Taxes and holdbacks in Canada

Tax touches a contractor's finances at every level: income tax on profits, GST/HST and provincial sales taxes on billings and purchases, payroll deductions held in trust for the government, and special rules for the holdback that owners withhold. Holdback itself is not a tax, but its timing drives when income and sales tax become payable, and holdback money is often held in trust under provincial construction legislation. This lesson explains how these rules interact for a general contractor. Tax law changes often and depends on each firm's facts; contractors should work with an accountant who specializes in construction.

Income tax on long-term contracts

Canadian income tax starts from profit computed under well-accepted business principles, which for most contractors means accrual accounting, then adjusts it as the Income Tax Act requires. For long-term contracts, the Canada Revenue Agency has long accepted the percentage-of-completion approach. Its archived Interpretation Bulletin IT-92R2, Income of Contractors, which remains a widely used reference, also allowed a completion method for contracts that can reasonably be expected to be completed within two years of starting, provided it is applied consistently to all such contracts. Under that method, the profit on a short-term contract is reported in the year the work is completed. Because the bulletin is archived, contractors should confirm current CRA practice with an adviser.

Even under the percentage-of-completion approach, tax results can differ from the financial statements. Reserves, such as provisions for future losses, are generally deductible only where the Act specifically allows them, so a loss provision recognized in the financial statements may not be deductible until the loss is incurred. Holdbacks have their own rules, explained below.

# Timing of taxable profit: percentage of completion vs completion method
# for an 18-month contract expected to finish within two years (illustrative)
price, cost = 4_800_000, 4_416_000
spend = {"Year 1": 2_650_000, "Year 2": 1_766_000}
cum = 0
for yr, c in spend.items():
    cum += c
    poc_profit = (price - cost) * c / cost
    completion = (price - cost) if cum == cost else 0
    print(f"{yr}: percentage of completion {poc_profit:>9,.0f}   completion method {completion:>9,.0f}")
rate = 0.122   # small business combined rate, illustrative (Ontario)
print(f"Tax deferred in year 1 by the completion method: {rate * (price - cost) * 2_650_000 / cost:,.0f}")

Year 1: percentage of completion   230,435   completion method         0
Year 2: percentage of completion   153,565   completion method   384,000
Tax deferred in year 1 by the completion method: 28,113

The total taxable profit is the same; only the timing differs. Deferring tax is valuable because it keeps cash in the business, but the deferred tax still has to be paid, and the financial statements record a deferred tax liability for it. Sureties look at the financial statements, not the tax return, so a contractor's tax strategy does not change its bonding capacity directly; it changes its cash.

Corporate income tax rates and structure

Most private Canadian contractors are Canadian-controlled private corporations. Active business income up to the small business limit, $500,000 federally, is taxed at a low combined rate (federal 9 % plus the provincial small business rate, for example about 12.2 % combined in Ontario); income above the limit is taxed at the general rate, about 26.5 % combined in Ontario. The small business limit is reduced for corporations with large taxable capital or passive investment income. Owners then pay personal tax on salaries and dividends. The choice between paying owners salary, bonus or dividends, and between keeping profits in the company or paying them out, affects both tax and bonding capacity (Lesson 9).

Holdback: what it is and why it matters

Under provincial construction and lien legislation, owners and contractors must withhold a holdback, usually 10 % of the value of work done, from each payment down the contracting chain. The holdback protects lien claimants: if the contractor fails to pay a subcontractor, the owner's liability is generally limited to the holdback it should have retained. In Ontario, holdback must now be released on an annual or phased basis on longer projects as well as at substantial completion, once the lien period expires (CON-310 Lesson 11 covers the release rules). For the contractor, holdback is a large and slow receivable, and often the largest single amount owed to it on a finished job.

# Cost of carrying holdback for Kestrel (illustrative)
holdback_receivable = 2_700_000
holdback_payable = 2_100_000
net_carried = holdback_receivable - holdback_payable
rate = 0.0625
print(f"Net holdback financed by Kestrel: {net_carried:,}")
print(f"Annual financing cost at {rate:.2%}: {net_carried * rate:,.0f}")
avg_months = 7      # average time from billing to release
print(f"Gross holdback billed per year at 10 %: {0.10 * 58_400_000:,.0f}; "
      f"average months outstanding {avg_months}")

Net holdback financed by Kestrel: 600,000
Annual financing cost at 6.25%: 37,500
Gross holdback billed per year at 10 %: 5,840,000; average months outstanding 7

Kestrel passes most of the holdback down to its subcontractors, so it carries only the difference, about $600,000, plus the holdback on its self-performed work and markup. A specialty contractor that self-performs most of its work carries much more of its holdback itself.

Income tax on holdbacks

Holdbacks receive special treatment in Canadian income tax. Under the long-standing CRA approach described in IT-92R2, the aggregate holdbacks on a contract become receivable, and must be included in income, at the later of the date of the architect's or engineer's final certificate of completion and the date the lien period expires. Until then, many contractors exclude holdbacks receivable from income; the deferral must be applied consistently from year to year. On the other side, holdbacks the contractor withholds from its subcontractors are generally not deductible until they become payable, for example when the subcontractor's work is certified complete and the lien period has expired. Because the receivable and payable sides move at different times, the net effect is a deferral of the contractor's margin and self-performed work in the holdback.

GST/HST and provincial sales taxes

Contractors register for GST/HST and charge it on their progress billings at the rate for the province where the work is done: 5 % GST, or HST at 13 % in Ontario and 15 % in the Atlantic HST provinces, with Quebec charging QST alongside GST. They claim input tax credits (ITCs) for the GST/HST paid on their purchases and subcontracts. The timing rule that matters most for holdback is in subsection 168(7) of the Excise Tax Act: where a payment is subject to a statutory holdback, GST/HST on the holdback becomes payable only when the holdback is required to be released, not when the progress claim is issued. Contractors who collect the tax earlier must remit it in the period they collect it. On the purchasing side, the contractor can claim ITCs on subcontractor holdback when it is paid or becomes payable. In British Columbia, Saskatchewan and Manitoba, which levy separate provincial sales taxes, contractors generally pay PST on materials they incorporate into real property, as CON-300 Lesson 9 explained.

Payroll remittances and trust funds

Employers deduct income tax, CPP and EI contributions from employees' wages and hold them in trust for the Crown until remitted, along with the employer's share. GST/HST collected is also held in trust. If a corporation fails to remit, its directors can be held personally liable under the Income Tax Act (section 227.1) and the Excise Tax Act (section 323), subject to a due diligence defence. A struggling contractor that uses unremitted payroll deductions or HST to pay suppliers is borrowing from the government on the directors' personal credit. Unremitted source deductions are also deemed trusts that can rank ahead of a bank's security, which is why banks deduct them from the borrowing base (Lesson 9).

Construction trust funds

In several provinces, construction legislation also impresses a trust on money received by owners, contractors and subcontractors for a project. In Ontario, for example, amounts received by a contractor on account of the contract price are held in trust for the subcontractors and others who supplied services or materials to the project, until those parties are paid. Using project funds to pay overhead or other projects' debts while subcontractors on the trust project remain unpaid can be a breach of trust, and directors and officers who assent to it can be held personally liable. The trust rules have accounting consequences: contractors should be able to trace receipts to the subcontractors and suppliers on each job and should not treat cash from one project as freely available for another. CON-220 discusses the legal details.

Managing holdback