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.

Principal Issues: Whether amounts billed to a contractor by a subcontractor that are subject to holdback requirements should be included in the contractor's capital, either as a reserve, or as other indebtedness.

Position: Amounts billed by a subcontractor that have been deducted in computing accounting income and that are subject to a holdback requirement are included in the contractor's capital as reserves. Once the work that is the subject of a billing is certified, the amount owing by the contractor in respect of the certified work would constitute indebtedness of the contractor and would be included in the contractor's capital if the indebtedness has remained outstanding for more than 365 days at the end of the taxation year.

Reasons: Jurisprudence provides that an amount billed by a subcontractor that is subject to a holdback requirement is a contingent liability of the contractor. In our view, such liabilities are reserves for capital tax purposes. Once the work that is the subject of the billing is certified, the subcontractor has a legal right to payment. Thus, as of the date of that certification, the amounts billed constitute legal liabilities of the contractor and "indebtedness" of the contractor for capital tax purposes. They would therefore be included in the contractor's capital if, at year-end, more than 365 days have elapsed since certification.

								April 5, 2000

	HEADQUARTERS	HEADQUARTERS
	Ann Wilson			Income Tax Rulings
	Verification, Enforcement and	  Directorate
	  Compliance Division	R. Maley
						957-9226

1999-001508

Part I.3 Issues

This is in response to a number of e-mails you have sent requesting information about the application of the Tax on Large Corporations in Part I.3 of the Act to certain expenses incurred by construction contractors. In particular, you have asked whether amounts billed to a contractor by a subcontractor that are subject to holdback requirements should be included in the contractor's capital, either as a reserve or as other indebtedness. In our view, amounts billed by a subcontractor that are subject to a holdback requirement constitute a contingent liability of the contractor, and generally would be included in the contractor's capital as a reserve. Once the subcontractor's work that is the subject of the billing is certified, the amount owing by the contractor in respect of the certified work constitutes a legal liability of the contractor, and would be included in the contractor's capital as indebtedness, if the amount has had the character of indebtedness for more than 365 days at the end of the taxation year. We have set out more detailed comments in this respect below.

You have also asked, more generally, in what circumstances you may refer to the notes to the financial statements, and to extrinsic evidence, in assessing amounts subject to capital tax. We are attaching, for your information, a copy of a memo we recently prepared for the Appeals Directorate, which addressed this same issue, and which we feel addresses many of your questions.

If you should have any questions about the comments in this memo, or in the attached memo, please do not hesitate to call.

Construction Contractors - Background

Income

As we understand it, construction contracts normally provide for a contractor to render, from time to time, progress billings as work on a project proceeds. Such contracts also normally entitle the contractor to be paid therefore, usually after the purchaser or the purchaser's architect or engineer has agreed that the part of the work covered by the progress billing has been satisfactorily completed. The terms of a construction contract may also require the purchaser to withhold a percentage from the payment of each progress billing pending satisfactory completion of the entire job. In some provinces this withholding, or holdbacks as it is commonly known, is mandatory by virtue of a provincial Mechanic's Lien Act or Construction Lien Act.

IT-92R2 provides that the amount of a progress billing, less the holdback if any, becomes receivable and must be included in the contractor's income at the time when the purchaser or the purchaser's architect or engineer approves the progress bill for payment ^{(Endnote 1).} The aggregate of the holdbacks becomes receivable and must be included in the contractor's income on the day that is the later of

a) the day on which the architect or engineer issues the final certificate of job completion, and

b) the day of expiration of the lien period as stipulated in the applicable provincial statute.

A contractor has the option of reporting its income for tax purposes by including therein all amounts that have been billed to the purchaser, even if not approved for payment by the purchaser, architect or engineer, or in respect of which a mechanic's lien period has not expired, as long as this method of reporting is used consistently year-to-year.

On the other hand, we understand that most construction contractors account for their income under GAAP by using the "percentage completion" method. This method generally calls for income inclusion over the course of the contract on a straight-line basis.^{(Endnote 2)} The balance sheet would reflect amounts with respect to accounts receivable, including holdbacks, and amounts with respect to Work-in-progress (or Construction-in-progress), being actual construction costs plus recognized profits, less amounts billed. If the amounts billed by the contractor exceed the constructions costs that have been incurred and the profit required to be recognized under GAAP, the excess constitutes deferred revenue to the contractor.

