On September 8, 2017, the Department of Finance re-released the March 22, 2017 draft legislative proposals as they affect billed-based accounting for professionals.
The March 22, 2017 Budget proposed to eliminate the election to exclude unbilled work-in-progress (“WIP”) and to bring those amounts into income over a two-year transitional period. The Department of Finance announced that the measures were targeted to undo a tax advantage perceived to be enjoyed by a limited group of professionals. On September 8, 2017, the Department of Finance re-released the draft legislative proposals which would extend the coming-into-force period to five years.
All professionals are required to include their WIP in income at the end of a taxation year. The amounts that are to be included are those that “can reasonably be expected to become receivable after the end of the year.” Historically, subsection 34(a) permitted designated professionals, listed as accountants, dentists, lawyers, medical doctors, veterinarians or chiropractors, to elect to exclude their WIP from income, resulting in a modified accrual method of accounting.
The proposed repeal of the election results in an acceleration of the tax due on unbilled fees. Proposed subsection 10(14.1) provides for a five-year year transition period that adds to income 20, 40, 60, 80 and 100 per cent of “the cost and fair market value” of a professional’s WIP in the first, second, third, fourth and fifth taxation years, respectively, that begin after March 21, 2017. This transitional relief is only available to professionals who elected to exclude WIP in years beginning prior to March 22, 2017.
What is the amount that “can reasonably be expected to become receivable after the end of the year”? The guidance in the Minister’s publications and the limited jurisprudence is unclear.
In Interpretation Bulletin IT-457R—Election by Professionals to Exclude Work in Progress from Income, the Minister recognized that “work in progress” is not defined in the Income Tax Act and must be “given its ordinary meaning which it has in business usage, i.e. partly finished goods or services which are in the process of completion and have not reached the stage where the taxpayer is required to include an amount in income pursuant to paragraph 12(1)(b).” According to the Bulletin, which is not binding on the Minister, the amount “will be determined on the basis of the expenses incurred that relate to services performed for which an amount has not become receivable or on the basis of what the billing for those same services would have been (including a profit element) if it had been rendered, depending on the method regularly followed in valuing this work in accordance with allowable inventory valuation principles...”
In CRA Views, September 1991-96—Inventory valuation of work-in-progress, the Minister confirmed the valuation methodology set out in the March 17, 1981 version of Interpretation Bulletin IT-473, which stated:
In the case of inventories of work-in-progress...cost means the laid-down cost of materials plus the cost of direct labour applied to the product and the applicable share of overhead expense properly chargeable to production. Either direct costing, which allocates variable overheads to inventory or absorption costing, which allocates both variable and fixed overheads to inventory will be accepted by the Department as a method of costing inventory, but if overhead is included in inventory on an acceptable basis for financial statement purposes, the method of valuation used for tax purposes must not be inconsistent with the method used for financial statement purposes. Prime costing, a method in which no overhead is allocated to inventory, is not accepted by the Department as a method of costing inventory.
In Morsher (AA) v. Minister of National Revenue, [1992] 2 C.T.C. 2534 the Tax Court considered sections 10 and 34 in assessing the deductibility of interest expenses incurred by a lawyer to finance his WIP and noted:
there appears to be some choice as to valuation of work in progress where the election to exclude has not been undertaken by the taxpayer. In other words, the amount to be included in income is based on either: (a) the amount of expense that relates to services to be performed for which an amount has not become receivable, or (b) the amount that would have been billed for those services, including some profit element, if the bill had been rendered.
The Court commented that the “net realizable value appears to include partners’ time, profit margins, and other elements of overhead that can reasonably be expected to be recovered on billing the specific unbilled work done before year-end.”
In CDSL Canada Ltd. v. Her Majesty the Queen, 2008 FCA 400, the Federal Court of Appeal considered whether subsection 10(1) of the Act would apply to permit a non-professional taxpayer to compute income in a manner inconsistent with generally accepted accounting principles. The Federal Court of Appeal confirmed that subsection 10(1) of the Act is mandatory and that inventory, including WIP, is valued at the lower of cost or fair market value, regardless of inconsistency with generally accepted accounting principles.
Notwithstanding the foregoing, on the Canada Revenue Agency’s website, under CRA 2017 Budget News, Billed-basis Accounting,[1] the Minister advised that the proposed amendments were not expected to apply to tax unbilled amounts under contingency fee arrangements:
Under the terms of a contingency fee arrangement, all or a portion of a designated professional’s fees may only become known and billable at some time after the taxation year in which the professional provided services under the arrangement (e.g., where, under the terms of a written contingency fee agreement between a personal injury lawyer and a client, legal fees are only billable by the lawyer on a periodic basis as amounts are received by the client under a negotiated settlement or a court judgment). Until such time, there is often no liability on the professional’s client to pay any fee; consequently, no amount is receivable by the professional until the right to collect the amount is established. Under these circumstances, for purposes of determining the value of the professional’s work in progress at the end of the year, no amount would normally be recognized. As a result, the proposed change to eliminate the ability of designated professionals to elect to use billed-basis accounting is not expected to have any impact on these types of contingency fee arrangements where the terms and conditions of such arrangements are bona fide.
If, as the foregoing suggests, the relevant factor is whether or not the right to collect the amount is established, it is unclear how any unbilled time could be included in income or what principles the Minister will apply to determine the reasonability of the amounts collectible after the end of any given taxation year.
The complexity of the valuation of work in process is not new. In both 1971 and 1981, the difficulties in valuing WIP were specifically considered and the resulting legislation continued to permit professionals to defer the inclusion of WIP in income until the professional chose to do so. For a thorough analysis of the complexities and uncertainty occasioned by the proposed amendments, see the May 31, 2017 Submission to Finance Canada made by the Joint Committee on Taxation of The Canadian Bar association and Chartered Professional Accountants of Canada and the June 1, 2017 Submission of the Canadian Bar Association.[2]
It remains to be seen how these complexities will be addressed or what if any compliance programs designed to review professionals’ valuation methodologies will be adopted by the Minister.
Professionals will need to ensure that that careful thought is given to the value of unbilled fees at the end of every year, with specific regard to the expenses related to those fees. To benefit from the transitional rules, professionals will need to ensure that an election to exclude WIP is filed for the last taxation year that began before March 21, 2017.
About the author
Leigh Somerville Taylor is a tax litigator in North York, Ontario.