Professionals' Rough Work-in-Progress Transition

For taxation years that begin on or after March 22, 2017, accountants, dentists, lawyers, physicians, veterinarians, and chiropractors no longer have the option to elect to exclude their year-end work in progress (WIP) from taxable income; consequently, revenue cannot be simply recognized as it is billed. Although the proposed repeal of this section 34 election allows for a two-year transitional period to include previously excluded WIP in taxable income, these changes will still have a significant impact on both the finances and the operations of these professions. Both cost and FMV of WIP will be difficult to determine, and changes to systems will be required.

Paragraph 10(5)(a) requires the inclusion of "work in progress of a business that is a profession" in inventory, overriding generally accepted accounting principles (GAAP) that may otherwise be relied on under section 9. Because WIP is ­required to be included in inventory, and therefore in income for tax purposes, it will be valued at the lower of cost and FMV pursuant to subsection 10(1). Alternatively, it may be valued at FMV pursuant to regulation 1801. Both FMV and cost ­present problems for WIP.

FMV determination is perhaps the worst problem. The ­determination is highly subjective, and it will create many disputes between taxpayers and the CRA. While legal and accounting firms typically track billable hours as an estimate of WIP to be billed to a specific project, there are often significant variances between the accrued WIP and the final billing to the client. Further, depending on the nature of the engagement, professionals may not bill their clients for months or even years after performing the WIP. Consider, for example, a litigation lawyer who works on a contingent-fee basis. Until a case is resolved, he or she will not know how much to bill the client or when the billing will occur. While it would be unreasonable to say that the FMV of the accrued WIP is nil, the determination of the FMV is highly speculative and unreliable. Professionals will face cash flow problems because they will be required to pay tax on WIP allocations well before they bill for the WIP and collect their fees.

The determination of cost is also problematic, although its use to value WIP inventory has the advantage of minimizing the income inclusion as a result of the repeal of the election. The Act and regulations currently provide no guidance on the determination of the cost of WIP for professionals, so significant differences among taxpayers are likely to emerge in respect of the following questions:
  • Is GAAP costing a reasonable basis for calculating WIP? International accounting standard (IAS) 2 provides relevant guidance, but accounting standards for private enterprises (ASPE), which are more likely to be used by the affected taxpayers, contain no similar guidance.

  • How should overhead expenses be allocated to WIP? Professionals will be required to develop a method to allocate direct overhead to projects while separating out general and administrative overhead costs not directly related to production.

  • Should the cost of WIP include an allocation for time incurred by a partner or owner who does not otherwise draw a salary from the company? In professional practices, the owners of the business often dedicate significant time to servicing clients, and they track their WIP accordingly. However, there is no offsetting deduction if the owners' remuneration is paid as a dividend or a partnership distribution.

Finally, given that the costing and valuation of WIP did not previously have an impact on professionals who relied on section 34, many firms do not have systems in place to accurately track either the cost or the FMV of WIP. Many professionals will face a significant compliance burden, and in many cases will have to implement new technological solutions in order to simplify the process. These solutions can be costly and time-consuming to develop; therefore, it is important that professionals start exploring these options now so that they will have solutions and procedures in place before the new rules take effect.

Further information is available in the May 2017 submission to the Department of Finance from the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada.

Nick Korhonen
MNP LLP, Ottawa
Nick.Korhonen@mnp.ca

Canadian Tax Focus
Volume 7, Number 3, August 2017
©2017, Canadian Tax Foundation