Pending income tax issues: December 4, 2001.

• Position: Canada Customs and Revenue Agency

On December 4, 2001, Tax Executives Institute held its annual liaison meeting with officials of the Canada Customs and Revenue Agency on pending income tax issues. Reprinted below is the agenda for the meeting, which was prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney of General Motors of Canada Limited. A full report on the meeting will be published in a future issue of The Tax Executive.

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Tax Executives Institute welcomes the opportunity to present the following comments and questions on pending income tax issues, which will be discussed with representatives of the Canada Customs and Revenue Agency (hereinafter, "CCRA" or "the Agency") during TEI's December 4, 2001, liaison meeting. If you have any questions about the agenda in advance of the meeting, please do not hesitate to call either Alan Wheable, TEI's Vice President for Canadian Affairs, at (416) 982-8003 or David M. Penney, Chair of the Institute's Canadian Income Tax Committee, at (905) 644-3122.

1. Audit Administration

   1. General. At the 2000 liaison meeting, TEI requested CCRA's comments on establishing a single point of contact with final decision-making authority for all audit determinations where various specialists (e.g., Scientific Research & Experimental Development (SR&ED), Tax Avoidance, and International) are involved in the taxpayer's audit. In response, CCRA stated that under the Single-Window Focus:

      The Large File Case Manager (LFCM) is responsible. for managing the compliance relationship with the corporation (and its controlled entities) for all business lines by developing and maintaining open, cooperative and timely communication, and working to address all areas in a speedy and professional manner. The LFCM is a single point of contact for the corporation relating to all audit activities. CCRA added:

      Each team member is responsible for developing and conducting specific audit procedures for their specialty area, establishing priorities and tentative completion dates with the LFCM, and communicating on their progress and findings on pre-established timelines. Requests for information and presentation of audit issues by the specialists are routed through the LFCM.... Ultimately, and as a focal point, proposed adjustments are presented through the LFCM, as the Agency's reassessment position. Operational differences will have been resolved with the local functional managers and, where required, through Headquarters' assistance. CCRA's increasing use of specialists in large-case file audits makes it more difficult for the LFCM to act as a the principal co-ordinator; hence, audit administration issues continue to provoke member concerns. Furthermore, members find that the LFCM does not necessarily act as the main point of contact even where the taxpayer requests that the audits be managed on that basis. We invite CCRA's comments and a discussion of what can be done to ensure that the message gets down to the field.

   2. SR&ED Audits. At the May 2001 Ottawa Conference on SR&ED, CCRA confirmed that the SR&ED Directorate rather than the Audit Directorate will control the review of SR&ED claims. This new administrative process seems at odds with making the LFCM the focal point for all audit decisions. How will CCRA implement the SR&ED claim review process? Will the LFCM retain final authority to resolve SR&ED claims? If not, who will have that authority? If the LFCM retains final audit authority, how will the claim review process be coordinated with the audit?

2. Fines and Penalties

   In many cases, auditors fail to take account of recent jurisprudence. For example, the Supreme Court decision in 65302 British Columbia Ltd. v. The Queen, 99 D.T.C. 5799, addressed the deductibility of fines and penalties, but few auditors seem aware of the decision or follow it unless TEI members bring the case to their attention. We invite CCRA's comments on its process for disseminating information about current jurisprudence to field staff in order to ensure that significant decisions are taken into account in audits that are underway when a case is decided.

3. George William Harris Litigation

   George William Harris, et al., have been waging a relentless challenge in the courts seeking the discovery of information related to CCRA's administration of the advance rulings process. If Harris is successful, confidential taxpayer information may be subject to public disclosure. Has this litigation affected CCRA's current operations? We invite a discussion of CCRA's views of what the effect might be should the Harris group ultimately prevail in its quest.

4. Installment Interest--Corporations

   In discussions with a Taxation Centre, members have been advised that the methodology for calculating installment interest on assessments and reassessments has been changed effective for taxation years ending in 2000 or later. For reassessments prior to 2000, CCRA will employ the old methodology only at the taxpayer's request. This change in the interpretation of the interest calculations has been effected without broad communication to taxpayers.

   Subsection 157(1) of the Income Tax Act (hereinafter "the Act") provides that tax installments must be made in an amount equal to an amount that is the least of:

1. The current year tax liability;

2. The preceding year tax liability; or

3. One twelfth of the 2nd preceding year's tax liability for each of the first two months of the year, and, for each of the next ten installments, one tenth of the difference between the preceding year's tax liability and the first two months' installment payments.

   Under the old methodology for installment interest, CCRA computed the required installments and related interest under all three methods and used the method that provided the least amount of installment interest. CCRA now interprets subsection 161(4.1} to mean that when the current year tax liability provides for the minimum total tax installment, the taxpayer must use option one in determining its monthly installments. To illustrate the results of applying the different methodologies, assume the following tax liabilities for each of the respective years for a calendar-year taxpayer:

   1998 $0 1999 $100 2000 $99 Under the old methodology, a taxpayer could pay the following installments (based on option three above) on account of its year 2000 tax liability:

   January and February $0 (1/12 of the 2nd preceding year's tax liability of $0) March to December $10 ($100-0)/10 The option three method is practical because the taxpayer cannot reasonably estimate its year 2000 tax liability by January 2000, nor would the taxpayer have finalized its estimate of its 1999 tax liability (which is usually prepared in time for the February make-up payment). As the year 2000 progresses and the 2000 tax liability approximates that of 1999, the taxpayer could switch methods and use option two (the 1999 tax liability) to bring certainty to its installments.

   Under the new methodology, CCRA has determined that subsection 161(4.1) limits the taxpayer to the installment methodology that requires the least total amount of tax installments. On the assumed facts, option one (current year tax) requires the payment of only $99 of tax and therefore the taxpayer is not entitled to use options two or three (which would require the payment of $100 of tax installments). As a result, CCRA will compute required monthly installments of $8.25. Since the taxpayer did not make any installments during months of January and February, the taxpayer would not have paid the required installments and installment interest will be calculated. Even though the taxpayer would correspondingly overpay its installments (vis-a-vis CCRA's calculations) for the months of March to December, there is insufficient time for the taxpayer to catch up on its installments. Hence, the taxpayer will be assessed installment interest even though it would have paid the minimum installments required under subparagraph 157(1)(a)(iii). Would CCRA please confirm the member's understanding and explain its revised interpretation of subsection 161(4.1)? Equally important, this is a fundamental change that affects the installment payments of every corporate taxpayer. TEI urges CCRA to issue a public announcement of the change as soon as possible.

5. Provisions of Service

   Where payments are received in advance of the taxable period where services will be rendered or goods delivered, paragraph 12(1)(a) of the Act requires an income inclusion in the period when the payment is received. Unless the taxpayer can "reasonably anticipate" that goods or services will be provided after year-end, no reserve can be established under paragraph 20(1)(m) by a vendor. To avail itself of the reserve provision of paragraph 20(1)(m), a taxpayer generally must demonstrate that there is a contractual obligation to provide the goods or services.

   Under most software maintenance agreements, the taxpayer can usually

   demonstrate that software code fixes, updates, or upgrades will be provided; the only question is the timing of the service or upgrade. Similarly, most equipment maintenance agreements include a clause requiring the vendor to provide preventive or routine maintenance on a predetermined schedule in order to ensure that the customer's business operations continue in an uninterrupted fashion. Preventive maintenance schedules for equipment are generally based on the passage of time, level of usage, historical failure rates, or some combination of these variables, whereas most software maintenance agreements generally do not provide for scheduled releases of upgrades, updates, or code fixes. Rather, these services are provided on an "as required basis."

   For both hardware and software agreements, a vendor receiving payment for an entire year of services near the end of its tax year must include the entire amount in income in the year of receipt. In addition, since few...