7 October 1996 Income Tax Severed Letter 9608645 - Timing of 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 Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

PRINCIPAL ISSUES:

(1) Treatment of what is basically capital expenditures to client's premises when such amounts may or may not be recoverable depending on the energy savings produced as a result of these improvements. (2) Timing of reporting revenue when the revenue is tentative in that energy savings have to be realized before contractor has a right to those savings as income and recovery of expenditures.

POSITION:

(1) Specific recoverable outlays for equipment installed in clients building should be inventoried as recoverable amounts. Other costs relating to the installation, etc. should be deferred and matched against the revenue they produce. The earliest that revenue should be recognized would be the date the contractor is entitled to invoice the client.

REASONS:

Matching principle, GAAP.

960864 XXXXXXXXXX A.M. Brake

Attention: XXXXXXXXXX

October 7, 1996

Dear Sirs:

Re: Energy Performance Contracting Business

This is in reply to your letter of February 28, 1996, wherein you outlined a hypothetical transaction in which an energy services company ("ESCO") will provide services which could include:

-feasibility studies, which could include concept reports -engineering and design of an energy saving system -purchase and installation of the equipment and system -training of client staff -maintenance and monitoring of on-going performance -arrange project financing as necessary

The overall intent is to increase the energy efficiency of buildings, to decrease energy costs and reduce carbon dioxide emissions. All projects require significant up- front external financing, and it is sometimes necessary for ESCO to obtain this financing.

The service to be provided by ESCO will include the installation of equipment such as chillers, boilers, heat exchange devices, and condensers and significant engineering costs in terms of automating and controlling the process. Contracts also involve a significant lighting component.

The energy saving equipment will be acquired by ESCO and will be installed by it at the client premises as part of its overall service. For security reasons, legal title to the equipment may remain with ESCO until the client has fully paid for the services. Normally ESCO insures the product during the construction phase, and after the construction phase, the equipment is generally insured by the client under its general insurance policies. The client will be responsible for the day-to-day operation of the equipment (i.e., to replace failed light bulbs, etc.) subject to scheduled and on-going maintenance provided by ESCO pursuant to the contract. Any servicing which is due to the neglect by the client is its responsibility.

As indicated above, ESCO may retain legal title to any equipment it installs until the end of the contract. The contracts will vary as to whether or not the installed equipment can be pledged by ESCO to its financial institution. In some cases, to support its own financing of the initial costs, ESCO will pledge the contract revenue stream to its bank together with the actual installed equipment. In other cases, it is not practical for the equipment to be pledged since it is not feasible that the property will ever be physically removed once it is installed on the client premises.

As compensation for its services, ESCO will charge the building owner (its client) an amount equal to the energy costs that will be avoided over the term of the contract, up to a maximum amount. The revenues (up to a maximum amount) in essence represent compensation for project management and servicing costs, equipment and, indirectly, for interest. If the actual savings are such that ESCO recovers its total project costs (maximum amount) prior to the expiration of an agreement, the building owner will stop making payments. On the other hand, should actual avoided energy costs over an extended term be less than projected, ESCO would bear the costs/losses, i.e., ESCO guarantees the energy savings over the contract term. Any risk that the avoided energy costs may not materialize (i.e., the technical risk) will be borne by ESCO. In addition, any financial risk (i.e., the risk that the avoided energy costs are not sufficient to service the debt required for the up-front capital investment) will usually be borne by ESCO. In some contracts, the owner may decide to raise the required capital itself in order to reduce financing costs. However, while the building owners cost of capital may be lower, the financial risk of performance will remain with ESCO.

ESCO will invoice its clients on a basis that reflects the realization of energy cost savings over the term of the contract. That is, ESCO will invoice and receive its profit margin over the contract term as energy savings are in fact realized. Actual energy savings realized will be determined monthly by ESCO (or a third party arbitrator) - actual energy costs after the installation of the energy saving equipment will be compared with an agreed upon base of what the energy costs would have been without the equipment. ESCO will invoice the client for the energy savings.

Contract terms will vary in length from 6 to 12 years. The period to install the equipment at a client's premises will range from three months to two years, and energy savings may accrue before all installation is completed.

ESCO's costs for a contract will be mostly incurred in the engineering, design, installation and training phases with the remainder being included over the contract term in the form of maintenance and monitoring costs. In most cases, the materials/equipment costs will exceed the labour costs. To the extent that ESCO finances the contract, it will also incur significant interest costs. Substantially all of the revenue generating activities of ESCO will be performed at the time of installation of the equipment or shortly thereafter.

You have requested our comments concerning the timing of the recognition of revenue and expense, and hence, income to the hypothetical situation. Your specific queries are as follows:

1. Should any income be recognized during the installation phase - i.e., during most installations, energy savings will accrue before all installation is completed?

2. Should revenues be only recognized when received over the extended contract term (conservatism). If so, how should expenses be characterized? Should the expenses be deducted as incurred (running expenses) or should they be deferred to match against revenues?

3. Should revenues (and receivables) be fully recognized at the end of the installation, save for revenue related to those services that can be traced to future work to be done, i.e., maintenance and monitoring amounts?

4. Can the revenue/income recognition policy differ for accounting and income tax purposes? Can ESCO recognize revenues fully upon completion of installation for accounting purposes based on anticipated savings with annual adjustments as required; but recognize the revenues as invoiced for income tax purposes (by perhaps arguing that the ESCO will obtain legal right to the revenues only as energy savings are in fact realized). An analogy would be the treatment of holdbacks receivable for contractors, i.e., the holdbacks are recognizable for accounting purposes, but not for income tax purposes. The Queen vs. Foothill Pipe Lines Ltd. [ [1990] 2 C.T.C. 448] (1991 DTC 6607, FCA) supports the premise that income under Generally Accepted Accounting Principles ("GAAP") and for income tax purposes may differ.

