7 September 1990 Income Tax Severed Letter - Meaning of “reasonable reserve” calculated in accordance with paragraph 20(1)(n)

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.

Subject: Paragraph 20(1)(n)

We are writing to you in reply to your memorandum of May 31, 1990 in which you sought clarification of what constitutes a "reasonable reserve" calculated pursuant to paragraph 20(1)(n) of the Act in a certain fact situation. Our understanding of that situation is outlined below.

Fact XXX

You noted that, for accounting purposes only, XXX XXX.

You also pointed out that the taxpayer's entitlement to a reserve under paragraph 20(1)(n) is not in dispute; rather it is the amount of the reserve which is being contended.

Taxpayer's View

In determining his profit from the sale, the taxpayer views his cost of sales as being the amount reported for tax purposes in the year of sale.

Your View

It is your view that the determination of profit for purposes of the paragraph 20(1)(n) reserve provision should take into consideration all costs of the projects, whether claimed as deductions in the current year or prior years.

Our View

The deductibility of soft costs in the year in which they arise is frequently a relevant issue but is not one which you have requested us to address. Accordingly, in our response, we assume that you are satisfied that the amounts claimed as soft costs in the prior years should not have included in the cost of inventory for this particular taxpayer (see Metropolitan Properties [[1985] 1 C.T.C. 169] 85 DTC 5128 and Guaranteed Homes [[1978] C.T.C. 636] 78 DTC 6510).

The determination of reasonableness in the situation presented can be clarified by the following example.

Sales proceeds              $100
"Soft costs"                 $10
Other costs                   60
Total costs                   70
Gross Profit                $ 30

In this example, if the soft costs were incurred in the current year and the sale proceeds were fully due in the year, the gross profit to be reported in the current year would be $30. If, instead, the soft costs were deducted in prior years and there were no sales in those years, the cumulative loss for those years would be $10 and the gross profit to be reported in the year of sale would be $40. Examining the language of paragraph 20(1)(n), one notes a reference to "profit from the sale" rather than "profit in the year." On this basis, one might argue that the "profit from the sale" is $30, whether the costs were deducted in the current year or in prior years. That being so, if none of the proceeds were due in the year, a reasonable reserve might be viewed as being $30 rather than $40. However, this would have the effect of requiring the taxpayer to bring into current year's income an amount equal to the amount of those expenses which were previously deductible. This result is not appropriate since the deductibility of those expenses was not dependent on gross profit reported. Accordingly, it is our view that "profit from the sale" for purposes of the 20(1)(n) reserve may be determined to be the gross profit reported in the current year, which would be $40 in the above example.