Accounting • Proven • Driven

The Taxation of Business Income in Canada

What is a Reserve for Tax Purposes and Canadian Corporations

 

 

Introduction

 

While it is usual and generally in accordance with normal business practices for a Canadian corporation to make allowances or take deductions or reserves for certain amounts, the Income Tax Act (Canada) does not permit a deduction, reserve or allowance to be deducted from the income of a corporation for tax purposes, unless the Act specifically makes a provision to do so.

 

Consequently, financial statements of Canadian corporations may include deductions, allowances or reserves for financial statement and reporting purposes which must be reconciled and taken into consideration when preparing the T2 corporate Income Tax Return.

 

The following items which commonly occur are outlined below:

 

Inventory Reserves

 

What is a Reserve for Tax Purposes and Canadian CorporationsGeneral “reserves” for inventory valuation are not permitted for tax purposes in relation to Canadian corporations. However, Subsection 10(1) of the Income Tax Act (Canada) states that “an inventory shall be valued at the end of the year at the cost at which the taxpayer acquired the property or its fair market value at the end of the year, whichever is lower, or in a prescribed manner.”

 

A deduction or “write-down” of a specific inventory item or a class of inventory items to fair market value is permitted. A general “reserve” or percentage applied overall to a Canadian company taxpayer’s inventory is not deductible for tax purposes.

 

In addition, a reserve can be claimed pursuant to paragraph 20(1)(n) of the Income Tax Act (Canada) for property sold in the course of a business if it is still payable to the taxpayer after the end of the year and all or part of the amount was, at the time of the sale, not due until at least 2 years after that time. In effect, the reserve under paragraph 20(1)(n) is limited to 3 years. The exception to this is where the property is real property. This exception is discussed in Capital Gains reserves, below.

 

Inventory reserves are reported on Schedule 13.

 

Allowance for Doubtful Accounts

 

The financial statements of a Canadian corporation may reflect an allowance made against the value of accounts receivable reflected on the balance sheet. To be deductible for this purpose, the allowance must be in accordance with the provisions of paragraph 20(1)(l) of the Income Tax Act (Canada). In general, to comply, the following criteria must be met.

 

  • The amount must first have been included in computing the taxpayer’s income for the year; and
  • Only a “reasonable” amount in respect of a doubtful debt can be claimed.

 

For a debt to be considered a “bad debt” the taxpayer must be able to demonstrate doubt as to the collectability of the amount. A general reserve or percentage does not meet the criteria under paragraph 20(1)(l) of the Income Tax Act (Canada). The taxpayer must identify the specific debts that are considered to be doubtful. Criteria to establish such amounts should consider

 

  • The length of time or period of arrears;
  • The financial status and prospects of the debtor;
  • The debtor’s credit rating; and
  • The value of any security taken against the receivable

 

Start by identifying which debts are doubtful. The maximum amount of the reserve can be calculated based on an estimate as to what percentage of the doubtful debts will probably not be collected. However, a reserve that is merely based on a percentage of all debts, whether doubtful or not, a percentage of gross sales or some similar calculation is not considered to be a reserve determined on a reasonable basis for the purposes of the Income Tax Act (Canada). A reserve for doubtful debts that is less than the amount that could have been claimed, following the guidelines above, will be viewed as a "reasonable" amount.

 

A reserve for doubtful accounts is claimed in part 2 of Schedule 13. The balance at the beginning of the year is recorded in Box 110, added to any of the other reserves shown in Part 2, and entered in Box 270. This is transferred to Line 125 of Schedule 1.

 

The balance of doubtful accounts at the end of the year is reported in Part 2, Box 120 of Schedule 13. Add this amount to the other year-end balances for reserves shown in Part 2 to arrive at the amount in Box 280. This amount gets transferred to line 413 on Schedule 1.

 

Reserve for Future Services to be Provided

 

Sometimes, a Canadian corporation will receive a deposit or an amount of cash in respect of future services to be provided. Generally accepted accounting principles would require that such amounts be accounted for as “unearned revenue” and only recognized as income once the service has been performed and completed.

 

However, section 9 of the Income Tax Act (Canada) generally requires that all amounts received by a taxpayer be included in computing the income of the taxpayer for the taxation year. Consequently, reserves claimed for financial statement purposes (such as unearned income), should be included in a Canadian corporation’s income for corporate tax purposes.

 

However, paragraph 20(1)(m) of the Income Tax Act (Canada) permits Canadian taxpayers to claim a reasonable reserve in respect of services to be delivered that can effectively be regarded as “unearned income” or anticipated future liabilities. Any reserve claimed in a specific taxation year must be added back into income in the immediately following taxation year. However, a new reserve can be established for each year, provided that the specified conditions exist for “unearned income”, at the end of the taxation year. The paragraph 20(1)(m) reserve is available where

 

  • The amount received has been included in the corporation’s income for the year;
  • It is reasonably anticipated that goods or services will have to be delivered after the end of the year in respect of such amounts so received; or
  • Rent or any-other similar charge for the use of land or chattels has been paid in advance to the taxpayer.

 

Reserves for future work to be provided or ‘unearned income’ also goes on Schedule 13, Part 2. These beginning balances are reported in Box 130 and the end of the year balance is reported in Box 140. These are transferred to Schedule 1 using the same steps as shown above for doubtful accounts.

