RESERVE FOR UNEARNED INCOME
If you carry on a business, amounts that you receive in advance of providing the goods or services (depending on your business) are included in income, even though they are not yet “earned”. In particular, if you receive an amount in one year on account of goods or services provided in a later year, you must nonetheless include the amount in the year of receipt. A similar rule applies to a landlord who receives advance rent in one year on account of future years.
Fortunately, the Income Tax Act generally allows you a "reserve", to defer the recognition of the amount until the year it is actually “earned” (e.g. when you provide the goods or services). The reserve can be deducted in the year of receipt. It is “added back” to income the following year. If the goods or services are provided in that following year, the add-back is permanent. If the goods or services are not yet provided in that year, the reserve can be claimed again, and the process continues until the goods or services are provided.
In the course of your business, you receive $60,000 in December 2019, for services to be rendered in each of 2020 and 2021 ($30,000 worth of services for each year).
For 2019, you must report $60,000 of income for tax purposes, but can claim the offsetting reserve of $60,000, for a net inclusion of nil.
For 2020, you add back $60,000, but deduct a reserve of $30,000 on account of the services to be rendered in 2021. Net inclusion = $30,000.
In 2021, you add back the $30,000 reserve claimed last year, with no further reserve. Net inclusion = $30,000.
The reserve is optional, so some flexibility is allowed. For example, you might choose to claim no reserve (or less than the maximum reserve) if you have loss carry-forwards to offset the resulting income, or if your tax bracket for the year of receipt is lower than your anticipated tax bracket for the following year.