Budget 2017 eliminated an important tax deferral advantage for professionals by denying their ability to use “billed-basis accounting” for reporting their income for tax years starting after March 21, 2017. The Department of Finance’s reference to billed-basis accounting created some confusion, however. The change was in fact directed at how professionals recognize their WIP rather than the amounts they bill. (See sections 34 and subsections 10(14) and (14.1) of the Income Tax Act (ITA). Also, a submission made by the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada includes a more detailed discussion of the rules.)\nWhen looking at direct costs incurred by professionals, some costs incurred (e.g. salaries, employee benefits) would relate to services that are billed during the year and some to services that would be billed in the future. Where the designated professional made an election (under ITA section 34), they could fully deduct these costs, even though some of them related to services that had not yet been billed.\nFor this rule, designated professionals are defined as accountants, lawyers, dentists, doctors, veterinarians and chiropractors. In this article, we refer to including an amount related to WIP in income, but it’s important to remember that the increase in income is actually due to the deferral of costs incurred during the year as inventory for tax purposes.\nBecause professionals didn’t have to recognize their WIP when computing business income, the tax rules did not require them to determine an amount for tax purposes. But now, for tax years starting after March 21, 2017, designated professionals and professional corporations must effectively include an amount for WIP at the year-end in business income for tax purposes. \nSo how is the amount of WIP computed? The tax rules consider the WIP of a professional business as its inventory, which is recorded at year-end at cost or its fair market value (FMV), whichever is less. It’s also possible to elect to record WIP at FMV. At year-end, the FMV of WIP is the amount that the professional can reasonably expect to bill in a later tax year. Most professionals would choose to record WIP at the lower of cost and FMV because that generally results in the lowest addition to business income.\nThe tax rules don’t define WIP, and there are some uncertainties in determining the carrying amount of WIP for professional service providers. CPA Canada and other groups have discussed issues around WIP with the Canada Revenue Agency (CRA), including whether previous guidance remains valid. \nSome questions answered\nThe CRA delivered some clarifications in a letter to CPA Canada, also published as an income tax ruling:\n\n The CRA reiterated that the basic principles of Canderel v. the Queen ( 1 SCR 147) would apply in computing WIP, and that whatever method is chosen, it should result in an accurate picture of profit for the given year. Thus, taxpayers have some flexibility in choosing how they cost WIP as long as they can show that the method they chose accurately depicts their income for the year.\n Designated professionals should use the guidance on inventory valuation in archived CRA Interpretation Bulletin IT-473R, “Inventory Valuation.” The CRA’s position in paragraph 12 has not changed, so taxpayers may use either direct or absorption costing. However, prime costing, a method where no overhead is allocated to inventory, remains unacceptable for income tax purposes.\n No matter what costing method is chosen, variable costs must be included in WIP (more on this later).\n WIP includes the cost of labour of designated professionals, including employee benefits, but does not include the time contributed to the WIP by partners or sole proprietors (as no costs are typically associated with this work).\n For contingency fee arrangements, when determining the FMV of WIP, the CRA says that designated professionals should use the amount of the fee that is reasonably expected to become receivable. In some cases, the CRA has recognized that it will not be possible to determine the expected fee and in these cases, the WIP would have a nil value (see the CRA letter for their specific comments in this regard). \n\nSome thoughts on overhead costs\nAs mentioned, the CRA has confirmed that it will accept either direct or absorption methods of inventory costing. As a result, many designated professionals will probably choose to use direct costing, because it only requires the inclusion of variable overhead costs. So, it will be important for professionals to identify their fixed versus variable overhead costs. \nSo what are variable overhead costs for a professional services firm? There is little published tax or accounting guidance on determining the cost of inventory in this context. International Accounting Standard (IAS) 2 Inventories says that “variable production overheads are indirect costs that vary directly, or nearly directly, with the volume of production.” \nTaking this definition into account and considering today’s modern professional services practice and the type of expenses typically incurred, it seems that many practices would have immaterial costs that meet the definition of variable overhead. However, this should be determined on a practice-by-practice basis. Professionals should perform this analysis based on their practice and ensure they document supportable positions when costing WIP, including any amount to be included as variable overhead.\nTransitional rules\nTo reduce the cash flow impact of these changes, the rules allow a five-year phase-in period for taxation years beginning after March 22, 2017 (so, for many professionals, the first tax year affected will be the year ending on December 31, 2018). Under the original budget proposals, the transition period had been set at two years, but this period was extended based on input from stakeholders, including a submission from the Joint Committee on Taxation of the Canadian Bar Association and CPA Canada. \nAs a result, professionals would include 20 per cent of the lower of cost or fair market value of the WIP in income for the first taxation year beginning after March 21, 2017. In the second year, 40 per cent of the lower of cost and FMV at year end is included in income. By the fifth year, the inclusion percentage will be 100 per cent. \nLooking ahead, CPA Canada will continue to identify uncertainties and issues with these new rules and work with the CRA to clarify how the rules should operate in practice.\nKeep the conversation going\nWhat other areas of uncertainty have you come across in determining how to value professionals’ WIP for tax purposes? Post a comment below.\nCPA Canada’s Tax Blog is designed to create an exchange of ideas on tax policy and practice issues, and their impact on those who practise tax. Your comments can provide helpful input into the public interest advocacy positions developed by CPA Canada.