Principal Issues: [TaxInterpretations translation]
Can the progress method be applied to a particular taxpayer?
Position: The taxpayer may avail himself of the progress method provided for in Interpretation Bulletin IT-92R2, provided that title to the construction passes to the taxpayer's client or to the owner of the building as the work progresses and that the manufacture and installation of the equipment are provided for in the plans and specifications for the construction of the building.
Reasons: First paragraph of Interpretation Bulletins IT-92R and IT-92R2, backup to those interpretation bulletins, documents E7809, F71902 and FA105.
January 5, 2001
XXXXXXXXXX Headquarters Audit Division Resources, Partnerships and Trusts Division XXXXXXXXXX Tax Services Office
2000-005376
Determination of income for tax purposes
This is further to your letter of October 26, 2000 and our telephone conversation of December 8, 2000 regarding the determination of income for tax purposes of XXXXXXXXXX. Since the majority of the facts presented are the same for all XXXXXXXXXX corporations, the term “Taxpayer” will apply, mutatis mutandis, to each of those corporations.
FACTS
1. The Taxpayer submits bids to general contractors. When a bid is accepted, the Taxpayer enters into a contract with the general contractor. The contracts entered into in Canada are based on the standard construction contracts in force in the province where the work is performed. The contracts are fixed price contracts. Canadian construction specifications apply to contracts entered into by the Taxpayer. XXXXXXXXXX.
2. The Taxpayer manufactures, purchases, instals or has installed stainless steel equipment for general construction and major renovation contracts. The Taxpayer manufactures cabinets, countertops, tables, sinks, hoods and shelving. For approximately 70% of industrial kitchen contracts, the Taxpayer must purchase the equipment from suppliers. For example, the Taxpayer buys cookers, grills, kettles, stoves and ice machines. Generally, suppliers deliver the goods ordered directly to the location where they are to be installed.
3. XXXXXXXXXX.
4. The XXXXXXXXXX monthly billing is not based on the number of pieces of equipment delivered to the customer's site, but rather on a percentage of the value of the equipment delivered in relation to the overall value of the contract.
5. Invoices must be approved by an architect or engineer of the general contractor's client. When these invoices are approved, the general contractor pays the Taxpayer an amount corresponding to the approved amount less a holdback. The Taxpayer may receive those holdbacks when all the work relating to the contract has been satisfactorily completed.
6. For tax purposes, the Taxpayer avails itself of the progress method provided for in paragraphs 3 to 9 of Interpretation Bulletin IT-92R2. The Taxpayer defers the taxation of its unapproved billings and holdbacks. In addition, the Taxpayer deducts the costs in the year in which they are incurred even if those costs relate to revenue that will be taxable in a subsequent year.
7. Essentially, you are of the view that the Taxpayer cannot avail himself of the methods provided for in Interpretation Bulletin IT-92R2 since it carries on a manufacturing and processing business. You added that the manufacturing and installation of kitchen equipment is not the same as the construction of a building, road, dam, bridge or similar structure for the purposes of the first paragraph of Interpretation Bulletin IT-92R2. You also stated that kitchen equipment has always been considered a tangible capital asset for capital cost allocation purposes and not a building. You also referred, by analogy, to Interpretation Bulletin IT-411R, which states that the fabrication of machinery on a construction site is not considered a construction activity for purposes of the deduction provided for in section 125.1 of the Income Tax Act (the “Act”).
In addition, you specified that the kitchen equipment being produced in the factory is the property of the Taxpayer. Ownership is transferred upon delivery to the worksite or approval by the purchaser or the purchaser's architect or engineer. Based on the jurisprudence, you are of the view that the costs incurred by the Taxpayer with respect to the production of goods will be deductible only in the year in which the sale is made for tax purposes.
8. XXXXXXXXXX. Relying on the first paragraph of Interpretation Bulletin IT-92R2, the XXXXXXXXXX representatives submit that it can avail itself of the method of evaluating work progress provided for in Interpretation Bulletin IT-92R2, since the purpose of that Bulletin is to allow all persons engaged in the construction of a building to benefit from the methods provided for in that interpretation bulletin. They also added that kitchen equipment is installed at various stages of building construction. Hoods, for example, are installed when the walls and ceilings are finished. Conveyors are installed before the finishing work. In addition, they are of the view that even if Interpretation Bulletin IT-92R2 does not apply to the Taxpayer, the jurisprudence and the principle of realization of income justify the tax treatment followed by the Taxpayer. Relying in particular on Wilson and Wilson Limited v. Minister of National Revenue (60 DTC 1018), the representatives state that costs relating to unrealized income are deductible in the year in which they are incurred even though the progress method set out in Interpretation Bulletin IT-92R2 does not apply to the Taxpayer.
YOUR QUESTIONS
9. You are asking us to confirm that the Taxpayer cannot rely on the progress method set out in Interpretation Bulletin IT-92R2. If the Taxpayer cannot avail itself of the methods provided for in that Interpretation Bulletin, you are also asking us to indicate the tax treatment of holdbacks and costs incurred in one year that relate to taxable revenue in a subsequent year.
OUR COMMENTS
10. The first paragraph of Interpretation Bulletin IT-92R2 refers to the type of taxpayers who may use inter alia the progress method to report their income. This paragraph reads as follows:
“This bulletin applies to any prime contractor or subcontractor who is engaged in the construction of a building, road, dam, bridge or similar structure, in circumstances such that title thereto vests in a person other than the prime contractor or the subcontractor as it is constructed. This bulletin has no application to contractors who, for any reason, retain title to the structure e.g. builders who construct houses on their own land). While the Department considers the fabrication of ships to be the manufacture of goods for sale, rather than construction, a shipbuilder who builds a ship under a contract which provides that title thereto vests in the ship owner as it is built, may, without impairing eligibility under section 125.1 or subsection 127(5), follow a method of computing income with respect to that contract as described in this bulletin.”
11. The first paragraph of that interpretation bulletin states, among other things, that title to the construction must pass to a person other than the principal contractor or the subcontractor as the work progresses. The information you have submitted does not allow us to conclude definitively whether that condition is legally respected. We suggest that you obtain the opinion of legal services to clarify this issue. We agree with your conclusion that this condition must be satisfied for a taxpayer to benefit from the methods set out in that bulletin. If that condition is satisfied, it must be determined whether the Taxpayer is a subcontractor engaged in the construction of a building, as claimed by the Taxpayer's representatives.
12. The Taxpayer manufactures, installs or has installed kitchen equipment that is generally attached to buildings. We are of the view that the equipment manufactured and installed by the Taxpayer is intended to serve the specific businesses operated in the buildings rather than to serve the buildings per se. However, where the installation of such equipment is provided for in the plans and specifications for the construction of a building and the installation is carried out at various stages of the building's construction, we are of the view that it would be difficult to conclude, for this type of contract, that the Taxpayer is not a subcontractor engaged in the construction of a building since those activities are part of the building's construction process. On the other hand, we are of the view that the manufacture and installation of kitchen equipment in buildings already constructed or inside various means of transportation do not constitute activities relating to the construction of a building even if the Taxpayer's business is part of the construction industry.
13. In view of the comments set out in the preceding paragraph, we are of the view that the Taxpayer may avail itself of the progress method set out in Interpretation Bulletin IT-92R2, provided that title to the construction vests in the Taxpayer's client or in the owner of the building as the work progresses and, furthermore, that the manufacture and installation of the particular equipment are provided for in the plans and specifications for the construction of a building.
14. You also asked for our opinion on the tax treatment of holdbacks where a taxpayer cannot use the methods provided for in Interpretation Bulletin IT-92R2. Paragraph 12(1)(b) provides, among other things, that a taxpayer must include in income any amount receivable by the taxpayer in respect of property sold or services rendered in the course of a business in the year. A right to receive an amount exists where the vendor has an absolute, but not necessarily immediate, right to be paid. This absolute right exists when all the suspensive conditions of a contract are satisfied. A suspensive condition is an event (beyond the vendor's control) that suspends the performance of the contract (such as the right to be paid in the case of a holdback) until the condition is satisfied or waived and which could void the contract from the outset if the condition is not satisfied or waived. We understand that holdbacks are refundable only when all work has been satisfactorily completed. Consequently, we are of the view that such holdbacks will constitute amounts receivable when a client's architect or engineer has confirmed that the work performed by the Taxpayer is satisfactory.
15. Where a taxpayer can avail itself of the progress valuation method provided for in Interpretation Bulletin IT-92R2, the taxpayer may deduct in computing income all costs incurred in the taxation year for the performance of a contract even though a portion of the revenue relating to that contract will only be added to income in a subsequent year. On the other hand, if a taxpayer cannot use the progress method, we are of the view that the expenses incurred will be deductible in accordance with the principle for matching revenue and expense since it is possible to associate the expenses with a specific item of income. We are of the view that this conclusion regarding the matching principle is consistent with the Supreme Court of Canada's decision in Canderel Limited v. Her Majesty the Queen (98 DTC 6100). Issue No. 16 of Income Tax Technical News, dated March 8, 1999, published by the Canada Customs and Revenue Agency (CCRA), discusses the impact of the decision in this case on the principle of matching of revenues and expenses. The publication reads, in part, as follows:
“Q. Do you agree that the matching principle is not a rule of law?
A. Yes, given the Supreme Court's pronouncement, the Department accepts that the matching principle is not a rule of law although it remains an important consideration in the determination of the most accurate picture of profit.
(...)
Before these decisions, determining whether or not an outlay was a running expense was a difficult judgment based on the particular facts and this remains the case today. These cases do not mean that all instances of tenant inducement payments would be deductible up front. A difficult decision has to be made whether the expenditure is incurred for the specific purpose of earning an identifiable item of revenue which results in the application of the matching principle or whether there are sufficient current benefits from the expenditure to justify treatment as a running expense.”
ACCESS TO INFORMATION
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the Legislative Access Bank version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
We hope you find our comments of assistance.
Marc Vanasse, CA
Manager
Resources, Partnerships and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch