July 30, 2018
New WIP Rules Means Tax Adjustment for Professionals
Starting with the March 21, 2017 Federal Budget, the new CRA WIP rules has meant a significant change to the way in which Canadian professionals calculate their taxable income. This change in bill basis accounting will have a significant impact over the short term for many professional businesses and may significantly affect cash flows as taxes increase under the new work in progress rules.
The CRA work in progress rule changes impact how the inventory or work in progress of a professional is taxed.
Professional corporations generally charge their clients or patients for their time. Many of these corporations record the time spent on clients and patients as work in progress, commonly referred to as “WIP.” This WIP is tracked as inventory until it is billed to the client and is usually recorded at the professional’s normal market charge-out rates.
For taxation of WIP, these professional businesses were required to record this WIP at either cost or fair market value. For those businesses that record inventory at its fair market value (bill out rates), they used to be able to elect to exclude this WIP for taxation purposes, effectively eliminating any impact for tax purposes on the recognition of this inventory. This was referred to as “billed-basis accounting” for income tax purposes and has now been repealed.
There is a phase-in of the existing WIP rules over a five year transitional period. Many professional firms and businesses did not even account for WIP, instead relying on these provisions to have the WIP and its deduction for tax purposes effectively cancel each other out.
As a result of these changes to WIP rules, professional businesses will have to take a fresh look at how they will be impacted in not only the transition period of implementing these new CRA work in progress rules, but also evaluate how they account for their inventory on a go-forward basis, as the WIP rules of old no longer apply.
The Manning Elliott blog article posted on July 17, 2017 entitled “WIP Tax Adjustment – Changes to Taxation of Professionals”, discussed the previous WIP rules and the changes as detailed in the March 21, 2017 Federal Budget. Here is a little refresher:
- For taxation years beginning prior to March 21, 2017, incorporated professionals including accountants, lawyers, dentists, medical doctors, veterinarians, and chiropractors, were entitled to deduct their WIP for income tax purposes.
- These CRA work in progress rules allowed a deduction of the WIP, effectively removing the revenue and embedded profit (which had not been billed to a client yet) from taxation until the following year.
- The old WIP rules also allowed the deduction of expenses/costs related to unbilled income to be deducted in the current year. This provided significant advantages to professionals in deferring their taxes to a later taxation year.
For taxation years commencing after March 21, 2017 the rules have been altered to remove the ability of professionals to deduct WIP at year-end for taxation purposes. The legislation (ITA Section 34) has been revised to remove the ability for professionals to exclude this WIP from their taxable income, therefore effectively making all WIP taxable to the professional businesses, even though these fees have not been billed to clients.
Professionals that are providing services on a contingency billing basis will not be subject to this work in progress accounting change in recognition of the difficulty in determining whether a fee will ever be received for services provided.
Updated Transitional Period
The Federal Budget previously provided a relief of a one year phase-in of the new WIP rules. Essentially the WIP in the first year of the application of these rules would be deducted on a 50% basis. Since our last publication, this transitional period has been revised to include additional relief to professional businesses, namely Subsection 10(14.1) of the Income Tax Act has been added to allow for a five year transition, allowing the WIP to be added into income on a 20% basis for each of the tax years starting after March 21, 2017.
The application of the transitional provision to phase in these WIP rules over five years can be outlined as follows:
Active Law Corporation has a December 31 taxation year and it earns $1,000,000 of net income during each of its 2017 to 2022 tax years. Active Law Corporation uses billed basis accounting; therefore their accounting income includes WIP at year-end at fair market value. The amount of WIP at the end of 2016 was Nil. For 2017 to 2022 taxation years the amount of WIP at the end of each year was $250,000.
As a result of the proposed new WIP rules, the computation of taxable income will be as follows:
Note that this transitional relief is only available for professionals that had previously elected to deduct WIP for tax purposes for the last taxation year, beginning before March 22, 2017. This would not be available to professional businesses that did not utilize the billed basis accounting provisions.
In our example, inventory continues to be accounted for using billed basis accounting and is therefore included in the $1,000,000 of income each year. However, for taxation purposes, the value/cost of inventory is deemed to be only 20% in the first year, 40% in the second year, etc. As a result a deduction is required under 10(14.1) to re-value this inventory to the appropriate percentage each year. For the first year this 250,000 of WIP is included in income and then must be revalued to 20% (50,000) for taxation purposes. This results in a deduction of $200,000 in 2018. This deduction is then added back into income in the following year under Section 12 of the Act.
Work In Progress Accounting Issues
How Do Professionals Value WIP?
The previous tax rules took into account the common business and accounting practices that professionals utilized to record their inventory and tried to work within that framework. It recognized that they accounted for their inventory in a manner different from many businesses. Now that the ability to fully deduct WIP at year-end has been eliminated, professionals should reconsider their accounting treatment for this inventory.
The above example assumes that the professional would value WIP at fair market value (“FMV”), but this does not necessarily have to be the case. The valuation of inventory is governed by subsection 10(1) of ITA and section 1801 of the Income Tax Regulations, which requires one of the two methodologies:
- Lower of cost and FMV
- Or simply at FMV
Professionals may continue to value their inventory/WIP at their standard charge-out rates but assuming that the cost of producing WIP is lower than the amounts billed, it could be more tax advantageous to value WIP at the lower of cost and FMV. By valuing WIP at cost, professionals will be able to effectively defer the recognition of their profit margin into income until actual billing.
Issues arise from the fact that determining the “cost” for professionals can be a complicated. CRA has historically provided commentary with regards to how professionals should “cost” their inventory.
In the now archived IT-473R, CRA notes that for taxation purposes cost should include “the cost of direct labour applied to the product/services and the applicable share of overhead expense properly chargeable to production.” CRA has recently indicated that some level of overhead costs needs to be allocated to WIP, but will accept that this methodology may only include variable overhead costs, and not fixed overhead costs.
Thankfully, CRA has also recently confirmed that a partner/sole proprietor’s time contribution is not part of professional’s WIP cost, as they are entitled to the net residual profits of the business. Further, in the past the Courts have interpreted Section 9 of the Income Tax Act to require that a taxpayer’s methodology to account for income should be an accurate picture of its profit for the given year.
Professional businesses will need to grapple with all of these considerations when formulating an appropriate work in progress accounting methodology.
There may be an added complexity to professional firms that choose to track WIP based on charge-out rates and cost basis separately for accounting and tax purposes. This will require annual “conversions” that can be somewhat complicated.
This may become particularly cumbersome where professional businesses operate with both contingency based billings and non-contingency based billings. In those cases, it may be beneficial to have divisional reporting to be able to ensure that appropriate adjustments for tax purposes can be determined.
Some professional businesses had previously neglected to record WIP at year-end as the amount was deductible for tax purposes. While their reporting was technically incorrect they would still arrive at the correct net tax result. These professionals will now be required to track and record their WIP, which may prove to be quite difficult and costly.
Items to Consider
To ensure compliance with the new CRA WIP rules, professional businesses will need to determine their specific reporting requirements. They will also need to address their own internal reporting and accounting functions to determine the best way to not only comply with these new rules, but also efficiently gather the information necessary to do so.
If you would like to discuss these work in progress accounting issues or the new CRA WIP rules, we’d be happy to assist. Our Manning Elliott tax team can provide valuable insight and assistance in understanding these new provisions of the Income Tax Act and can help you develop a strategy for taxation of WIP to address these changes.
The above content is believed to be accurate as of the date of posting. Canadian and US Tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.