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:
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.
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
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.
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.
MNP LLP, Ottawa