NO: IT152R3
DATE: June 18 1985
SUBJECT: INCOME TAX ACT
Special reserves – Sale of land
REFERENCE: Paragraph 20(1)(n) and subsection 20(8) (also section 78 and paragraphs 72(1)(a) and 72(2)(a))
This bulletin cancels and replaces Interpretation Bulletin IT-152R2. Current revisions are designated by vertical lines. Proposals contained in the Notices of Ways and Means Motions of May 9 and May 23, 1985 are not considered in this release.
¶ 1. This bulletin deals with the operation of paragraph 20(1)(n) as it relates to the sale of land (which normally includes any buildings or other structures situated thereon) in the course of a business. For any taxation years ending after November 18, 1974, paragraph 20(1)(n) of the Act provides that in computing income, taxpayers may deduct a reasonable reserve for certain amounts which, although included in computing income, are not “due” until a day that is after the end of the taxation year. Thus, the reserve will be allowed only where an amount is owing but the taxpayer has no immediate legal right to call for the payment.
Reserve Allowable
¶ 2. Where property is sold in the course of the business of a taxpayer and instalments of the sale price or a lump sum commitment, whether secured by mortgage or otherwise, are not due until after the end of the taxation year, the taxpayer may claim a reasonable reserve in respect of that part of the profit on the sale that can reasonably be regarded as not yet due. It is important to note that a reserve under paragraph 20(1)(n) is allowable in respect of only the profit element in the amount due after the end of the taxation year. With respect to the amount receivable itself, a reserve for doubtful debts may be allowable under paragraph 20(1)(l), where applicable.
¶ 3. The only requirement in regard to the allowable amount of a reserve in respect of the profit element included in the amount due after the end of the taxation year is that the reserve must be a reasonable amount. Normally, it is considered reasonable to assume that the profit element in any amount due after the end of the taxation year is the proportion of the amount due that the gross profit on the sale bears to the gross selling price (before any deduction for outlays or expenses); thus a reserve might be allowed equal to the full amount of the profit if no part of the selling price was due. Stated as a formula, the foregoing would be:
Gross profit (gross selling price) × amount due after the end of the taxation year = reserve
Having calculated what is a reasonable reserve, a taxpayer need not claim the maximum amount of that reserve in any particular taxation year, but may claim such amount up to the maximum as he wishes.
¶ 4. A claim for a reserve under paragraph 20(1)(n) for an amount equal to the lesser of the gross profit on the sale or the amount due after the end of the taxation year will not be allowed as it is not considered reasonable to assume that the vendor receives no profit until after he has recovered his full investment in the property sold.
¶ 5. Subsection 20(8) provides that no reserve may be claimed in a taxation year under paragraph 20(1)(n) where a taxpayer, at the end of the year or at any time in the immediately following year, was exempt from tax under any provision of Part I of the Act or was not a resident of Canada and did not carry on the business in Canada (effective for property sold after May 6, 1974). For property sold before May 6, 1974, no reserve may be claimed in a taxation year where the taxpayer ceased to be a resident of Canada or became exempt from tax under any provision of Part I of the Act at any time in the year or in the immediately following year. In addition, paragraph 72(1)(a) provides that no reserve may be claimed in the year of a taxpayer’s death unless his legal representative and the transferee use the election permitted by paragraph 72(2)(a) of the Act.
¶ 6. Subsection 20(8) also provides that, with respect to property sold after November 12, 1981 otherwise than pursuant to the terms of a written agreement or offer made or entered into on or before that date, no reserve may be claimed for a taxation year which ends more than 36 months after the date of sale. Accordingly, a reserve under paragraph 20(1)(n) is limited to a maximum of three years.
Non-Arm’s Length Transactions
¶ 7. In addition to the above criteria for determining what is a reasonable amount as a reserve, the Department will take cognizance of the following factors where the parties are not dealing with each other at arm’s length:
(a) any disposition of the property by the purchaser,
(b) whether the terms of payment for the property are reasonable, and
(c) whether the terms of payment for the property are adhered to.
¶ 8. Where the terms of payment for the sale of property in a non-arm’s length transaction are reasonable but are not adhered to, a reasonable amount allowable as a reserve to the vendor ordinarily is the amount that would have been allowable had the payments been made.
¶ 9. Where property is sold in a non-arm’s length transaction and the terms of payment for the property extend until after the end of the second following taxation year of the purchaser, the application of section 78, concerning unpaid amounts, should be considered by the purchaser. Paragraph 78(1)(b) provides that an agreement in prescribed form in respect of an unpaid amount is effective for purposes of the Income Tax Act (which would include paragraph 20(1)(n)).
Reserve Where Sale of Land Involves a Mortgage
¶ 10. A sale of land often involves the giving of a mortgage by the purchaser to the vendor, the assumption by the purchaser of a mortgage already given to a third party by the vendor or, sometimes, the continuing existence of a mortgage given by the vendor but not assumed by the purchaser. The transaction constitutes a “sale” for the purpose of paragraph 20(1)(n) even where it is made by means of a long-term purchase-and-sale agreement under which the purchaser cannot obtain a clear title to the property until the agreement has been completed or the mortgage has been discharged. Where the circumstances of a sale involve one or more mortgages, the formula set out above may be altered depending on the circumstances in the particular case. Some typical situations are outlined below.
¶ 11. An amount secured by a mortgage given by the purchaser to the vendor as part-payment of the purchase price is an “amount due” after the end of the taxation year to the vendor for the purposes of the above formula, and it remains so from year to year to the extent that it is held by the vendor and its principal amount has not become due by the end of a particular year. Where blended payments of principal and interest are being made by the purchaser, only the part of each such payment that is made on account of the principal acts to reduce the amount due to the vendor for the calculation of the reserve.
¶ 12. A simple case is where, for example, the gross selling price of a parcel of land was $300,000, the gross profit was $30,000, and the purchaser paid cash of $100,000 and gave the vendor a mortgage of $200,000. Application of the formula at the end of the year of sale would allow the vendor a reserve as follows, provided no further payments have been made:
($30,000 × $200,000) ÷ $300,000 = $20,000 reserve
¶ 13. Where the vendor has previously given a mortgage to a third party either at the time of acquisition of the land or to finance the cost of improvements to the land including construction of a building on the property, and the unpaid balance of the mortgage is assumed by the purchaser as part-payment of the purchase price, that unpaid balance may be deducted from the gross selling price in the denominator of the formula in 12 above to arrive at a reasonable reserve. For instance, if the property sold for $300,000 and the purchaser paid $40,000 cash, gave a second mortgage for $80,000 to the vendor, assumed mortgages of $50,000 and $130,000 for the original acquisition of the land and the construction of the building respectively, and the vendor made a gross profit of $30,000, a reasonable amount as a reserve could be calculated as follows at the end of the year of sale, provided no further payments have been made:
($30,000 × $80,000) ÷ $120,000 = $20,000 reserve
This exception does not apply where the vendor has given a mortgage on the property for any other reason, and there would therefore be no reduction of the denominator for such a mortgage that was assumed by the purchaser.
Link to Source:https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it152r3/archived-special-reserves-sale-land.html