 

Contractor Holdbacks

 

For Canadian corporations carrying on business in construction, it is normal business practice to incur amounts payable to subcontractors, subject to a “hold back”, pending completion or approval at some future date, and to record amounts receivable that are only collectible, based on a future contingent event. Contractor holdbacks receivable and payable are typically accounted for on an accrual basis on a Canadian corporation’s financial statements. However, for tax purposes, a corporation is entitled to claim a reserve in respect of amounts receivable that are subject to a holdback. Correspondingly a Canadian corporation cannot deduct (and must therefore add back), amounts deducted as an expense and included as a holdback payable at the end of the taxation year.

 

Effectively, the holdbacks receivable and payable are taxed on a cash basis for tax purposes.

 

This amount is also claimed as undelivered services in Box 130 of Schedule 13, added to other amounts in Part 2 and is then entered on Line 125 of Schedule 1 of the Canadian Corporate T2 Return.

 

Capital Gains Reserve

 

If proceeds from the sale of capital property are not all receivable in the year of disposition, a Canadian  corporation is permitted to defer the recognition of the taxable capital gain, to a subsequent taxation year, based on a specific formula set out in the Income Tax Act (Canada).

 

The amount of the capital gain which can be deferred for tax purposes is calculated as follows:

 

Capital gains               x               Proceeds not payable               =                Reserve

___________                                    Until after the end of

Proceeds of                                   the taxation year

disposition

 

For dispositions arising after November 12, 1981 the capital gains reserve is restricted to a maximum of 5 years with a minimum of 20 percent of the capital gain which must be reported in the year of disposition, and an additional 20 percent which must be reported each taxation year thereafter. The computation and reporting of this reserve is reflected in Schedule 6 of the T2 Canadian Corporate Income Tax Return.

 

Specified Partnership Income Reserves

 

New rules were introduced in the March 22, 2011 Federal Budget in Canada which ended the tax deferral enjoyed by corporate partners who structured their business interests through a partnership.

 

Where a Canadian corporation is a partner in a partnership, and the corporation and partnership have different fiscal years, there is now a requirement for the company to include an “accrued” stub period income in respect of their share of partnership income, based on a formulaic calculation. The rule applies for a corporate partner with a March 23, 2011 fiscal year end or later.

 

Specified Partnership Income Reserves are reported on Schedule 73 of the Income Tax Act (Canada).

 

Tax Reserves – What is Allowed for Tax Purposes?

 

Schedule 6 – Dispositions of Capital Property

 

Schedule 6 is used to calculate the gains or losses on capital assets for Canadian corporations. The exact same process used on a T1 return is used for a T2 return on S6 using the same formula. As we know, capital gains are currently taxed on ½ of the gain, with the “tax exempt” portion not being taxed and in the hands of the individual shareholder. The following is an additional step to be taken for corporate returns which allows the exempt portion of the capital gain.

 

Because the corporation is not the “individual” shareholder, a corporation will have a separate record of the exempt portion of capital gains. This is called a Capital Dividend Account (CDA). This is a sub account of retained earnings on the Balance Sheet. Subsequently, the shareholders of the corporation can then declare a Capital Dividend from the CDA which pays the dividend to the shareholders tax-free with zero T1 income reporting requirements.

 

Note: It is important to obtain all documents that represent the sale, as well as the cost of all capital property to record all the expenses against the proceeds of the sale, plus this will then be available as an audit trail.

 

Audit Point – Manual Calculation

 

Unlike T1 software, not all T2 software used for Canadian corporate accounting tracks individual capital assets. If any property disposed of is capital in nature, it is necessary to dispose of the capital asset on S8 back to the ACB of the property if the property was depreciable in nature. This results in recapture of CCA. Note: The ACB recorded on S6 will be the actual ACB, not the UCC.

 

Schedule 13 – Continuity of Reserves

 

Corporations can have several items on their balance sheet that affect their day to day business flow that are not daily occurring events. Corporations and their management will normally take allowances, deductions and reserves allowed under Generally Accepted Accounting Principles (GAAP). Most of these are not permitted under the Income Tax Act (Canada). Canada Revenue Agency does however allow for the following:

 

  • Inventory Reserves
  • Allowance for Doubtful Accounts
  • Reserve for Future Service
  • Capital Gains Reserves
  • Specified Partnership Income Reserves

 

All of these, except Specified Partnership Income reserves, are reported on Schedule 13. While each allowable reserve for a Canadian corporation under the Income Tax Act (Canada) has its own purpose, the treatment of reserves is similar throughout the T2 return.

 

Schedule 73 – Income Inclusion Summary for Canadian Corporations that are Members of Partnerships

 

As stated earlier, corporate structures that were also members of partnerships were able to structure the various fiscal year-ends to defer taxation of partnership net incomes. This was eliminated in the Canadian March 2011 federal budget.

 

Corporations in Canada that are members of partnership are now required to align their fiscal periods. Schedule 73 is designed and used to phase in the “stub” year that result from the change in year-ends.

 

 

We can assist you with navigating the Tax Reserves and determining the best solutions for your Small Business in White Rock, Langley or Surrey, BC. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses  in White Rock South Surrey, Langley and Surrey BC, we assist Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy.

 

Contact us today at 778-791-2864 or 604-970-0658, let’s talk, or send us an email here and we will be in touch very shortly.

 

 

 

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