11 May 2001 Internal T.I. 2001-0072367 - Accrued Royalty Income

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:

1. Does paragraph 12(1)(g) override subsection 9(1)?

2. Does paragraph 12(1)(g) apply to accrued royalties?

Position:

1. No.

2. Yes.

Reasons:

1. Subsection 12(1) does not provide specific exceptions to the computation of income under subsection 9(1), but expands on the range of amounts that can be included in income. Therefore paragraph 12(1)(g) is not an authority for deducting an amount that has been included in income under section 9, but permits an amount that may not have been included in income under section 9, to be included in income for tax purposes.

2. In the context of computing income for tax purposes under section 9, income is computed on the accrual basis unless the Act specifically provides for another method of computation such as section 28(1).

		May 11, 2001

	Large Business Audit Division	HEADQUARTERS
	Industry Specialist Services	Reorganizations and
	Bob Neville	  Resources Division
	Co-ordinator, Resource Industries	David Shugar
	957-2134
	Attention: Bharat Patel
   	Oil and Gas Specialist
	2000-007236

Paragraph 12(1)(g) of the Income Tax Act (the "Act")

This is in reply to your correspondence of February 26, 2001 wherein you requested our views on the application of paragraph 12(1)(g) of the Act with respect to oil and gas royalties. You also requested our comments with respect to the reply you received from the taxpayer regarding your audit query of October 2, 2000 in which the taxpayer argues that paragraph 12(1)(g) provides for the deferral of accrued royalty income for income tax purposes. All references are to the Income Tax Act unless otherwise indicated.

Facts

Our understanding of the principal facts are as follows:

The taxpayer excluded its accrued royalties from income for tax purposes. The auditor proposes to include the accrued royalties in income for tax purposes on the basis that the royalties are income from a business, not income from a property, and that the accrual method applies to the calculation of income from a business. The auditor's position is that paragraphs 12(1)(a) and (b) ensure that accruals are included in income, and take precedence over paragraph 12(1)(g).

The taxpayer's response to the audit query was to, apparently, concede that the royalty income is business income, but took the position that royalties can, concurrently, be both income from property and income from business. The taxpayer could then avail itself of the deferral of accrued royalties which it believes paragraph 12(1)(g) provides, in respect of income from property. The taxpayer stated that "the characterization of the taxpayer's royalty income as a business does not preclude the application of paragraph 12(1)(g) to those amounts."

Our Comments

Property or business income

It is a question of fact whether income in respect of a royalty is income from a business or income from a property. Based on the information provided we agree with the auditor's finding that the royalties are income from a business. However, that does not preclude the royalties from, concurrently, being income from a property. We agree with your opinion that the definition of specified investment business in subsection 125(7) is not relevant in this situation, and the definition of business in subsection 248(1) is the useful reference in determining whether an amount is income from a business.

Income under section 9

Under the scheme of the Act, the general rule for computing income from a business or property is set out in section 9. Generally, it is the Canada Customs and Revenue Agency's (CCRA) view that the accrual method of calculating income must be used for purposes of section 9 unless the Act specifically provides an alternative method. Specifically, paragraph 5 of Interpretation Bulletin IT-261R, "Prepayments of rents" states:

"As a general rule taxpayers must use the accrual method of accounting to calculate income from a business or property, unless the Income Tax Act provides otherwise in respect of specific items of income or expense."

According to the general principles for profit computation enunciated by the Supreme Court in Canderel Limited (98 DTC 6100), a taxpayer is free to adopt any method for computing profit which is consistent with the provisions of the Income Tax Act, established case law principles or "rules of law," and well-accepted business principles, and which will yield an accurate picture of his or her income for that year. Furthermore, the Supreme Court stated:

"...the goal of the legal test of "profit" should be to determine which method of accounting best depicts the reality of the financial position of the particular taxpayer. If this is accomplished by applying the matching principle, then so be it. On the other hand, if some other method is appropriate, is permissible under well-accepted business principles, and is not prohibited under the Act or by some specific rule of law, then there is no principled basis by which the Minister should be entitled to insist that the matching principle-or any other method, for that matter-be employed.

.....

In the simplest cases, it will not even be necessary to resort formally to the various well-accepted business principles, as the simple formula by which revenues are set against the expenditures incurred in earning them is always the basic determinant.

However, where the income picture is more complicated, as is frequently the case, the taxpayer is free to employ whichever well-accepted business principles will be most useful in depicting profit, provided again that the method adopted is not inconsistent with the law."

In its response to the audit query, the taxpayer referred to the principles of profit computation given in Canderel, as well as the CCRA's position in paragraph 5 of IT-261R, and concluded that the recognition of royalty income on a received (cash) basis is not inconsistent with the Act, and is also consistent with the CCRA's position outlined in IT-261R. However, the taxpayer did not explain how it reached its conclusion, which it gave immediately after stating the Canderel principles and the excerpt from IT-261R. In addition, the taxpayer did not state whether its position was with respect to royalties in general, or in respect of the facts of their particular situation. We do, however, disagree with the taxpayer's conclusion for the following reasons.

In your audit query you state that there is no dispute that the taxpayer had legal entitlement to the royalties at year-end, and the company included the royalties in income for financial statement purposes on the accrual basis. In your opinion, the fact that the royalties were included in income indicates that the accrual method more accurately reflected the income for the year. Based on your findings, it is your opinion that: the inclusion of the accrued royalties results in a more accurate picture of income for the year; the inclusion is consistent with well-accepted commercial practice; and, the industry has consistently included royalties receivable in income for financial statement purposes and tax purposes. You also noted that the CICA Handbook, in section 3400, entitled Revenue, at paragraph .03, defines Revenue as:

" ... the inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise, normally from the sale of goods, the rendering of services, and the use by others of enterprise resources yielding interest, royalties and dividends."

Paragraph .09 of the CICA Handbook states:

"Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should be recognized when reasonable assurance exists regarding measurement and collectability. These revenues should be recognized on the following bases:

... (b) royalties: as they accrue, in accordance with the terms of the relevant agreement; ..."

In Brian Arnold, Canadian Tax Paper No. 71, at page 127, he states, "The principle that revenue can be recognized for income tax purposes at a time other than its actual receipt is applicable only for the purposes of determining income of a business and income from property pursuant to section 9." At page 130, B. Arnold states, "that an amount is considered to be realized for tax purposes only when it has been earned... [B]usiness or trading revenue is generally considered to be realized for tax purposes when the taxpayer acquires all legal right to receive the revenue either immediately or at some future time."

In Ikea Limited, 98 DTC 6092, at p. 6099, the Supreme Court affirmed the realization principle as the rule of law for determining when revenue is to be recognized. In this regard, the Court stated the following:

"In M.N.R. v. Benaby Realties Ltd., [1968] S.C.R. 12, Judson, J. considered the timing of recognition of certain proceeds of expropriation. He concluded, at p. 16, that the Act requires that profits be taken into account or assessed in the year in which the amount is ascertained."

In Canderel, the Supreme Court found that the primary purpose of making the tenant inducement payments in their particular situation was to attract tenants, and therefore deduction of the entire payment in the year the payments were made provided a more accurate picture of income than amortizing the payments would provide using the matching principle. In Ikea the matching principle was rejected in favor of the realization principle in deciding that the tenant inducement payments should be included in the year of receipt, rather than being amortized over the life of the leases it attracted.

