14 May 1991 Ministerial Correspondence 903044 F - 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.

Dear Sirs:

This is in reply to your letter of October 26, 1990 wherein you requested our views regarding the appropriate revenue recognition policy for income tax purposes in the following hypothetical situation that may be encountered by any prime contractor or subcontractor engaged in construction activities.  We apologize for the delay in replying to your letter.

Hypothetical Situation

1.     Company A is a subcontractor involved in construction activities with a December 31 fiscal year-end.

2.     Company A has a number of fixed-total-price contracts, most of which may reasonably be expected to be completed within two years from the date of their commencement and some of which may reasonably be expected to be completed more than two years from the date of their commencement.

3.     Pursuant to the guidelines provided in Interpretation Bulletin IT-92R2 (Income of Contractors), for those contracts it expects to complete within two years from the date of their commencement, Company A follows the "completion method" of revenue recognition. For those contracts that may reasonably be completed more than two years from the date of their commencement, Company A follows the "progress method" of revenue recognition.

4.     In certain of the contracts that commenced on, say, December 1, 1988, and that were originally estimated to be completed within two years from their commencement, Company A encounters delays such as work stoppage, adverse weather, or change orders that result in it being unable to complete the contracts by December 1, 1990 and the anticipated date of completion is now March 1, 1991.  At the time of preparing its financial statements and tax returns for calendar 1988 and 1989, Company A still anticipated that these contracts would be completed by December 1, 1990.

Your Opinion

In paragraph 12 of IT-92R2, Revenue Canada states that,

"Where the completion method is used, additions to a job requiring extra work to be performed which will postpone completion of the job from one taxation year to a later one should be treated as a separate contract."

The circumstances described in paragraph 4 above are different than an addition to an original contract such that it is not possible to treat any of them as a separate contract.

In preparing its financial statements and corporate tax returns for the 1988 and 1989 calendar years, Company A would use the "completion method" of revenue recognition for the above-mentioned contracts described in paragraph 4.  You believe that this approach is supported by generally accepted accounting principles ("GAAP") due to the uncertainties related to ultimate profit realization on any particular contract, particularly in the first year or so of a contract.  This approach is also supported by the guidelines provided in IT-92R2 since, at the time of preparing its 1988 and 1989 financial statements and tax returns, it was still anticipated that the contracts would be completed within two years from the date of their commencement.

The financial statements and tax returns for calendar 1990 would be prepared by applying the "progress method" of revenue recognition to such contracts.  You believe this approach is supported by GAAP on the basis that, in the second year and subsequent years of a contract, some of the uncertainty regarding the ultimate profit realization on a contract has been removed.  Also, since at the time of preparing the 1990 financial statements and tax returns it has become evident that the contracts will not be completed within two years from the date of their commencement, the guidelines in IT-92R2 would no longer support the use of the "completion method"of revenue recognition.

Our Comments

Generally, where a contractor reasonably estimated that a contract would be completed within 24 months from its commencement, but due to unforeseeable and uncontrollable circumstances such as labour problems, unusual weather, etc., the completion date was not until after the

2-year period, it is our view that the contractor should continue to use the completion method to report the income from this contract.

As noted, paragraph 12 of IT-92R2 indicates that change orders which require extra work to be performed which will postpone completion of the job from one taxation year to a later one should be treated as a separate contract and, generally, the completion method may still be used for the original contract.  However, in your opinion, recording of the change orders as a separate contract is not applicable in this hypothetical situation.  In our opinion, if the original contract is written in such a way that it will be finished in less than two years but a change order or a series of change orders are made which are not treated as separate contracts and which cause the original contract to extend for more than two years, the Department may challenge the use of the completion method for the contract and may require the progress method to be used for the entire duration of the contract.  This would be a question of fact to be determined after a review of all the pertinent facts.

The completion method of reporting income for tax purposes was accepted as a matter of convenience for both the Department and contractors regardless of which method was required under GAAP or adopted by the contractors for accounting purposes.  Therefore, it is possible to use different methods for tax and financial statements purposes provided that the requirements under paragraph 12 of IT-92R2 are met.  As stated in paragraph 13 of IT-92R2, a taxpayer may change from the completion to the progress method, however, the change has to apply to all short-term contracts.  The Department will not agree to a reversal to the completion method in a later year.

These comments represent our opinion of the law as it applies generally.  As indicated in paragraph 21 of the Information Circular IC 70-6R2, this opinion is not a ruling and accordingly, it is not binding on Revenue Canada, Taxation.

Yours truly,

for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch