Prepaid Income – Whether Subsection 9(1) or Paragraph 12(1)(a)Applies?
There is currently some uncertainty over the scope and the application of the “quality-of-income” concept that originated in the Kenneth B.S. Robertson Ltd. case. 1 There is also some uncertainty with respect to the interrelation between the “quality-of-income test” and the “earning requirement” under the Act. For instance, it is not clear whether or how the quality-of-income test applies to unearned amounts described in paragraph 12(1)(a).
Two recent court cases (the Blue Mountain Resorts Limited decision 2 handed down by the Tax Court of Canada and the Compagnie Meloche inc. decision 3 handed down by the Quebec Court of Appeal) have applied paragraph 12(1)(a) rather than subsection 9(1) with respect to prepaid income that, arguably, had the quality of income. Unfortunately, the courts did not expressly rule or comment on the quality-of-income issue. In the Blue Mountain Resorts Limited, the Tax Court simply held that the case could be decided by reference to the statutory provisions at issue, that is, paragraphs 12(1)(a)and 20(1)(m). In the Compagnie Meloche inc. case, the Quebec Court of Appeal held that the portion of the fees that related to services to be rendered was unearned when received by the taxpayer and that a reserve under paragraph 20(1)(m) could be claimed in that respect.
However, we understand that, on the basis of court cases such as Burrard Yarrows Corporation 4 , Kenneth B.S. Robertson Ltd. and Ikea Limited 5 , the CCRA has, on some occasions in the past, applied subsection 9(1) to prepaid income described in subsection 12(1)(a) that, arguably, was free of conditions or restrictions upon its use by the recipient.
Question 1
What is the practical impact of applying subsection 9(1) or paragraph 12(1)(a) to prepaid income?
Response 1
Both subsection 9(1) and paragraph 12(1)(a) have the effect of bringing amounts into income. However, paragraph 20(1)(m) allows a taxpayer to claim a reserve only with respect to amounts included in income under paragraph 12(1)(a). In other words, the paragraph 20(1)(m) reserve does not apply to amounts included in the income of a taxpayer under section 9.
The application of paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) to prepaid income allows the deferral of the recognition of income to the period in which the services are effectively rendered or the goods effectively delivered. Under paragraph 12(1)(a), prepaid income is included in the income of the taxpayer in the year in which it is received, but an optional reserve under paragraph 20(1)(m) may be claimed. This inclusion/deduction mechanism allows the recognition of the prepaid income as performance of the acts progresses. Under such a mechanism, the “earning event” (i.e. the rendering of the services or the delivery of the goods) is the “recognition event” for income tax purposes.
The application of subsection 9(1) to prepaid income results in an upfront inclusion of the amounts in a taxpayer’s income. Under such an approach, the prepayment is fully included in the income of the recipient in the year of receipt. Furthermore and based on paragraphs 18(1)(a) and 18(1)(e), no deduction or reserve is generally allowed in the year of receipt to take into consideration the obligations that the recipient has to perform or fulfill in the following years. The recipient will be allowed to deduct in a particular taxation year amounts in respect of his obligations towards the payer when he will effectively incur an outlay or expense in such particular taxation year.
Question 2
What is the current position of the CCRA with respect to the application of paragraph 12(1)(a) and subsection 9(1) to prepaid income that, arguably, has the quality of income?
Response 2
We have recently undertaken a review on the question of the application of paragraph 12(1)(a) and subsection 9(1) to prepaid income. In light of this analysis, the CCRA is now of the view that, as a general rule, the inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) should apply to amounts received in a year by a taxpayer in the course of a business in respect of services not rendered or goods not delivered before the end of the year or that, for any reason may be regarded as not having been earned in the year or a previous year. This inclusion/deduction mechanism is a specific statutory scheme dealing with the taxation of some types of prepaid income. It normally allows a closer matching of costs and revenues and therefore generally results in a more accurate picture of a taxpayer’s profit for a particular period.
Question 3
Will the inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) always be applicable?
Response 3
No. In certain situations, the application of the inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) may prove to be inappropriate or inadequate, having regard to the scheme of the Act. In some circumstances, the inclusion in income of amounts received by a taxpayer in the year of receipt under subsection 9(1) may turn out to be more appropriate and more in accordance with the scheme of the Act. Again, it is an examination of all the facts and circumstances surrounding a particular situation that will determine in which situation the application of subsection 9(1) is required. Such determination will need to be made on a case-by-case basis.
Question 4
Could the CCRA give some general examples of situations where subsection 9(1), rather than subsection 12(1)(a), would apply to prepaid income?
Response 4
As an example, a prepayment would normally have to be included in the taxpayer’s income upon receipt under subsection 9(1) where, having regard to all the circumstances, it is determined that the actions required to be done by the taxpayer and/or its obligations under the agreement are substantially performed at the time of receipt of the prepayment, or shortly after. On this point, reference can be made to the decision Dixie Lee (Maritimes) Ltd. 6 In such cases, an “upfront inclusion approach” would arguably present the best measure of the recipient’s tax position. The actions or obligations that the taxpayer would still have to perform in the future would not be substantial enough to justify the application of the inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m).
An “upfront inclusion approach” would also impose itself in situations where the agreement between the taxpayer and its client would lawfully provide that the taxpayer would be allowed to retain the prepayment made by the client in any event, regardless of whether or not the services or goods will in fact ever be provided. In other words, under this type of clause, the taxpayer would be allowed to retain the prepayment even if the taxpayer would not fulfill its obligations under the contract and would be in default. In such a case, the prepaid amount received by the taxpayer cannot be considered as an amount received on account of services not rendered or goods not delivered before the end of the year. Arguably, such a clause in a contract has the effect of dissociating the prepaid amount with any services to be rendered or goods to be delivered. In the presence of this type of clause, the link between the prepayment and the services or goods to be provided is absent or is not sufficient to permit the application of paragraph 12(1)(a). Consequently, the amounts received in such circumstances would generally be included in the taxpayer’s income upon receipt under subsection 9(1), without the possibility of deducting any amount as a reserve under paragraph 20(1)(m).
Question 5
What can be done to avoid any uncertainty on the whole issue of the application of paragraph 12(1)(a) and subsection 9(1) to prepaid income in a particular situation?
Response 5
We would of course recommend to a taxpayer that has some concerns about the application of paragraph 12(1)(a) and subsection 9(1) in a particular situation to apply for an advance income tax ruling.