Expenses

IT-92R2 provides that a contractor's costs incurred in a taxation year in the course of performing a contract are generally deductible in computing its income for the year, even where part of the revenue relating to that work is not included in income until a subsequent year because progress billing with respect thereto have not been approved for payment and thus are not receivable before the end of the particular taxation year ^{(Endnote 3)}. Two significant exceptions to this general rule, however, are certain amounts in respect of work performed by subcontractors, including

a) holdbacks withheld by a contractor from a subcontractor if the contractor's liability to the subcontractor in respect thereof has not been established by the issuance of a required certificate by an architect or engineer, and

b) the gross amount of billings rendered by subcontractors to the contractor that requires, but has not received, approval prior to payment.

These amounts are not deductible in the year, as they are not considered to have been incurred in the performance of a contract in that particular year.^{(Endnote 4)}

Under GAAP, expenses are generally recorded as incurred, subject to the requirement that they reflect the extent of the work accomplished. For example, payments made in the period to a subcontractor that are not determined in accordance with the extent of the work accomplished by the subcontractor may not properly be attributed to that period.^{(Endnote 5)}

Capital Tax

A corporation's capital under Part I.3 of the Act includes its reserves, except to the extent that they were deducted in computing its income for the year under Part I.^{(Endnote 6)} Subsection 181(3) of the Act provides that, in determining values and amounts for the purposes of Part I.3, the amounts reflected in the balance sheet shall be used.

As noted, a contractor's financial statements will reflect a deferred revenue account in those periods where the contractor's billings exceed the sum of its actual costs and the profit it is required to recognize under GAAP. Deferred revenues for completed services not received in cash constitute "reserves" for capital tax purposes as defined in subsection 181(1) of the Act (e.g. E9614387) . Where the amounts billed are, as yet, uncertified, IT-92R2 allows the contractor to exclude those amount in calculating its income for the purposes of Part I of the Act. This exclusion from income does not constitute a "deduction in computing income for the year under Part I" for the purposes of computing the corporation's capital, i.e., amounts so excluded are not deducted in computing the contractor's reserves subject to capital tax. In our view, reserves "deducted in computing income for the year under Part I" include statutory reserves that are deductible under Part I, but do not include amounts that are deductible only by virtue of an administrative position (e.g. E9605017; E9614387).

Similarly, whether or not a contractor may deduct amounts billed by subcontractors under IT-92R2 in computing its income under Part I for the year is not relevant in computing the contractor's capital under Part I.3. Instead, the legal nature of the amounts billed determine the treatment of those amounts for capital tax purposes.

Our understanding is that an amount billed by a subcontractor that may not be paid by the contractor until certification of the subcontractor's work constitutes a contingent liability to the contractor until such time as the work is certified.^{(Endnote 7)} Such a contingent liability (which we understand would generally be deducted in computing income for accounting purposes) would, in our view, be included in the contractor's capital as a reserve. In this respect, we would note that it is our view that the definition "reserve" in subsection 181(1) of the Act has a broader meaning than the definition "reserve" under GAAP, and includes all amounts that are reserves for the purposes of the Act.^{(Endnote 8)} Once the work that is the subject of the billings is certified, however, the amount of the holdback becomes a legal liability of the contractor, and "indebtedness" of the contractor for capital tax purposes. Therefore, the holdback amounts would be included in the contractor's capital under 181.2(3)(f) if, at year-end, more than 365 days have elapsed since certification.

We trust that these comments are helpful. If you have any questions, or wish to discuss these issues in further detail, please contact Robin Maley (613-957-9226) of the Financial Industries Division directly.

F. Lee Workman
Section Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

ENDNOTES

^1. IT-92R2, paragraph 3.

^2. CICA handbook, paragraph 3400.14.

^3. IT-92R2, paragraph 6.

^4. Ibid, paragraph 8.

^5. EIC-78: Construction Contractors - Revenue Recognition when the Percentage of Completion Method is Applicable.

^6. 181.2(3)(b).

^7. For example, see John Colford Contracting Company Limited 60 DTC 11331 (Exch. Ct.), J.L.Guay Ltee, 71 DTC 5423 (FCTD) and Newfoundland Light & Power Co. Ltd. 90 DTC 6166 (FCA).

^8. For a definition of what constitutes a "reserve" for the purposes of the Act, see paragraph 2 of IT-215R.

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