Reserves for Tax Purposes
Reserves for Tax Purposes
Reserve for Installment Sales/ Uncollected Proceeds (Long Term Receivables)
This reserve applies to situations where
• Real property is sold (i.e. land inventory); or
• Where any portion of an accounts receivable is not due until at least 2 years (i.e. installment sales)
Reserve Formula:
Reserve = 1 – [total cash received to date/contract price i.e., total sale ] x Gross profit
A Reserve is allowed in the year of sale, year 2 and year 3; however, on the fourth year the remaining profit needs to be included in income.
Example:
A good that’s costs $100 is sold for $1,100 in 2012. The amount is receivable over 5 years in equal amounts ($220 per year) starting in 2012. Therefore, per the solution, no reserve is allowed in year 4 and year 5.
Previous year reserves are always added back; and current year reserves deducted:
Note in 2013, $800 would be added back to income and you would take a deduction of $600. Basically this means that since you collected $220 during the year (also 20% of the sales) you include 20% of the gross profit in income ($1,000*20% = $200)
In 2015 you add back the $400 claimed in 2014 and take no reserves.
| Year # | Year | cash received to date (B) | B/$1100 = C | 1-C=D | Reserve = D *Gross Profit |
| 1 | 2012 | $220 | 0.2 | 0.8 | $800 |
| 2 | 2013 | 440 | 0.4 | 0.6 | 600 |
| 3 | 2014 | 660 | 0.6 | 0.4 | 400 |
| 4 | 2015 | 880 | 0.8 | 0.2 | – |
| 5 | 2016 | 1100 | 1 | 0 | – |
Reserve for Installment Sales/ Uncollected Proceeds (Long Term Receivables)
This reserve is used in situations where you sold a property and realized a capital gain; however, some of the proceeds are yet to be collected. CRA gives this reserves, because to pay taxes on a gain, you need to collect the amounts owing first.
Reserve Formula:
The capital gains reserve is the lesser of:
A = Reasonable Reserve = Capital Gain x (amount not yet collected/total proceeds of disposition)
B = Capital Gain x [4 – # of years since disposition]/5
Example:
A land with an ACB of $100 is sold for $2100 in 2012. The amount is due equally ($210 over 10 years starting in 2012.
Reserve in 2012 (current year) is the lesser of
A= 2000 * ((2100-210)/2100)) = 2000*0.90 = $1,800
B = 2000 * (4-0)/5 = 2000*4/5 = $1,600
Therefore, the reserve in 2012 should be $1600.
In 2013, $1600 is added back to income and a reserve for 2013 is deducted using the formula above.
Reserves for Bad Debts
A reserve can be taken on all debts owing to the taxpayer, that are established to have become bad debts in the year.
- You need to assess each account (debt) one by one, to determine what the yearend reserve should be for bad debts.
- For accounting, if you are using the ageing method to calculate the Allowance for Doubtful Accounts, the reserve for tax purposes and the reserve for accounting purposes may be similar.
- However, if for accounting you are using the % of sales method to come up with the bad debts expense; your accounting reserve (i.e. the Allowance for doubtful account) will likely not be the same as the tax reserve for bad debts.
- Previous year reserves for bad debts is added back to income, and the current end of year reserve for bad debts is deducted
Reserve for goods and services undelivered or unrendered at year end
Example #1
You get a 3-month contract with a price of $50,000 and you get the $50,000 upfront on December 1, 2010. It is now December 31, 2010, the taxation year end and you have done 1/3rd of the services; yet 2/3 has yet to be done.
- For accounting purposes, you would have realized revenues of $16,667 ($50,000*1/3) and would have unearned revenues (liabilities) = $33,333
For tax purposes
- You need to add $33,333 to accounting income (i.e. your financial statement reserve)
- You then deduct the tax reserve
- Tax reserve = upfront payment less the value of service unrendered at year end = $50,000 – 50000* 1/3 = 33,333
- As you can see, in this case, the amount of accounting reserve (the unearned revenues) = the tax reserve (value of service unrendered). The accounting and the tax treatment are the same. The effect on income under both cases is 16,667.
Example #2:
You get a 3-month contract with a price of $100,000 and you get $50,000 upfront on December 1, 2010. It is now December 31, 2010, the taxation year end and you have done 1/3rd of the services; yet 2/3 has yet to be done.
- For accounting purposes your revenues will be $100,000*1/3 = $33,333 and your unearned revenues (accounting reserves) will be $50,000 – 33,333 = 16,667
For tax purposes
- You need to add back the financial statement reserve = $16,667
- You then take a tax reserve = upfront payment less the value of service unrendered = 50,000 – 100,000 * 1/3 = 16,667
- Again, in this case, the accounting and the tax reserves are the same and cancel each other out. Basically, the effect on income in both cases is $33,333.