If you carry on a business, you normally must include accounts receivable at year end (under the Income Tax Act they are called “amounts receivable”) in your income, even if you have not yet received the amounts.
There are some exceptions. For example, if you carry on a farming or fishing business, you can elect to use the “cash method”. Under this method, you include the amounts in income only in the year you receive payment. If you carry on a non-farming/fishing business, you may be able to use the cash method, as the Courts have said you can use that method if it reflects a more accurate picture of your income relative to the receivable method. In practice, this is rarely possible.
In general terms, an amount is receivable if, by the end of the relevant year, you have an unconditional right to receive the amount even though it is due after the year. This applies both to services rendered and to goods or property sold in your business.
But there is also a deeming rule in the Income Tax Act for services rendered in your business. This deeming rule says that in respect of services rendered, the amounts owed to you are deemed to be receivable on the day that is the earlier of
- the day on which the account in respect of the services was rendered, and
- the day on which the account in respect of those services would have been rendered had there been no “undue delay” in rendering the account in respect of the service (“undue delay” is not defined, so it depends on the circumstances of your business).
So, what happens if you don’t ultimately receive the amount receivable? That is, you have already included it in your income, but you haven’t received the cash.
Fortunately, there are some possible remedies under the Income Tax Act where you can cancel the inclusion.
First, there is a general reserve or deduction for your income property sold in the course of your business. There are a couple of restrictions. First, if the property is not real estate, you can claim this deduction only if the amount receivable is due at least two years after the date of the sale. Second, you can normally claim the deduction for only three years. So, if you sell the property in year 1, you cannot claim the reserve in year 4 or afterwards even if some or all of the proceeds are due after year 4.
The deduction is based on a reasonable portion of the profit from the sale of property that is due after the year (see example below).
Since this deduction is considered a reserve, if you claim it in one year you must add it back into income the next year. Then, if the amount is still due in a future year you can claim the deduction again, subject to the above limitations.
I am in the business of selling real estate. In Year 1, I sell a property for $1 million, and my cost was $400,000.
So, my initial profit included in Year 1 income is $600,000.
However, under the sales agreement, the purchaser pays me 1/3 of the price in each of Years 1 through 3.
In such case, I can spread out the $600,000 over the three years, so I would include $200,000 in income in each of those years.
The reserve is optional, so I do not have to claim it. But normally it makes sense to do so.
Next, there is a “doubtful debt” deduction. Basically, if it is doubtful at the end of a year that the amount will be received, you can claim a deduction equal to the doubtful amount. Again, unfortunately, “doubtful” is not defined.
If you claim the doubtful debt deduction in one year, you must add it back into income in the next year. Then, if it’s still doubtful at the end of the next year, you can reclaim the deduction, and the procedure continues. If you ultimately receive the amount, obviously you cannot continue to claim the deduction. But if you don’t receive the amount, you may be able to claim the “bad debt” deduction.
The bad debt deduction allows you to deduct “bad debts” at the end of the relevant year. Again, this term is not defined. But you may be able to claim the deduction if the debtor is insolvent, bankrupt, or, say, moves out of the country and apparently has no intention of paying the amount.
The bad debt deduction does not have to be added back to income in the next year. However, if you end up receiving an amount you claimed as a bad debt in a later year, the amount must be included in income for the year in which you receive it.