Income Reporting Conflicts 

FROM: JUL-AUG 2008 ISSUE | BY J. THOMAS McCALLUM

Income reporting conflicts sometime arise for what I call “shadow” taxpayers: individuals who are the controlling shareholder of a private corporation. The corporation is often merely an extension of that person; hence the description – shadow. One such potential for conflict flows out of the fact that individuals generally report income on a cash basis, whereas corporations follow the accrual method. This timing difference sets up the possibility of a tax advantage in that expenses accrued by the corporation as payable to the individual will not be income to the individual until paid.

To prevent an individual controlling shareholder from gaining an unreasonable deferral in reporting income, the Income Tax Act contains provisions which resolve this possibility. One example, and the one most familiar to many CGAs, is the requirement under subsection 78(4) regarding salaries and similar remuneration. When the corporation has accrued these in its expenses, they are only deductible if actually paid within 180 days of the corporation’s taxation year end. A failure to do so results in the salary or wage not being deductible until it is paid.

Under this rule, the best deferral which can be gained is one taxation year, and only if the corporation’s year end is not before July 4. That long a deferral isn’t quite true because withholding taxes are required on the salary or wages when paid, so the tax payment deferral is really six months plus a few days after the payroll withholding remittance is due.

For the purposes of this 180-day rule, salary or wages do not include reasonable vacation or holiday pay, nor amounts under a salary deferral arrangement. The latter are excused because they are subject to another set of rules. Retiring allowances and superannuation or pension benefits are also included within the rule.

A second, and lesser known example, applies to any outlays or expenses accrued by a corporation and which are due to a non-arm’s length person. There is a much more generous rule at subsection 78(1) than that for salary or wages. The accrued amount can stand as a deductible item to the corporation in the year accrued, but if it is still unpaid at the end of the second taxation year following the year it was accrued, it becomes income to the corporation in the next taxation year. In essence, the outlay or expense is reversed. This is known as the three successive balance sheet rule.

A primary example of this rule is amounts owing to the non-arm’s length individual for rent on the business premises. He or she reports that income on a cash basis, whereas the corporation follows the accrual method. If not for the above rule, the income deferral would be unlimited.

As noted in Interpretation Bulletin 109R2, Unpaid Amounts, once reversed, there is no provision in the Act allowing this amount to be claimed as an expense if it is subsequently paid. The Act provides for an alternative to the reversal of the outlay or expense. A joint election (Form T2047) can be made by the corporation and the individual, under which the individual includes the otherwise unpaid amount as income.

This joint election is due not later than the day the corporation’s tax return is due for that third successive taxation year. Late elections are permitted, although there isa fairly substantial late filing penalty: the corporation needs to include 25 per cent of the otherwise unpaid amount in its income; this is in addition to the 100 per cent included in the individual’s income.

A somewhat strange thing occurs where there would have been a withholding tax required on the amount when paid. The corporation must remit that tax, but the individual is not credited with the withholding tax until the income amount is actually paid. As the amount under the election is deemed paid on the first day of the third taxation year, the corporation is required to send it with its usual remittance for that month.

These provisions are but two of the many in the Act recognizing there are two separate taxpayers, but really only one economic unit, which needs to be addressed as a whole. Anything less would give us a much simpler Act, but it wouldn’t be fair.

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