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Are You Tax-Ready?

  • December 18, 2017
  • Dennis Tmej and Jin Wen

In the March 22, 2017 Budget, the federal government proposed to eliminate the option to exclude the value of work in progress (WIP) in income for tax purposes for individuals in certain professional occupations, such as lawyers. The proposed tax measures would impact lawyers’ accounting system and tax filing in the coming years. 

Currently lawyers are required to include the value of their WIP at year end in computing their income for tax purposes. However, an election is available to exclude the WIP and have his/her income for tax purposes based on the amount that has actually been billed. In other words, lawyers can defer the tax on the WIP until such time that it is billed while continuing to deduct the expenses associated with that WIP in the year they are incurred.  This results in a mismatch of revenues and expenses for tax purposes and is one of the reasons the federal government is proposing to remove the option to exclude the WIP. 

The changes being proposed require that for the first taxation year that begins after March 21, 2017 (i.e. generally, as of the 2018 taxation year), individuals and partnerships with a December 31 year-end, will no longer be able to exclude the value of WIP in computing their income for tax purposes.

Since a professional’s WIP is considered to be inventory, it will be taxed in accordance with the tax rules applicable to inventory – measured at the lesser of cost and fair market value (FMV). 

Transitional relief is provided to mitigate the effect of these proposed changes to professionals. Specifically, the inclusion of WIP into taxable income will be phased-in over five taxation years. Therefore, for lawyers operating with a calendar year-end, the percentage of WIP required to be included in computing income for tax purposes will be: 0% in 2017, 20% in 2018, 40% in 2019, 60% in 2020, 80% in 2021 and 100% in 2022 and taxation years thereafter. This means lawyers will likely find themselves facing additional taxes payable over the next five taxation years. 

Upon closer review of these proposed rules, the net tax impact of having to include WIP may not be as onerous because the “profit” portion of any unbilled WIP is not required to be included in income for tax purposes.  Consider the following simple example:  Mr. Atticus Finch, a sole practitioner, has WIP that is valued at $20,000 as of December 31, 2017. For simplicity, let’s assume Mr. Finch’s WIP stays at the same level at each year-end and let’s also assume that the cost associated with the WIP is $16,000. The profit on the WIP would therefore, be $4,000.  For the 2017 taxation year, Mr. Finch can defer the entire $20,000 worth of WIP.  For the 2018 taxation year, Mr. Finch will include $3,200 in his income for tax purposes, representing 20% of the cost of the WIP.  For the 2019 – 2022 taxation years, Mr. Finch will continue to include an additional $3,200 of the cost of the WIP in his income for tax purposes until the point the entire $16,000 has been included in income. 

The proposed rules treat the entire WIP as having been billed but tax is only imposed on the profit portion of the WIP. Therefore, the greater the spread between the cost of WIP and its FMV, the greater the amount that can be deferred for tax purposes. The determination of cost and FMV of WIP is therefore, important. Although the proposals do not define FMV or cost of WIP, the Canada Revenue Agency (CRA) has provided some guidance over the years. According to the CRA, the FMV of WIP of a legal practice would be the amount that has been billed to clients, and the cost of WIP is usually limited to salaries and disbursements directly related to providing the service in question. Taxpayers are not required to include a partner or sole proprietor’s time, or fixed or variable overhead expenses such as secretarial and general office expenses in the calculation of the cost of WIP.

A major concern from the legal community over these proposals is that they do not differentiate the WIP under a contingent fee arrangement from the WIP under other fee structures. Lawyers who provide services under a contingent fee agreement do not typically bill their fees until a settlement has been reached perhaps years later.  Therefore, the inclusion of the entire WIP in income for tax purposes under a contingent fee arrangement and the taxes thereon would be particularly punitive considering that no cash has been collected. Fortunately, the CRA has recognized this and subsequently announced that it will not apply the proposed changes to contingent-fee arrangements. Still, the Canadian Bar Association has sought clarification from the Minister of Finance as to what arrangements would be considered contingent fee arrangements because lawyers may have de facto contingent fee arrangement or deferred payment arrangement where the legal fees may not depend entirely on a successful outcome and there are many factors outside the lawyer’s control. 

The proposed tax measures may impact a lawyer’s income for tax purposes in the coming years and will require a determination of the FMV and cost of the year-end WIP. For small and medium practices that have never tracked their WIP in the past, this may mean substantial tax compliance cost. Submissions have been made to the Ministry of Finance requesting a de minimis exception for smaller practices, and guidance on the determination of the cost of WIP. Lawyers should consult with their tax advisors to determine the impact of these proposals to them and the necessary steps to be undertaken to comply with these proposals.

Dennis Tmej is a Chartered Professional Accountant and a tax partner at Grant Thornton LLP in Toronto. Jin Wen is a Chartered Professional Accountant and a senior manager with Grant Thornton LLP’s tax group in Toronto.

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