Q. 9 Amounts received subject to marketing-participation obligation
Principal Issues: 1. Does a company that receives an amount by installment during the first two years following the signature of an agreement that commits it to respect the conditions of a “Program Of Excellence” for 8 years, may spread the income inclusion of the amount over the same eight-year period under paragraph 9(1)
2. Otherwise, may that sum be included in the company's income under paragraph 12(1)a) and accordingly, be entitled to claim a deduction under paragraph 20(1) m) if all conditions are met ?
Position: 1 & 2. Question of fact
Reasons: 1 & 2. General comments. The amount can be included in income pursuant to section 9 or paragraph 12(1)(a).
9 OCTOBER 2015 FEDERAL TAX ROUNDTABLE
2015 APFF CONFERENCE
Question 9 Retail Trade Agreement
A manufacturing corporation has entered into an agreement with its distributors, all of which are independent from it. The purpose of the agreement is to enhance the brand image of the manufacturer's products and to enhance the customer retention rate.
The manufacturing corporation agrees to pay an amount of $1,000,000 over two years if the distributor agrees to meet the various conditions of the program of excellence over a period of eight years. Under the terms of the agreement, the following conditions apply:
- Participate in marketing and customer retention initiatives;
- Align the distributor's image with the standards established by the manufacturer;
- Adopt the manufacturer's digital strategy;
- Adopt its communication strategy through social media;
- Involve their sales team in the various training sessions offered by the manufacturer;
- Produce a business plan that will include the various elements of the program of excellence;
- Report annually on the maintenance of conditions.
Performance criteria have been established for the various conditions that must be met by the end of the second year of the agreement and for the duration of the agreement thereafter.
The agreement provides for the payment of damages by the distributor to the manufacturer if after the second year the conditions are no longer met. The damage is calculated as follows:
- In the case of a breach of conditions in the third year or the fourth year of the agreement, twice the amount received under the program of excellence;
- In the case of a breach of conditions in the 5th or 6th year of the agreement, one and a half times the amount received under the program of excellence;
- In the case of a breach of conditions in the 7th or 8th year of the agreement, one times the amount received as part of the program of excellence.
Under the accounting standards for private enterprises in Canada, the distributing company will include in revenues over eight years the amounts received during the first two years from the manufacturing company.
The distributing corporation will recognize the amount over a period of eight years on the basis of section 9 and on the principle that this method presents a true and fair view of the corporation’s profit in accordance with the judgment of the Supreme Court of Canada in the case of Canderel Ltd. v. The Queen (footnote 1). The Supreme Court of Canada decided that a taxpayer may use a method that is not inconsistent with the ITA, the principles and rules of jurisprudence and generally accepted business principles. The distributing corporation participating in the program of excellence, once it accepts the agreement, has an obligation to comply with this program of excellence over a period of eight years under penalty of substantial damages.
Questions to the CRA
(A) On the basis of the facts set out in the question, does the CRA agree with the position adopted by the distributing corporation with respect to the recognition over eight years of amounts received in the first two years?
(B) If the CRA does not agree with this treatment, does the inclusion have to take place under paragraph 12(1)(a) and, as such, could a deduction under paragraph 20(1)(m) be granted?
CRA Response to Q.9(a)
The Supreme Court of Canada considered the concept of profit in Canderel Ltd. v. The Queen, [f.n. [1998] 1 S.C.R. 147], and enunciated six relevant principles for calculating profit for purposes of the Income Tax Act. One of these principles is to the effect that a taxpayer is free to adopt any method which is not inconsistent with the provisions of the Income Tax Act, established case law principles or “rules of law,” and well-accepted business principles.
However, the Supreme Court of Canada also added that well-accepted business principles, which include but are not limited to the formal codification found in generally-accepted accounting principles (“GAAP”), are not rules of law but interpretive aids. It concluded that the way in which a transaction is recorded in accordance with well-accepted business principles, such as GAAP, is not determinative as to its treatment under tax law.
Respecting the timing of income inclusions, Ikea Ltd. v. The Queen [f.n. [1998] 1 S.C.R. 198] is apposite. This judgment also confirms that the matching principle is not a controlling rule of law. In fact, this case confirmed the importance of the realization principle under which amounts received or realized by a taxpayer – free of conditions or restrictions as to their use – are taxable in the years in which they are realized subject to any contrary provision in the Income Tax Act or other rules of law.
In the situation described above, only an examination of all the facts of a particular case and a review of the contracts which created the obligations binding on the parties would permit us to provide a definitive response respecting the tax consequences arising under an application of the realization principle. Consequently, if it is determined that the $1,000,000 that the manufacturing corporation is obligated to disburse over two years (the “sum”) was, for the distributor corporation, free of conditions or restrictions respecting its use from the commencement of the contract, the sum could be included in the income of the distributor corporation in such taxation year [of commencement] under the terms of subsection 9(1).
Furthermore, an examination of the relevant documentation and the applicable private law would be necessary in order to determine if the damages clause, applicable where the distributor corporation does not comply with the program of excellence for a period of eight years, constitutes by itself a condition restricting the use of the sum by the distributor corporation.
CRA Response to Q.9(b)
Paragraph 12(1)(a) in general provides for the inclusion in income of any payment received in the ordinary course [“cours normal”] of a business on account of services not rendered before the end of the year or that, for any other reason, may reasonably be regarded as not having been earned in the year or a previous year.
In the case under review, the sum, once received, could be subject to paragraph 12(1)(a) if the acts and obligations which the distributor corporation had to accomplish after the end of the taxation year were sufficiently significant to reach a conclusion that the sum was not earned in that year or a previous year. Again, it is only after an examination of all the facts and circumstances respecting a given situation that it will be possible to make such a determination.
Finally, an amount included in the computation of income by virtue of the realization principle could also come within paragraph 12(1)(a). In such a case and subject to subsection 20(7), the distributor corporation could have the right to deduct a reasonable amount as a reserve if the situation was described in one of subparagraphs 20(1)(m)(i) to (iv).
Nancy Deslandes
613-670-9023
2015-059566
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 [1998] 1 SCR 147
2 Ibid.
3 [1998] 1 SCR 196