Unearned Revenue Reserve: Prepayments, Gift Cards, Store Credits

Is a customer prepayment income when I receive it or when I deliver?

A Canadian business generally reports a customer's advance payment as income in the year it receives the money, not the year it delivers. Paragraph 12(1)(a) of the Income Tax Act includes any amount received in the course of a business for services not rendered or goods not delivered before year-end. A reserve under paragraph 20(1)(m) can then take out the part still owed, and the next year's return adds it back.

Business books may hold a prepayment as a liability called unearned revenue (also deferred revenue or customer deposits) until delivery. Accounting standards decide how the books show it, and this page does not cover that. The tax rule is different: it starts at receipt, and the deferral comes only from a reserve claimed on the return and tracked each year.

The case is not simple when:

• The money may be refundable, part of it may be a security deposit, or you may keep it whether or not you deliver.
• One payment covers several years of service.
• A gift card or store-credit program leaves many small balances at year-end.
• The business sells food, drink or transportation, which have their own cap.
• An earlier return claimed a reserve that was never added back, or never claimed one at all.
• The business is a corporation, which tracks reserves on a schedule filed each year.

What to gather: amounts received by customer and date, delivery or use dates and what remains at year-end, a gift-card and store-credit report with issue dates, the contract's refund terms, and last year's reserve with the schedule that supports it.

What is the unearned revenue reserve, and can my Canadian business claim one?

The unearned revenue reserve is a deduction for a reasonable amount of goods still to be delivered, services still to be rendered, or advance rent still to be earned after year-end. Paragraph 20(1)(m) allows it only for amounts described in paragraph 12(1)(a) that were included in income from a business, in the year or an earlier year. A sole proprietor, partnership or corporation carrying on a business may claim it unless an exclusion below applies.

Paragraph 12(1)(e) adds the amount deducted for the previous year back to income. The reserve therefore defers income; it does not remove it. Claiming it is a choice, and the add-back matches the amount actually deducted.

Which prepayments qualify: goods not delivered, services not rendered, rent paid in advance?

A prepayment qualifies when the business still has something to deliver, render or let after year-end. Paragraph 20(1)(m) lists four cases.

Two situations do not qualify, and a third may not:

• A payment kept whatever happens, or work done at or soon after receipt. The CRA's archived technical news says section 9 (the general profit rule) normally applies instead of paragraph 12(1)(a) when the work is substantially done at or soon after receipt, or when the contract lets the business keep the payment whether or not it ever delivers. The whole amount is then income when received, with no reserve. The CRA treats that choice as case by case, and its later Technical News No. 32 allows that an amount taxed under section 9 could also fit paragraph 12(1)(a). The contract and the work still owed decide, so get a non-refundable payment classified before you rely on either answer.
• Warranties, guarantees, indemnities, insurance and reclamation obligations. Subsection 20(7) bars this reserve for them.
• Prepaid rent on a rental property. Paragraph 20(1)(m) applies only to income from a business, and whether rent from a rental property is business income depends on the facts. Start with how rental income is taxed.

Can I claim outstanding store credits and gift cards at year-end?

A business reports gift-card sales as business income on the day of sale and may deduct a reserve for the cards it predicts will be redeemed after year-end. The CRA's Guide T4002 and sources of income page say calculating the reserve is a choice and that it is added back to business income the following year. The CRA counts cards, vouchers, receipts and tickets with a money value as gift cards or certificates. GST/HST on gift cards runs on a different timeline: see GST/HST on deposits, gift certificates and unpaid invoices.

Three points decide the amount:

• The reserve is the amount predicted to be redeemed, not the whole balance. Cards a business does not expect to be redeemed add nothing to the reserve.
• A store credit the customer paid for is the closest fit to a gift card. The CRA pages name gift cards and certificates, not store credits, so confirm the fit.
• A credit issued instead of a refund on a returned sale is a different question. It reverses part of a sale rather than selling a card, and the CRA's gift-card pages do not say how it is reserved. Get it reviewed before claiming a reserve on it.

Keep a year-end report of every card and credit by issue date, with past redemption history. It supports the prediction.

How much reserve is reasonable, and what happens to it the next year?

The Act sets no percentage: paragraph 20(1)(m) allows "a reasonable amount". Two archived CRA documents, no longer updated, show how the CRA has read that phrase.

• Where no special cap applies, Interpretation Bulletin IT-154R (1988) says a reasonable reserve is normally the gross proceeds received for goods or services still owed after year-end. It does not require an estimate of profit and is not limited to the cost of delivering.
• Technical News No. 32 says the amount depends on the business's past experience and the services it reasonably expects to provide after year-end, and should be reduced where its obligations are contingent.

For gift cards, the CRA's measure is the amount predicted to be redeemed after year-end.

Each year-end repeats the same steps: add back last year's reserve, then deduct a new reserve for what is still owed. By its wording, paragraph 20(1)(m) looks at amounts included in income for the year or a previous year, so a prepayment that covers several years can carry a reserve each year. The CRA pages cited here do not address multi-year prepayments, so confirm before relying on it. Food, drink and transportation are the exception below. The Example section traces one pack year by year.

Do the special rules for food, drink and transportation apply to me?

The special cap in subsection 20(6) applies only when the prepayment is for food, drink or transportation. It replaces the normal reserve with an amount not above the total included in that year's income, received or receivable in the year, for food or drink not delivered, or transportation not provided, before year-end.

The cap looks only at the year's own receipts. A prepayment received in an earlier year therefore does not support a reserve in a later year, so the deferral runs about one year. A meal plan or a prepaid fare is covered. A catering deposit may be covered for the food and drink part; any service part follows the normal rule. A gift card good only for a meal or a fare may be covered too; the CRA's gift-card page does not say. A yoga studio or a contractor is not affected.

Does cash or accrual change the answer, and who cannot claim the reserve?

The reserve is built for businesses on the accrual basis (income counted when earned, not when cash moves). The CRA's accounting methods page says farmers, fishers and self-employed commission agents may use the cash or accrual method, and all other self-employment income must use accrual. For corporations and partnerships, see cash or accrual accounting in Canada.

Is a customer deposit or retainer taxable income when I receive it?

A deposit paid toward the price of goods or services still to come follows the same rule: income when received, with a reserve for the part still owed. A deposit with a different purpose needs its own look.

• A deposit toward the price (a contract deposit): income under paragraph 12(1)(a) with a reserve while work remains.
• A retainer held in a trust account for the customer: whether it is yet the business's money, and so "received" under paragraph 12(1)(a), depends on the terms and any professional rules. The Act and the CRA pages cited here do not settle it. Get it reviewed before treating it either way.
• A deposit repayable when an article in which goods were delivered comes back (a container, for example): paragraph 12(1)(a)(ii) includes it, and subparagraph 20(1)(m)(iv) allows a reserve for the expected repayment. Bottles are excluded.
• A deposit you repay because the customer cancels: it was income when received. Paragraph 20(1)(m.2) allows a deduction for the repayment in the year you make it, so a repayment after year-end falls in the later year.
• A refundable security deposit held against damage or loss: paragraphs 12(1)(a) and 20(1)(m) do not say how it is treated. The contract and what happens to the deposit matter. Do not assume either answer.
• A deposit or fee you keep whether or not you deliver: usually taxed in full when received, as in the section 9 case above. Whether a non-refundable deposit is kept in any event, and whether it also fits paragraph 12(1)(a), depends on the contract and the facts.

For a professional's unbilled work, see December sales paid in January. For unpaid invoices and doubtful debts, see writing off unpaid customer invoices.

How is the reserve tracked from year to year on a corporation's return?

A corporation shows each reserve's balance on Schedule 13, filed with the T2, and carries the change onto Schedule 1. A book liability for unearned revenue and the tax reserve are two separate numbers to reconcile. If the books already defer the revenue, make sure the book deferral and the tax reserve do not both apply to the same dollars: Schedule 1 has separate lines for reserves from the financial statements (126 and 414), and which balances go where is settled with the year-end entries. The full reconciliation is in why book profit differs from T2 taxable income.

Each year's opening balance should equal the previous year's closing balance. A gap usually means a reserve was missed or dropped. A sole proprietor adds back last year's reserve on line 8290 in Part 3C of Form T2125 and, following the CRA's Guide T4002 on allowable reserves under other expenses, deducts this year's reserve on line 9270 in Part 4, specified as a reserve. For the year-end entries around it, see the year-end close checklist for a corporation and year-end financial statements and GIFI.

What if earlier years missed the reserve or the add-back?

Paragraph 12(1)(e) adds a reserve deducted last year back to income this year, so a return that left the add-back out understated that year's income. A year that never claimed a reserve it could have claimed may have reported too much income, but a late reserve only defers income, because the next year adds it back. The years are linked, so look at them together from the first large prepayment. For how far back a filed year can be changed, see how far back the CRA can reassess.

Does my province change the answer?

The reserve rule on this page is federal. The CRA administers provincial and territorial corporation tax on the T2 for every province and territory except Quebec and Alberta.

• Alberta: a corporation with a permanent establishment there files an Alberta return unless exempt. Alberta says its taxable-income calculation parallels the federal one, while discretionary deductions can differ between the two returns.
• Quebec: Quebec runs its own corporate tax. Check how Revenu Québec treats the reserve before relying on this page.

Example

All amounts are in Canadian dollars and are illustrative.

A yoga studio sells class packs

A Toronto yoga studio on the accrual basis sells C$40,000 of class packs in December. By year-end, C$15,000 of classes have been taken and C$25,000 remain.

• Year one: the studio includes the C$40,000 received and deducts a C$25,000 reserve for classes still to give, so income from the packs is C$15,000. If its history shows some packs expire unused, a reasonable reserve is lower.
• Year two: it adds back the C$25,000. If C$20,000 of classes are given and C$5,000 remain, it deducts a new C$5,000 reserve. Income from the packs is C$20,000: the C$25,000 added back, less the C$5,000 new reserve.

A gift shop holds gift cards and store credit

A Vancouver gift shop sold gift cards and prepaid store credit that customers paid for. C$12,000 is unused at year-end. The sales were income when sold. From its redemption history, the shop expects C$9,000 to be redeemed after year-end and C$3,000 not to be. Treating the paid store credit like a gift card, it may deduct a reserve for the C$9,000 and adds that amount back to income the next year. A C$500 credit given to a customer instead of a refund on a return is a separate question and is not part of this reserve.

A renovation contractor takes a deposit

A Hamilton renovation contractor receives a C$30,000 deposit in November for a job that starts in March. No work is done by year-end. If the deposit is a payment toward the contract price, it is included in income and the contractor may deduct a reserve for the services still to be rendered; the reserve is added back the next year, when the work begins. If the contract treats part of it, say C$5,000, as a refundable security deposit, that part is a different question that the Act and the CRA pages cited here do not settle. The contractor books it separately and gets it reviewed before treating it either way.

Different for you?

• Your year-end carries large prepayments, a gift-card program or store-credit balances: deciding which balances qualify, how large a reserve is reasonable and how the books and return carry it each year takes professional judgment. See bookkeeping help or corporate tax help.
• Earlier returns never claimed a reserve, or never added one back: the income of more than one year is affected. See corporate tax help, the guide on catching up overdue books and the year-end close checklist.
• You sell food, drink or transportation: the cap in subsection 20(6) limits the reserve. Raise it with corporate tax help.
• You farm or fish and use the cash method: the reserve is not available. See cash or accrual accounting in Canada.
• Part of a deposit may be refundable, or a retainer sits in a trust account: the contract and the facts decide. Raise it with corporate tax help.
• Customers have not paid, or you wrote off an invoice: see writing off unpaid customer invoices.
• You need to know when GST/HST is due on a deposit or gift card: see the sales tax guide on deposits.
• You did the work in December and the client paid in January: see December sales paid in January.
• You pay another person to take over prepaid customer obligations: a joint written election under subsections 20(24) and 20(25) may allow a deduction for a reasonable payment, and you then stop claiming a reserve for those obligations. The recipient includes the payment as a paragraph 12(1)(a) amount if it receives it in the course of business. Notify the Minister in writing by the earlier of the two parties' return filing deadlines for the year of payment. Raise it with corporate tax help.
• You collect prepaid rent on a property you own: see how rental income is taxed.
• Your corporation is in Quebec or Alberta: a separate provincial return applies; start with corporate tax help.
• The same deposit is taken by a US business: see the US treatment of customer prepayments and deposits.