).

In Canderel (footnote 6), the Supreme Court held that the tenant inducement payments were related at least partially to benefits realized entirely in the year incurred, and the taxpayer therefore should not be required to amortize them. Moreover, this conclusion complied with the principles set out in paragraph 53 of that judgment.

The question of whether the findings of Canderel would apply to the facts described in the question can be resolved only after having considered all the relevant facts.

Sophie Lambert

2014-053811
957-2121
October 10, 2014

FOOTNOTES

Due to our systems requirements, footnotes contained in the original document are reproduced below:

1 [1998] 1 S.C.R. 147 ( "Canderel").
2 Id., para. 53.
3 [1998] 1 S.C.R. 196 ( "Ikea").
4 Id., para. 37.
5 Supra note 1, para. 45.
6 Supra note 1, para. 66.