5. Can the revenue recognition policy differ for income tax and goods and services tax purposes?

6. Should the services provided by ESCO be segregated and charged to the client on an individual basis if they are all included in one contract, i.e., if there was a separate charge for the feasibility study, should it be recognized as revenue upon its completion?

7. To the extent that ESCO borrows to acquire the equipment, an element of its revenue may constitute the pass through of interest. Should the "deemed" interest be segregated from other service revenue for income tax purposes (and Goods and Services Tax purposes)?

8. What factors would cause your answers to change? For instance, if legal title to the equipment was transferred to the client after installation, would your responses change?

Our Comments The fact situation which you set out is quite specific and it appears that it may relate to definite contemplated transactions. Assurance as to the tax consequences of contemplated transactions can only be given in response to a request for an advance income tax ruling. If you wish to obtain any binding commitment with respect to an actual case with facts similar to your example, an advance income tax ruling request should be submitted. We do, however, provide the following comments for your information:

A. It appears that most of the costs incurred are outlays for equipment that result in improvements to the client's building that may or may not be recovered in the event that there are insufficient energy savings enjoyed by the client to pay for these improvements. Whether or not there will be sufficient energy savings to recover these outlays with any remainder resulting in actual revenue to ESCO is actually a contingent matter. Should ESCO's share of the savings exceed recoverable costs there would be revenue. However, should the costs not be recovered, ESCO would have to absorb the responsibility or risk for the remainder and revenue would only accrue to ESCO if and when its share of the energy savings exceed recoverable outlays. You have basically asked us to provide you with the GAAP treatment of these arrangements and that is not the function of this Directorate. Accordingly, we are unable to comment substantively, with respect to the timing of matching these outlays, against the recovery of ESCO's share of anticipated savings, other than to say that GAAP would be appropriate, taking into consideration that the costs for equipment could represent capital expenditures made on behalf of the client rather than an expense incurred to produce revenue containing a profit element.

With regard to the client, it should be noted that the amounts paid ESCO, resulting from energy savings for effectively improving the client's building, likely constitute a capital expenditure by the client that should be treated as an addition to a prescribed class, possibly the building, rather than the client treating such outlays on account of current expense. The client would not have any cost for these assets until they have actually paid ESCO or until such time that they have a definite obligation to pay.

B. Subsection 9(1) of the Act states that "subject to this part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year." Profit from a business is computed in accordance with GAAP. The arguable position that income reported in accordance with GAAP for financial statement purposes must also be the income for tax purposes was clarified in the case of West Kootenay Power and Light Co. Ltd. v MNR, [ [1991] 1 C.T.C. 327] 91 DTC 5214, at the Federal Court Trial Division and the Federal Court of Appeal, [ [1992] 1 C.T.C. 15] 92 DTC 6023. The taxpayer until 1979 had not taken into income, either for accounting or for tax purposes, amounts which had been earned but were not billed at its year end. It began to do so, however, when reporting its income for its 1979 taxation year, adjusting its 1978 return to reflect the new treatment for 1979. This change was accepted by the Minister. In reporting its income for tax purposes for its 1983 and 1984 taxation years, however, the taxpayer reverted to his pre-1979 practice, of eliminating from its income for tax purposes for both of those years all earned amounts which had not been billed. Expert evidence given at the Trial Court showed that either method of reporting revenues was acceptable within GAAP. The witness, Mr. Culver, went on to say that, in his opinion, the accruing of unbilled income more closely matches the revenues of the organization with its relevant costs and therefore produces a more accurate determination of net income for a particular period. Trial Judge, MacKay, J., concluded that the Act does not require or permit a taxpayer to account for revenues, and thus profits, on one basis for financial statement purposes and on another basis for tax purposes notwithstanding that both methods are within GAAP. At the Appeal Court, Justice MacGuigan determined that the Trial Judge had erred in finding that as an absolute requirement under the Act that there must always be conformity between the accounting treatment used in any taxpayer's financial statements and its tax returns. When there are two methods acceptable within GAAP, MacGuigan decided the approved principle to be followed is that, for tax purposes, the accounting method which presents the "truer picture" of the taxpayer's revenue is the appropriate one. In summary, income for tax purposes, must be computed in accordance with a method within GAAP that produces the "truer picture". Hence, when there is only one acceptable method within GAAP and that method is reflected in the financial statements, the income for tax purposes, absent a specific provision of the Act, should not be different.

C. Recognition of revenue for income tax purposes is also the basis for recognition for goods and services tax purposes.

D. Certainly any right ESCO has to originate a billing should be considered in evaluating the timing of revenue recognition.

E. In most situations, in our view, equipment installed in a building becomes a part of that building and ownership effectively passes to its owner. However, it might be a determination of fact based on relevant law, including common law and the relevant agreements, as to whether title, in fact, passed to the client at the time a particular piece of equipment became an integral part of the client's building even though it might come to pass that the client may never have an obligation to pay for that equipment. While the cost has been incurred by ESCO, in our view, it would not be a depreciable asset but rather would be recoverable costs or deferred expenditures. It would seem appropriate that at such time as inventoried recoverable expenditures are established as not being recoverable, these amounts, for which ESCO has to bear the cost, could be written off at that time.

The foregoing comments are given in accordance with the practice of providing opinions referred to in paragraph 21 of Information Circular 70-6R2 dated September 28, 1990 and are not binding on Revenue Canada, Taxation.

We trust our comments will be of assistance to you.

Yours truly,

R. Albert for Director Business and Publications Division Income Tax Rulings and Interpretations Directorate Policy and Legislation Branch