10 December 2003 Internal T.I. 2003-0035777 - PURCHASER DEPOSIT COMPLETED CONTRACT

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:

Amounts received as purchaser's deposits under residential construction contract and recorded on balance sheet as "purchaser's deposits" under contract completion method. Are they advances for Part I.3 purposes?

Position: Yes.

Reasons:

The amounts reflected as "purchaser's deposits" were paid in advance of the related work pursuant to the construction contract. Under the completed contract method of accounting, GAAP permits the recognition of income in the year the contract is completed. Amounts billed which are not considered to be earned under this method are advances for Part I.3 purposes to the extent that they have been received in cash, pursuant to the principles set out in PCL Construction Management Inc..

December 10, 2003

Vancouver TSO						Headquarters
R. Maley
Attention:  Bernie Lum 					(613) 957-9226

2003-003577

Part I.3 - Purchasers Deposits - Completed Contract Method

This is in response to your e-mail of September 29, 2003 attaching a copy of the memoranda to you of July 30, 2003 from Delly Tse of the Appeals Division, Calgary Tax Services Office and a draft agreement entitled "Purchase Agreement (For Home and Land)" dated June 9, 2000 ("the draft contract"). You have asked for our views as to the appropriate treatment, under Part I.3 of the Income Tax Act ("the Act"), of amounts paid pursuant to XXXXXXXXXX of the draft contract to a residential construction contractor, XXXXXXXXXX ("the taxpayer"), and recorded on the taxpayer's balance sheet as "purchaser's deposits".

We understand that that the taxpayer's view is that the unique nature of the residential construction industry distinguishes amounts reflected on their balance sheet as liabilities from the amounts discussed in PCL Construction Management Inc. ("PCL") 2000 D.T.C. 2624 (TCC). The Tax Court of Canada confirmed, in PCL, that unearned amounts reflected in the balance sheet may be characterized as advances after the billings giving rise to them have been paid. The TCC also confirmed that aggregate balances comprised of amounts that are advances and amounts that are not advances may be broken down into components in order to assess the quantum of advances for Part I.3 purposes.

Our view is that amounts paid as described in XXXXXXXXXX of the draft contract and recorded as "purchaser's deposits" on the taxpayer's balance sheet are "advances" within the meaning of paragraph 181.2(3)(c) of the Act.

Additional Comments

The taxpayer's submission suggests that deposits made pursuant to the draft contract would not be advances as they are required to be paid at stipulated times under the contract (i.e., the deposits are paid when due because the contract requires them to be paid at the time that they are paid).

Our view is that relevant jurisprudence clearly recognizes that amounts paid pursuant to the terms of a contract may be advances for Part I.3 purposes. For example, the TCC in PCL recognized as advances amounts recorded in the holdback account that were made pursuant to the percentage completion method" (see additional comments below) and the Federal Court of Appeal recognized as advances in Oerlikon Aérospatiale Inc. ("Oerlikon") 99 D.T.C. 5318 (FCA) amounts paid pursuant to the terms of a purchase order.

In our view, an amount reflected on a taxpayer's balance sheet will be an advance for Part I.3 purposes if, at the time it was paid, a liability was imposed on the recipient to repay the amount or to provide goods or services to the payor. For example, see the comments of the Federal Court of Appeal in Oerlikon which cited with approval the definition of "advance" adopted in TransCanada Pipelines Ltd. v. Ontario (Minister of Revenue) [1993] 1 C.T.C. 277 (Ont. C.A.):

[28] TCPL attempted to deduct the surplus portion of these payments as "loans and advances" to its suppliers under paragraph 54(1)(c) of the Ontario legislation. The Ontario Minister of Revenue issued assessments disallowing this treatment. TCPL successfully challenged these assessments both at first instance and on appeal. After a brief analysis, the Court of Appeal emphasized the fact that the payments in question:

...fell within dictionary definitions of "advance" as a "payment [made] beforehand or in anticipation" and a "payment made before ... the completion of an obligation for which it is to be paid": Dictionary of Business and Finance (1957), p. 9.*

and held that these amounts constituted, inter alia, "advances" within the meaning of paragraph 54(1)(c).

