19 September 1996 Internal T.I. 9614387 - PART I.3 - INCOME OF CONTRACTORS

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)Whether the adverse decision in the Tax Court of Canada case "Grocery People Ltd. v. MNR" (95-686(IT)I) changes the Part I.3 position on outstanding cheques.

(2)Whether deferred revenue of a construction company, with respect to services rendered, partially composed of uncertified progress billings, is included in capital.

(3)Uncertified progress billings of a contractor are included in income under paragraph 12(1)(b). IT92-R2 allows those amounts to be excluded from income. Does this exclusion reduce the Part I.3 capital inclusion under paragraph 181.2(3)(b) because of the wording "...except to the extent...deducted...under Part I,".

Position:

(1)No.

(2)Yes under either paragraph 181.2(3)(b) as a reserve or 181.2(3)(a) as surplus.

(3)No.

Reasons:

(1)The legal basis for our position, outlined in the 1994 and 1995 TEI (E9410400 and E9510220), was not presented and accordingly not considered by the court in arriving at the decision. The issue was decided strictly upon an argument that indebtedness had not in fact been created by the mere existence of an outstanding cheque. The case was not appealed on this basis. The department will await a subsequent challenge before reconsideration of this position.

(2)Deferred revenue in respect of services rendered is considered a reserve as defined in subsection 181(1) and included in capital pursuant to paragraph 181.2(3)(b). Certification is irrelevant for purposes of that paragraph. Arguments also in favour of inclusion as "surplus" per paragraph 181.2(3)(a).

(3)The words are interpreted as referring to a statutory reserve only.

September 19, 1996

EDMONTON TAX SERVICES HEADQUARTERS
Complex Case G. Donell
(613) 957-8953
Attention: Marlene White
961438

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

This is further to our file 960501 and in response to your request dated April 18, 1996 for further assistance with respect to arguments advanced by the above-mentioned taxpayer corporation (XXXXXXXXXX) as a result of a reassessment of its Part I.3 liability for each of its 1993 and 1994 taxation years. Specifically XXXXXXXXXX questions (1) whether the departmental position on outstanding cheques, most recently outlined in question 22 of the 1995 TEI round table, remains unchanged in light of the recent adverse decision in the "Grocery Peoples Ltd." case heard under the informal procedure at the Tax Court of Canada and (2) whether the words "...except to the extent...deducted...under Part I," in paragraph 181.2(3)(b) of the Income Tax Act (the "Act") includes a reduction in Part I income for uncertified billings specifically allowed by IT92-R2 rather than by statute. There also appears to be some misunderstanding on XXXXXXXXXX part as to the Department's position on deferred revenue which we will clarify.

We apologize for the length of time it has taken to respond. This delay, in our view, could not have been avoided since many of the issues we were asked to consider involved not only interpretative issues but issues of tax policy which prompted our consultation with the Department of Finance.

OUTSTANDING CHEQUES & "THE GROCERY PEOPLES" DECISION

The Department's position on outstanding cheques is best illustrated with an example. Assume that, at year end, a corporation (in a common law jurisdiction) with unlimited overdraft privileges and a positive bank balance of $100 writes a cheque for $1,000 that is not post-dated. The common law jurisprudence clearly states that the delivery of the cheque constitutes payment at that time. By granting the overdraft privilege the banks, in our view, acknowledge and tacitly approve the amounts for payment. Our position, detailed in each of the 1994 and 1995 TEI round tables, is that if that payment results in indebtedness or a negative bank balance that such resultant amount would be considered as a loan or advance to be included in capital of a corporation pursuant to paragraph 181.2(3)(c) of the Act. The amounts of the cheques themselves are not necessarily included in capital only the resultant overdraft that would have arisen had the cheques been honoured on the day they were delivered; the day that payment was considered to have been made. In our example an overdraft of $900 would be added to capital as a loan or advance.

In the Grocery Peoples case the court, in considering whether outstanding cheques are included in capital pursuant to paragraph 181.2(3)(c) of the Act as a loan or advance, concluded that "the mere presentation of a cheque by the taxpayer to its creditor does not create a bank indebtedness...", in the absence of a legal obligation between the bank and its customer with respect to that cheque. The court added that the payment between the debtor and creditor is conditional on the subsequent honouring of that cheque by the bank and does not represent indebtedness between the debtor and the bank until that time.

The fact that the payment is conditional and subject to a condition subsequent (the honouring of the cheque by the bank) does not alter the legal date of payment unless the cheque is not honoured. It is also our view that by granting overdraft privileges the bank has removed the condition subsequent. This and other such legal issues were not presented and considered by the court in reaching its decision, accordingly it is our view that our position remains unchanged until a subsequent court challenge will have the opportunity to fully consider the legal arguments that support the position we have taken.

UNCERTIFIED PROGRESS BILLINGS, IT92-R2 & Paragraph 181.2(3)(b)

In our memorandum to you dated March 1, 1996 (Our File 960501) we discussed at length the accounting methods adopted by XXXXXXXXXX in the preparation of their annual financial statements and to a lesser degree their method of computing construction income for tax purposes. For purposes of Part I of the Act, "Generally accepted accounting principles" (GAAP) and section 9 are considered the first step in working towards income for tax purposes. GAAP does not consider the certification or approval process as relevant in the determination of accounting income. For tax purposes however progress billings represented by uncertified amounts are not considered to pass the "quality of income" test espoused by the courts (See "Foothills Pipe lines" 90 DTC 6607 at 6612) and would therefore not be included in income for tax purposes pursuant to section 9 of the Act. Paragraph 12(1)(b) of the Act captures uncertified progress billings deeming them receivable when the accounts are rendered. As you are aware and as we indicated in our previous memo there is no statutory reduction with respect to these uncertified amounts included under paragraph 12(1)(b). Paragraph 5 of IT92-R2 however allows uncertified progress billings to be excluded from income. This exclusion is accomplished by XXXXXXXXXX via its T2S(1) income reconciliation.

The above Part I construction income analysis is generally irrelevant for purposes of Part I.3. 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. Accordingly our focus is upon what is reflected in the GAAP-prepared balance sheet of XXXXXXXXXX. The net result of XXXXXXXXXX construction contract accounting practice is that progress billings exceed construction costs and profit required to be recognized in accordance with GAAP using the percentage of completion method. The resultant difference, a deferred revenue, appears as a credit titled "XXXXXXXXXX". The balance sheet of XXXXXXXXXX reflects (1) recognized profit which flows through to retained earnings included in capital pursuant to paragraph 181.2(3)(a) and (2) deferred revenue or profit, we consider falling within the definition of a "reserve" as defined in subsection 181(1) of the Act and therefore included in capital pursuant to paragraph 181.2(3)(b) of the Act. It may be that a portion of the deferred revenue and the recognized profit represents uncertified amounts but as indicated previously certification is irrelevant for purposes of paragraph 181.2(3)(b).

XXXXXXXXXX has contended that if the deferred amount is included in capital as a reserve under paragraph 181.2(3)(b) of the Act, the latter wording of that paragraph, "...except to the extent that they were deducted in computing its income for the year under Part I," allows the deferred revenue to be reduced by uncertified amounts deducted in arriving at Part I income via the T2S(1) adjustment authorized by IT92-R2. It is our view that the words of paragraph 181.2(3)(b) of the Act refer specifically to a statutory deduction permitted by Part I and not by any other means such as an interpretation bulletin. Since there is no statutory deduction with respect to the inclusion of uncertified progress billings and holdbacks pursuant to paragraph 12(1)(b) of the Act no reduction is available in the context of paragraph 181.2(3)(b) of the Act.

PART I.3 & DEFERRED REVENUE

In its representations XXXXXXXXXX appears to have understood that deferred revenue is included in capital as an "advance" under paragraph 181.2(3)(c). They claim that in your March 4, 1996 letter to them that "...the Department has changed its mind and now intends to treat unearned revenues as reserves...". While this may be a matter of a simple misunderstanding we will reiterate our positions on deferred revenue, supported in policy terms by the Department of Finance, for clarification purposes:

- Deferred revenue received in cash is added to capital pursuant to 181.2(3)(c) whether the related services have been completed or not.

-Deferred revenue for completed services not received in cash is included in capital as a reserve or other surplus.

-Deferred revenue for services not completed where no amount has been received in cash is generally not included in capital.

ADDITIONAL POINT - SUBCONTRACTOR COSTS

In the course of our analysis of the various issues affecting the reporting of contractors income for purposes of Part I and I.3 it was noted that
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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
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch