1 March 1996 Internal T.I. 9605017 - INCOME OF CONTRACTS, GAAP & PART I.3

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.

RULINGS DIRECTORATE
CORRESPONDENCE SUMMARY

Principal Issues:

(1)Whether the amount reflected on the liability side of the balance sheet (93/94) of
XXXXXXXXXX

represents an amount to be included in capital pursuant to subsection 181.2(3).

(2)Whether architect/engineer certification or approval, generally relevant to the determination of the timing of income recognition with respect to long-term construction contracts (Para.3 of IT-92R2), is relevant for Part I.3 purposes.

Position TAKEN:

(1)Yes. We consider the account to represent deferred revenue which is to be included in capital as a "reserve" under paragraph 181.2(3)(b) to the extent it is represented by amounts billed with respect to services rendered.

(2)No.

Reasons FOR POSITION TAKEN:

(1)Subsection 181(3) and previous positions (941653 & 951794).

(2)Subsection 181(3). Certification/approval is irrelevant to the recognition or determination of income on long-term construction contracts for purposes of GAAP. (See also #921686)

								March 1, 1996

	EDMONTON TAX SERVICES			HEADQUARTERS
	Complex Case					G. Donell
(613) 957-8953
	Attention:  Marlene White
								960501
	XXXXXXXXXX

Large Corporation Tax (Part I.3) - Income of Contractors
Subsection 181.2(3) & (4) of the Income Tax Act

This is in reply to your request dated and received by fax February 5, 1996, in which you have requested our comments as to the characterization of a balance sheet account titled "XXXXXXXXXX" for purposes of Part I.3 of the Income Tax Act (the "Act"). Specifically you have asked us whether such balance as is reflected on the balance sheet of XXXXXXXXXX for its' fiscal years ending October 31, 1993 and 1994 is to be included in capital pursuant to subsection 181.2(3) of the Act. You have also asked us whether architect/engineer certification or approval that is relevant for the purpose of recognizing, for Part I purposes, income of contractors in accordance with the guidelines described in IT-92R2 is also relevant for Part I.3 purposes.

GAAP & THE BALANCE SHEET

Paragraph 181(3)(b) provides that "...the amounts reflected in the balance sheet presented to the shareholders of the corporation...prepared in accordance with generally accepted accounting principles,..." are to be used to determine the various components that comprise the Part I.3 tax base. The generally accepted authority for GAAP in Canada, the CICA handbook, states, in part, at section 1000.60 that "...generally accepted accounting principles comprise the Accounting Recommendations in the Handbook...". We would also add that the notes to the financial statements are, in our view, an integral component of those statements.

XXXXXXXXXX

As indicated above, paragraph 181(3)(b) of the Act requires the use of a balance sheet that has been "...presented to the shareholders...in accordance with GAAP". This is clearly not the case with respect to the balance sheet you have submitted to us. Subparagraph 181(3)(b)(i) of the Act, however, provides guidance with the words "...or, where such a balance sheet was not prepared in accordance with generally accepted accounting principles...the amounts that would be reflected if such a balance sheet had been prepared in accordance with generally accepted accounting principles,...". The determination of the particular GAAP that apply in a given situation is, of course, a question of fact. We therefore caution your complete reliance upon these financial statements as representing GAAP. It would be appropriate to determine which disclosures have been omitted in the preparation of these statements. For purposes of the discussion that follows we have not attempted to ascertain whether a particular accounting practice or principle adopted by XXXXXXXXXX is in accordance with GAAP. We have however, where necessary, provided only comments of a general nature on the application of GAAP in a given situation.

XXXXXXXXXX

The liability/equity side of the 1994 balance sheet of XXXXXXXXXX indicates an account titled "XXXXXXXXXX"
XXXXXXXXXX

reveals that the percentage of completion basis has, for financial statement purposes, been utilized in accounting for construction contracts; revenue has been recognized, on a contract by contract basis, by determining the ratio of actual costs to date to total estimated contract costs and applying that ratio to the estimated net profit to be earned on that particular contract.

The CICA in addressing the appropriate treatment to be accorded long-term contracts has at section 3400.08 stated:

"In the case of rendering of services and long-term contracts, performance should be determined using either the percentage of completion method or the completed contract method, whichever relates the revenue to the work accomplished. Such performance should be regarded as having been achieved when reasonable assurance exists regarding the measurement of the consideration that will be derived from rendering the service or performing the long-term contract."