[29] The appellant was unable to show how the advances at issue in this case were distinguishable from the advances the Ontario Court of Appeal considered in TCPL. Both cases dealt with payments made in advance for the eventual performance of the resulting reciprocal obligation. (NB emphasis added)

XXXXXXXXXX of the draft contract contemplates the periodic payment of deposits to the contractor at specified stages of the project, starting with the signing of the contract and upon waiver of conditions to the contract. The draft contract then contemplates a series of progress deposits, with each new deposit becoming payable when the work relating to the previous deposit is inspected. In short, the draft contract contemplates that each payment will be paid in advance of the related work. In our view, these payments would be advances for Part I.3 purposes.

Subsection 181(3) of the Act provides that, for the purposes of determining any amount under Part I.3, the amounts reflected in the balance sheet prepared in accordance with GAAP shall be used. The taxpayer has recorded the amounts received pursuant to XXXXXXXXXX of the draft contract as "purchaser's deposits" on the balance sheet. As noted, our view is that these amounts are advances for Part I.3 purposes.

You have confirmed that the taxpayer accounts for its revenues on the basis of the "completed contract method" i.e., all revenues and expenses are recognized in the period that the contract is completed. Accordingly, deposits paid in accordance with XXXXXXXXXX of the draft contract would not be considered to be earned under this method or recognized as revenues until the year the contract is completed.

We understand that the taxpayer has emphasized the distinction between this accounting method, and that discussed by the court in PCL. In PCL, the amounts at issue were paid pursuant to the "percentage completion method" of construction accounting. This approach is described in PCL as follows:

[9] In the case of these Appellants, the amount of profit to be recognized and brought into income each year for financial statement purposes was determined by what is called the cost-to-cost method. By this method, the costs incurred by the contractor for each of its contracts during each fiscal period are compared to the estimated total costs to complete that contract, thereby establishing the percentage of completion for the period. This percentage is then applied to the total profit which it is estimated will be realized on the whole contract, to establish the profit to be recognized for that contract for the fiscal period in question. The calculations for succeeding fiscal periods are based on estimates of total cost and total profit that have been revised as a result of experience to date.

In other words, under the percentage completion method of accounting GAAP permits the recognition of income based on the percentage of costs incurred to date, rather than the percentage of work completed. Amounts billed but not required to be included in revenue for the year under this method are characterized, for accounting purposes, as "unearned". Unearned amounts received in cash were advances for Part I.3 purposes.

While we recognize that the "percentage completion method" and "completed contract method" of accounting are different in some respects, both accounting approaches may result in amounts being billable under a construction contract before the time that they would be earned revenues under GAAP. The court concluded in PCL that such amounts, when paid in cash, are advances to the recipient for Part I.3 purposes. We see no reasonable basis for distinguishing the court's reasoning in that respect in characterizing the "purchaser's deposits" reflected on the taxpayer's balance sheet as advances for Part I.3 purposes.

We would also note that principles set out in PCL, when applied to the purchaser's deposits at issue, result in a reasonable and accurate picture of the taxpayer's capital for Part I.3 purposes over the term of the construction contract. The company's capital will increase when a deposit is received and an advance is recognized for Part I.3 purposes. When the company recognizes the related revenues, it will reduce its advances in respect of the deposit and increase its retained earnings. This outcome is reasonable, in our view, as the company's resources in respect of the deposit have not changed. Under the approach that the taxpayer favours the deposit would only be included in capital when it is included in the calculation of its revenue. As noted, this approach is inconsistent with PCL, which recognizes that amounts received, even though not earned under GAAP constitute capital of the taxpayer.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

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