2 April 2004 External T.I. 2004-0057741E5 - Paragraph 20(1)(m) reserve and 12(1)(e) inclusion

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.

Principal Issues: When a business is transferred on a tax-deferred basis to another Canadian resident taxpayer, does a paragraph 20(1)(m) reserve follow the business to the transferee and, if so, does this relieve the transferor from including the reserve in its taxable income for the subsequent taxation year pursuant to subparagraph 12(1)(e)(i).

Position: The paragraph 20(1)(m) reserve does not follow the business which has been transferred on a tax deferred basis. Since neither the transferor nor the transferee may claim a reserve under paragraph 20(1)(m) at the end of the taxation year in which the transfer of the business occurred, neither is required to include an amount in calculating business income for the immediately following year under subparagraph 12(1)(e)(i). However, where the transferor has paid a reasonable amount to the transferee as consideration for undertaking to provide the goods or services, the transferor and transferee may file a joint election under subsection 20(24) to alleviate the tax consequences described above.

Reasons: The transferor ceases to carry on the business and generally no longer has any obligation to deliver goods or render services related to that business so the transferor cannot claim a paragraph 20(1)(m) reserve in the year the business is transferred for an amount that is included in computing business income in the year under paragraph 12(1)(a). The transferee is not entitled to claim a reserve under paragraph 20(1)(m) because it did not include in its business income under paragraph 12(1)(a) any amount which related to the obligation to deliver the goods or render the services in question.

XXXXXXXXXX 						2004-005774
										Kathryn McCarthy, CA
April 2, 2004

Dear XXXXXXXXXX,

Re: Paragraph 20(1)(m) and Subparagraph 12(1)(e)(i) of the Income Tax Act (the Act)

We are writing in response to your e-mail of January 21, 2004, wherein you requested our opinion on the application of the above-noted provisions.

In your letter, you described a situation where a business is transferred by a Canadian resident taxpayer on a tax-deferred basis to another Canadian resident taxpayer. You inquired whether the paragraph 20(1)(m) reserve "follows the business to the transferee taxpayer and, if so, does this relieve the transferor taxpayer from including the reserve in its taxable income for the subsequent taxation year pursuant to subparagraph 12(1)(e)(i) of the Act."

Our Comments

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. We are, however, prepared to provide the following comments.

In general terms, any amount received in a taxation year by a taxpayer in the course of carrying on business that is on account of services not rendered or goods not delivered before the end of the year or that, for any other reason, may be regarded as not having been earned in the year or a previous year, must be included in computing the taxpayer's income from the business for the year pursuant to subparagraph 12(1)(a)(i) of the Act. Where an amount has been included in a taxpayer's income in accordance with subparagraph 12(1)(a)(i), paragraph 20(1)(m) provides for a deferral of taxation on such unearned income by permitting the taxpayer to deduct in computing income from the business for the taxation year, a reasonable reserve in respect of the goods or services that are reasonably anticipated to be delivered or rendered after the end of the year. It should be noted that the paragraph 20(1)(m) reserve is subject to the restrictions imposed by subsections 20(6) and (7). Further, pursuant to subparagraph 12(1)(e)(i), any amount deducted as a reserve under paragraph 20(1)(m) is required to be included in computing the taxpayer's business income for the taxation year immediately following the year in which any such deduction was made. For more information, see IT-154R, Special Reserves, which is available on our website at www.cra-arc.gc.ca.

In a situation where a business has been transferred on a tax-deferred basis to another Canadian resident taxpayer, the transferor ceases to carry on the business and generally no longer has any obligation to deliver goods or render services related to that business. As a result, we are of the view that the transferor cannot claim a paragraph 20(1)(m) reserve in the year the business is transferred for an amount that is included in computing business income in the year under paragraph 12(1)(a) of the Act. In addition, we are also of the view that the transferee is not entitled to claim a reserve under paragraph 20(1)(m) because it did not include in its business income under paragraph 12(1)(a) any amount which related to the obligation to deliver the goods or render the services in question. Further, since the transferor and the transferee did not claim a reserve under paragraph 20(1)(m) in the taxation year in which the business is transferred, neither is required to include an amount in calculating business income for the immediately following taxation year under subparagraph 12(1)(e)(i).

However, where the transferor has paid a reasonable amount to the transferee as consideration for undertaking to provide the goods or services, the transferor and transferee may file a joint election under subsection 20(24) of the Act to alleviate the tax consequences described above. Where a valid election is filed, paragraph 20(24)(a) provides that the transferor may deduct the amount paid in computing income for the taxation year in which the payment was made, but no amount can be deducted under paragraph 20(1)(m) by the transferor in respect of the undertaking for the taxation year or for any subsequent taxation year. Pursuant to paragraph 20(24)(b), the transferee is deemed to have received the payment as an amount described in paragraph 12(1)(a) and therefore may be entitled to claim a reasonable reserve under paragraph 20(1)(m).

We trust our comments will be of assistance to you.

Yours truly,

Randy Hewlett, B. Comm.

for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch