7 January 1991 Income Tax Severed Letter - Sale of Construction Contracts

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:

Re: Sale of Construction Contracts

This is in reply to your letter of October 5, 1990 concerning the application of section 85 of theIncome Tax Act(the Act) in respect of the transfer of a partially completed construction contract.

You describe a hypothetical situation where a corporation (the transferor) which uses the “completion method” described in IT-92R2 proposes to transfer to a wholly-owned subsidiary (Subco) a partially completed construction contract under section 85 of the Act. The amount of deferred revenue and deferred costs representing work in progress in respect of the contract is $1,000.00 and $800.00 respectively. The total price of the contract is $1,500.00 and a profit of $200.00 is expected to be realized on the uncompleted portion of the contract. You state that the work in progress is owned by the other party to the contract by operation of law having become affixed to land owned by that other party.

It is your view that for purposes of section 85 of the Act the transferred contract would be considered to be inventory of the construction company on the basis that this particular contract is only one of many which the company has from time to time. You propose to transfer the contract to Subco electing under section 85 of the Act at the amount of the deferred cost ($800.00 in your example) to achieve a “ rollover”. At the same time the transferor would make a payment to Subco equal to the amount of the deferred revenue ($1,000.00 in your example). Subco will presumably assume responsibility for all costs respecting the deferred revenue.

Our Views

Interpretation Bulletin IT-92R2 outlines methods of reporting the income of a contractor and is not relevant in determining transfers of property pursuant to section 85 of the Act. In the situation described above the transferor appears to be transferring to Subco the profits earned in respect of the work in progress. As stated in paragraph 17 of IT-92R2 the amount received on the sale of a partially completed contract is regarded as being in lieu of profits earned on the portion completed and the profits expected to be earned had the contract been carried out in full and the amount is therefore considered to be income. The transferor's deferred costs would be deductible in the year of sale.

Inventory is defined in subsection 248(1) of the Act to mean “a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year”. Only in the case of a taxpayer buying and selling contracts as part of his business would a contract be considered inventory. Thus the transferred profits would not be considered to be inventory for purposes of section 85 of the Act.

As stated in paragraph 13 of IT-92R2 and as suggested above the use of the completion method is administratively permitted by the Department as a convenience only, to contractors in respect of their short term contracts. From a strict technical view the correct method of reporting income by contractors is described in paragraphs 3 to 9 of IT-92R2.

It follows that the provisions of section 85 of the Act would not be applicable in respect of the type of transfer described above.

We trust this will be of assistance to you.