14 December 2006 External T.I. 2006-0191831E5 - Part I.3 Tax - Construction Advances

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: How are payments received under construction contracts treated for purposes of Part I.3 tax? In particular, are they advances and should the amount included under paragraph 181.2(3)(b) be net of work in progress costs?

Position: Generally, the payments will be considered advances and will not be netted by construction work in progress costs for purposes of determining the amount of the advance to be included in capital under paragraph 181.2(3)(b).

Reasons: Legal meaning of advance determines whether an advance exists for purposes of Part I.3 tax. Payments under construction contracts are not generally reimbursement of expenses incurred by the contractor to date under the particular contract, but rather are payments made on account of the contract which is not yet complete.

XXXXXXXXXX 							2006-019183

December 14, 2006

Dear XXXXXXXXXX:

Re: Construction Advances - Part I.3 Tax

This is in reply to your letter dated June 12, 2006, concerning the meaning of the term "advance" for purposes of Part I.3 of the Income Tax Act ("Act"). In your letter, you raised concerns regarding two previous letters issued by the Canada Revenue Agency ("CRA"). Rather than address each of the individual comments that you provided with respect to the two previous letters, we believe it will be clearer to restate the CRA's position.

Pursuant to subsection 181(3) of the Income Tax Act (Canada) (the "Act"), the carrying value of a corporation's assets, or any other amount, is the amount reflected on the corporation's balance sheet prepared in accordance with generally accepted accounting principles ("GAAP"). Therefore, GAAP and the method of GAAP chosen by a taxpayer, will determine whether an amount is reflected on the balance sheet.

It is our view, after taking into account the jurisprudence dealing with Part I.3 of the Act, that the characterization of amounts reflected on the balance sheet will be determined by their legal meaning. The exception to this is where the terms or description in subsection 181.2(3) of the Act, primarily derive their meaning from accounting (e.g. reserves, surpluses, retained earnings).

With regard to the term "advances" used in paragraph 181.2(3)(c) of the Act, it is our view that an amount reflected on the balance sheet will only be included as such if it legally constitutes an advance. In this regard you have cited the various legal definitions of "advance" which is what we would look at in determining whether an amount reflected on the balance sheet constitutes an advance.

We continue to follow the decision in Oerlikon¹ in determining the treatment of payments under construction contracts for purposes of Part I.3 of the Income Tax Act. In that case, the amounts received were determined to legally constitute advances and this amount was not reduced by the costs incurred by the contractor. Neither the Minister nor the taxpayer suggested that the costs should be deducted from the advance presumably because there was no basis for doing so. An amount is either an advance or it is not. In our opinion, PCL² , which dealt with the billing of unearned revenues and contract advances, does not distinguish the finding of the Court in Oerlikon³.

The fact that a contractor receives progress payments which are used by the contractor to defray costs under a contract does not in our view diminish the fact that the amounts received constitute advances (being amounts received prior to the completion of the contract). We would not generally view such amounts as constituting a reimbursement of expenses. Whether the contractor uses the amount of the advance to pay for costs incurred in respect of the related contract, some other contract or to finance some other expenditure should not have any bearing on whether the amount received constitutes an advance. The fact that a contractor has disclosed on its balance sheet, the amount of such payments received net of construction costs also does not, in our view, dictate the conclusion that the payment was a reimbursement of expenses of the contractor as opposed to a payment on account of a contract that is not completed.

We have not looked at a specific case in Rulings where a contractor received a payment from a customer that was clearly a reimbursement of expenses of the contractor, as opposed to a payment made on account of a contract that has not been completed. If we were asked to do so, we would likely seek legal advice at to whether the payments made by the customer constitute a reimbursement of expenses to the contractor or an advance in satisfaction of the contract price with reference to the terms of the contract. If it were determined that the legal nature of the payment was that of a reimbursement of expenses of the contractor and not an "advance" at law, the payment would not be considered an "advance" for purposes of paragraph 181.2(3)(c) of the Act.

In summary, for purposes of paragraph 181.2(3)(c) of the Act, progress billings under a construction contract that have been received in cash, are generally treated as advances which are not reduced by costs incurred by the contractor in respect of the contract.

As a final point we note that if the recent Tax Court of Canada decision in Ford Credit Canada Limited, is not overturned on appeal, the result may well be that the characterization of all amounts on the balance sheet will be determined by the accounting terminology used to describe them.

We hope the above clarifies our position on this matter.

Yours truly,

F. Lee Workman
Manager
Charitable and Financial Institution Sectors
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

¹ Oerlikon Aeorspatiale Inc. v. The Queen (FCA) 99 DTC 5318; (TCC) 97 DTC 694

² PCL Construction Management Inc. et al v. The Queen (TCC) 2000 DTC 2624

³ Supra