Most businesses must use an accrual method in computing their business income for income tax purposes. An exception is made for certain taxpayers such as farmers or fishers, who can use a cash method.
Under the accrual method, a taxpayer carrying on a business must include amounts receivable in a year, even if they are not received in the year. In general terms, an amount is receivable where the taxpayer has an unconditional right to the amount in the year even though it is not due until a future year.
In some cases, a business of selling property (inventory) may deduct a reserve in respect of an amount receivable. The reserve, under Income Tax Act paragraph 20(1)(n), is allowed only if part or all of the proceeds of the sale are not due for at least two years after the date of sale, or in the case of real estate if all or part of the proceeds are due after the year of the sale.
The reserve in a year is limited to the portion that may “reasonably be regarded as a portion of the profit from the sale”. Typically, this portion will equal:
gross profit on sale / total sales price x amount still due
The reserve deducted in one year is added back into income in the next year. If another reserve is available in the next year, it can be claimed, and the process continues until proceeds are no longer due after the relevant year.
RealCo is in the business of selling real estate. In year 1, it sells a property for $600,000, of which $200,000 is profit. One-third of the proceeds are due in each of years 1 through 3.
Year 1: RealCo includes the $200,000 profit in income. It can deduct a reserve of $200,000 / $600,000 x $400,000, or $133,333, for a net inclusion of $66,667.
Year 2: RealCo includes the $133,333 reserve from year 1, but can deduct a reserve of $200,000 / $600,000 x $200,000, or $66,667.
Year 3: RealCo includes the $66,667 reserve from year 2. No further reserve is allowed.
The reserve is available for a maximum of three taxation years, even if some of the proceeds are due after year 3. The reserve is optional.
Unfortunately, the reserve is not allowed for accounts receivable for services rendered.