The use of the completed contract method, while sanctioned by the CICA, is restricted as indicated in section 3400.15 which reads:

"The completed contract method would only be appropriate when performance consists of the execution of a single act or when the enterprise cannot reasonably estimate the extent of progress toward completion."

The percentage of completion method however appears to be the method that would have application in the majority of cases. Guidance as to its application is provided in section 3400.14 as follows:

"The percentage of completion method is used when performance consists of the execution of more than one act, and revenue would be recognized proportionately by reference to the performance of each act. Revenue recognized under this method would be determined on a rational and consistent basis such as on the basis of sales values, associated costs, extent of progress, or number of acts. For practical purposes, when services are provided by an indeterminate number of acts over a specific period of time, revenue would be recognized on a straight line basis over the period unless there is evidence that some other method better reflects the pattern of performance."

It is our understanding that in accounting for long-term construction contracts pursuant to the percentage of completion method the balance sheet generally reflects amounts with respect to (1) accounts receivable including holdbacks and (2) an asset often titled Work-in-process (WIP) or construction-in-process (CIP) the balance of which is composed of actual construction costs plus recognized profit less contract billings. The CIP/WIP account represents costs in excess of billings that are to be recovered in a subsequent accounting period. In the case of XXXXXXXXXX the reverse is true; the CIP/WIP account is in a credit balance and represents amounts billed in excess of costs and recognized profit. This deferred credit or revenue represents amounts relating to services that have been rendered by XXXXXXXXXX pursuant to contracts it has entered into but is not recognized for accounting (GAAP) purposes because it is in excess of the income required to be recognized in accordance with the percentage of completion method pursuant to GAAP on a straight-line basis.

The T2S(1) of XXXXXXXXXX adjusts 1994 income for financial statement purposes by adding the year-end balance of the 1994 "XXXXXXXXXX" account in the determination of income for tax purposes. This account is brought into income by virtue of paragraph 12(1)(b) of the Act as an "...amount receivable by the taxpayer in respect of property sold or services rendered in the course of a business in the year,...". There is no provision in the Act which permits a reserve in respect of amounts required to be included in income pursuant to paragraph 12(1)(b) of the Act.

In our view the deferral of amounts relating to services that have been rendered for accounting purposes constitutes a reserve (within the meaning of that term as defined in subsection 181(1)) that is required to be included in capital pursuant to paragraph 181.2(3)(b) except to the extent such reserve is deducted in computing income under Part I of the Act. Since, as is indicated above, no portion of that amount is deductible in computing XXXXXXXXXX income for the year, the full amount is therefore included in capital.

"INCOME OF CONTRACTORS - CERTIFICATION/APPROVAL"

As noted above contractors are generally required, in accordance with GAAP, to use the percentage of completion method to determine revenue from long-term contracts. The percentage of completion method however is not an appropriate method of reporting contract revenues for income tax purposes. The determination of contract income for tax purposes is generally based on whether the amount received or receivable by the contractor has the quality of income - the right to it is absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment, which is a question of fact to be determined in each case. Where certification or approval of work covered by a progress billing of a contractor is required under a contract, the unapproved or uncertified billings may not have the quality of income for purposes of section 9 of the Act because the amount of the work provided has not been ascertained and confirmed by the parties to the contract therefore the contract's right is not absolute.

For accounting purposes the "percentage of completion method" which is defined in CICA section 3400.05 as "a method of accounting that recognizes revenue proportionately with the degree of completion of goods or services under a contract" is generally used. The certification or approval referred to in IT-92R2 ("Income of contractors") is not relevant in determining whether an amount reflected on the balance sheet constitutes a "reserve" within the broad meaning assigned that word in subsection 181(1) of the Act. Notwithstanding that income of contractors is calculated in accordance with IT-92R2 there is no provision in the Act which permits the deduction of a reserve in respect of services that have been rendered in the year.

We understand that there is an element of urgency in this particular file and we have accordingly endeavoured to treat your request on a priority basis. We further understand that notice of capital tax reassessments may be issued with respect to our comments and representations made by XXXXXXXXXX. Should you require our further services in respect of this or any other matter please do not hesitate to contact us.

for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch