31 December 2002 External T.I. 2002-0163545 - construction deferred revenue

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:

1. In light of recent court decisions, are amounts reflected in "deferred revenue" of a corporation using the percentage completion or completed contract methods of accounting for long-term construction contracts, that have been billed but not received, included in computing capital under subsection 181.2(3)?

2. Can we break down amounts reported on the balance sheet of a corporation, into its components to extract the amount of any items to be included in capital that may be reflected in the balance sheet amount?

3. If the answer to (2) is affirmative, does it matter whether the balance sheet amount is on the asset or liability side of the balance sheet?

4. Are Holdbacks Receivable included in computing capital under subsection 181.2(3)?

Position:

1. Generally no
2. Yes
3. No
4. No

Reasons:

1. Recent court cases have clarified that such amounts do not constitute reserves for purposes of Part I.3. However, to the extent amounts have been received under the contracts, such amounts are advances and are included in computing capital under paragraph 181.2(3)(c).

2. The court held in PCL that it was appropriate to examine the components of an amount on the balance sheet to determine whether the balance sheet amount reflects amounts that are included in capital, such as advances.

3. The concept of looking to components of a balance sheet balance to determine the amount of any components reflected in the balance sheet amount, that are included in capital applies equally to debit balances and credit balances.

4. There is nothing in subsection 181.2(3)(c) that would require Holdbacks Receivable to be included in the computation of capital.

XXXXXXXXXX 							2002-016354
								Alison Campbell
December 31, 2002

Dear XXXXXXXXXX:

Re: Large Corporations Tax - Construction Contractor's Deferred Revenue

This is in reply to your letter of September 11, 2002, wherein you asked for our comments on several issues related to the treatment for purposes of Part I.3 of the Federal Income Tax Act (the "Act") of deferred revenue. Your questions deal in particular with the treatment, for purposes of Part I.3 of the Act, of deferred revenue reported in the GAAP financial statements of a corporation engaged in long-term construction contracts. It is our understanding that GAAP reporting of revenue for long-term construction contracts involves the use of either the "percentage completion method", or the "completed contract method" of revenue recognition. The percentage completion method generally calls for income inclusions over the course of the contract on a straight-line basis, whereas the completed contract method defers the recognition of income for accounting purposes until the time that the contract is completed. The corporation will typically have separate accounts for recording construction costs incurred (often called the "construction in progress" account), "construction billings", contract billings receivable, construction liabilities payable, holdbacks receivable and holdbacks payable. For purposes of balance sheet presentation on the corporation's GAAP financial statements, it is our understanding that the balances of the "construction in progress" account and the "construction billings" account are often combined. If the combined amount is a credit, the amount is shown on the balance sheet as a deferred credit/revenue item, and if the net amount is a debit (i.e. costs incurred to date exceed billings to date), it will be shown as some type of current asset such as "construction in progress inventory".

Paragraph 29 of the current version of interpretation bulletin IT-532 reflects our views on the treatment of deferred revenue on construction contracts, at the time the bulletin was written, as follows:

"In certain instances, such as in the accounting for long-term construction projects, GAAP does not necessarily require the complete recognition of income in a given year although the earning process is complete. In such case, the amount of deferred revenue (i.e., uncertified progress billings) that represents completed services is considered a reserve and accordingly added to the capital tax base irrespective of whether architectural or engineering approval or certification has been obtained. Since there is no statutory Part I deduction allowed with respect to these amounts, the full amount is included in the capital tax base pursuant to paragraph 181.2(3)(b)."

However, following a series of court decisions dealing with tax under Part I.3 of the Act, the CCRA has reconsidered its position that any portion of deferred revenue that represents completed services will be considered a "reserve" for purposes of Part I.3 of the Act. The decision of the Tax Court of Canada in PCL Construction Management Inc. et al v The Queen (2000 DTC 2624), dealt specifically with the treatment of deferred revenue under GAAP accounting for long-term construction contracts for purposes of Part I.3 of the Act. Based on the findings of the court in this case, we are now of the view that, in general, the only amounts reflected in the deferred revenue balances that will be included in computing capital of a corporation using the percentage completion or completed contract methods of accounting for long-term construction contracts, will be amounts that have been received under the contract. Such amounts are advances and would be included in the computation of capital pursuant to paragraph 181.2(3)(c) of the Act.

The issue of breaking down the components of a balance sheet item, in order to extract the components of the single line balance that do represent capital of the corporation was also addressed in the PCL decision. In addressing this issue, Justice Bowie concluded as follows:

"The use of the words "reflected in the balance sheet" indicates a clear intention on the part of the drafter to leave it open to consider the components of a balance sheet item where some, but not all, of those components fall within the statutory definition of capital. This is such a case. The intention that GAAP should prevail in fixing quantum would be frustrated if the item "Unearned Revenues and Contract Advances" could only be excluded or included in its entirety. If that were the legislative intent then parliament would have used the expression "appearing on the balance sheet". The unearned amounts which are advances do not appear on the Appellants' balance sheets, but they are reflected in them as an identifiable component of the amounts which do appear there."

It is therefore our view, that the "deferred revenue" reported on the balance sheet can be broken down into its components in order to extract those amounts reflected in the balance that are to be included in capital. This would also be our view where the amount that is reported on the balance sheet is a debit amount because the construction costs to date exceed the billings to date.

Finally, you asked for our views as to whether "Holdbacks Receivable" are included in capital for purposes of taxation under Part I.3 of the Act. Holdbacks Receivable are not included in the computation of capital as they do not, in our view, fit any of paragraphs 181.2(3)(a)-(g) of the Act. However, given that Holdbacks Receivable are the uncollected portion of amounts that have been billed, there may be an amount that relates to a Holdback Receivable that has been recognized as income and therefore forms part of the retained earnings of the corporation. Retained earnings of a corporation are included in the computation of capital pursuant to paragraph 181.2(3)(a) of the Act. It is also possible that a Holdback Receivable corresponds to amounts reflected in the deferred revenue of the corporation. As discussed earlier in this letter, deferred revenue would be included in the computation of capital under paragraph 181.2(3)(c), to the extent components of the deferred revenue are advances.

The above comments represent our general view with respect to the subject matter and are not binding on the CCRA, as explained in paragraph 22 of Information Circular 70-6R5. However, we trust that the foregoing will be of assistance to you.

Yours truly,

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