In the situation at hand, the determination of whether earned but unpaid royalties on oil or gas should be included in income for tax purposes is not a complex matter. The amount of royalties that were earned but unpaid at the end of the year could be accurately measured and matched to a specific period. In our view, the earned royalties should be included in profits under section 9, based on the matching principle, to provide an accurate picture of income. The taxpayer has not provided any information to show that any of the six principles stated in Canderel justify deferring the accrued royalties to a later period. Following the decisions in Canderel, Ikea, and Toronto College Park, the onus of proof was placed on the CCRA to show that its method of computing income for tax purposes produces a more accurate picture of income than the taxpayer's method. In our view, not only would it be less accurate, but it would be incorrect, in this situation, to report royalty income on the cash basis, under section 9, whether the royalties are income from a business or income from property.

Relationship between subsections 9(1) and 12(1)

The preamble to subsection 9(1) uses the limiting phrase, "Subject to this Part," which means that subsection 9(1) must defer to other provisions of Part 1 where other such provisions dictate that income from a business or property is to be calculated on some basis other than profit. The preamble to subsection 12(1) states that, "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." Subsection 12(1) describes specific items which must be included when making the computation of income whether or not they are included in income under section 9. In the situation at hand, the taxpayer's position is based on the assumption that subsection 12(1) overrides subsection 9(1).

In Driedger on the Construction of Statutes, 3rd Edition, 1994, p. 248, R. Sullivan states,

"When analysing the scheme of an Act, the court tries to discover how the provisions or parts of the Act work together to give effect to a plausible and coherent plan. It then considers how the provision to be interpreted can be understood in terms of that plan."

Sullivan then quotes the Court in Melnychuk v. Heard, (1963) 45 WWR 257, (Alta S.C.):

"The court must not only consider one section but all sections of an Act including the relation of one section to the other sections, the relation of a section to the general object intended to be secured by the Act, the importance of the section, the whole scope of the Act and the real intention of the enacting body."

In addressing the problem of overlapping provisions, Sullivan said that where two provision overlap, or are in conflict with one another, the court turns to various conflict resolution techniques at their disposal. On page 177, Sullivan states,

"Where two provisions are applicable to the same facts, it is presumed that each is meant to operate fully according to its terms. So long as overlapping provisions can apply, it is presumed that both are meant to apply. The only issue for the court is whether the presumption is rebutted by evidence that one of the provisions was meant to provide an exhaustive declaration of the applicable law."

Case law supports the position that subsection 12(1) does not override subsection 9(1). The relationship between subsections 9(1) and 12(1) was described in Maritime Telegraph and Telephone Co., Ltd. v. The Queen, 92 DTC 6191, at 6193, where MacGuigan, J.A. wrote:

"In my view, the statutory language and structure support the respondent's position. That is particularly true of s. 12(2), which explains that the purpose of s. 12(1) is only to provide greater certainty, obviously by specifying with more exactitude what is to be included in income, and which clearly forbids any construction that would have the effect of excluding income that would otherwise be included. This interpretation is also confirmed by s. 12(1) itself, which begins with the words "there shall be included in computing the income of a taxpayer for a taxation year ...

In my opinion, s. 12(1) operates so as to expand s. 9(1)'s ambit of inclusion. Obviously, at the boundary line of inclusion there may logically be some exclusions, but the joint thrust of s. 9 and s. 12(1) is to include, not exclude, and s. 12(2) has the effect of ensuring, at the very least, that nothing clearly included in s. 9 is henceforth excluded."

In The Queen vs. La Capitale, FCA, 98 DTC 6428, the Court stated, "... that the purpose of subsection 12(1) is to expand and not to limit the scope of the inclusion set out in subsection 9(1), so that what is included under section 9 cannot then be excluded."

Based on the case law referred to above, the wording of the Act, and supported by the analysis in Driedger, it is evident that subsection 12(1) does not provide specific exceptions to the computation of income under subsection 9(1), but expands on the range of amounts that can be included in income.

Subsection 1204(1) of the Income Tax Regulations (the "Regulations")

We agree with your opinion that income for the year for purposes of subsection 1204(1) of the Regulations would be calculated in the same manner as under subsection 9(1).

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch