R. Langevin 957-2138
MAR 15 1988
Dear Sirs:
This is in reply to your letter dated December 10, 1987, requesting our comments in respect of a proposed transaction in circumstances in which your client owns a large parcel of land which he is subdividing into residential building lots, to be sold without a building thereon. Some of the lots will be sold before services, required by a municipality, are actually installed, however, the full price for a serviced lot will be received. You have asked whether the taxpayer can accrue the estimated costs of providing the services as part of the current cost of sales, or alternatively, whether the taxpayer can claim a reserve under paragraph 20(1)(m) of the Income Tax Act (the "Act") for a portion of the sale price received and taken into income under paragraph 20(1)(a) of the Act.
As indicated at paragraph 23 of Information Circular 70-6R, the Department will not, in general, provide a written opinion with respect to a proposed transaction as in the current matter. In circumstances in which a proposed transaction is submitted for our review, an advance income tax ruling request is made. In the interests of providing you with a reply at the earliest possible occasion, we will provide some general comments, which may or may not be appropriate to the facts and documentation associated with the proposed transaction.
It is the Department's view that in order for costs (expenses) to be incurred, either the amount of the costs must have been expended or a legal liability to pay someone for the performance of the service in question must exist. Accordingly, in the case in which a lot is sold and services must be rendered by a vendor but the vendor is under no obligation or legal liability to pay a shirt party for the services which are to be performed at a later date, it could not be maintained that an expense had arisen and, anticipated costs would not form part of the current cost of sales.
It is our view that paragraph 20(1)(m) of the Act permits a taxpayer to claim a reserve for amounts described in paragraph 12(1)(a) of the Act and is intended to allow a taxpayer to deduct from income amounts received but not yet earned. In this regard, we note that an amount will be considered earned in circumstances in which a taxpayer's right to payment is under no restriction, contractual or otherwise, as to its disposition, use or enjoyment. In the event that your client has an absolute right to payment without such restrictions, then the reserve permitted by paragraph 20(1)(m) of the Act would not be available inasmuch as the amount would be considered to be earned, that is, it would not be an amount described in subparagraph 12(1)(a)(i) of the Act.
In circumstances in which an amount is considered not yet earned, paragraph 20(1)(m) of the Act would permit the deduction as a reserve, of specific costs, which a taxpayer can identify as having to be incurred in a later taxation year. The latter provision does not apply to allow a taxpayer to claim a reserve for costs which may arise in the years subsequent to the date of contract which are merely anticipated but in respect of which there is no reasonable assurance at the present time that such costs will actually be incurred. It proceeds from this that in the general circumstances you have described, a reserve pursuant to paragraph 20(1)(m) of the Act would be available to the extent that the amounts received have not yet been earned, it is reasonably anticipated that the costs will be incurred and such costs can be identified. It is also noted that the reserve must, of course, be justified and reasonable in every case.
Although we cannot comment definitively in respect of the four categories of contract that you have enumerated because these reflect a proposed transaction, we can provide some general remarks on your enumeration which follows:
1. A simple contract of sale with no specific reference to the services to be rendered and no amount allocated to the said services;
2. A contract that specifies the vendor is to provide services subsequent to the sale, but no monetary value being placed on the services;
3. A contract that specifies the vendor is to provide services subsequent to the sale and that identifies what proportion of the sale price is attributable to these services; or
4. Two separate contracts would be entered into: one for the sale of land and the other for services to be rendered. Each contract would set out the amount of consideration to be paid to the vendor.
We opine that a contract should specify the particular services which are to be rendered in a later taxation year and the related costs should be capable of identification for the purposes of the reserve under paragraph 20(1)(m) of the Act. Accordingly, category 1 would not, in our view, be in appropriate form inasmuch as the services are not identified with the result that related costs would not be identifiable. Categories 3 and 4 would, in general terms, be appropriate inasmuch as they would appear to meet the above criteria in this regard. Category 2 may also be appropriate to the extent that services are identified in the body of the contract and from such identification the related costs can be ascertained.
This opinion is our best understanding of the law as it applies generally, however, it may not be appropriate in respect of the facts of a particular case and is not binding upon the Department.
Yours truly,
ORIGINAL SIGNED BY Wm. R. McColm for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch