If you are an owner of a Canadian professional corporation such as a medical doctor, lawyer, dentist, accountant, chiropractor or veterinarian the changes to the work in progress (WIP) rules will likely impact your business.
What were the old rules?
Generally, all income earned in a corporation whether billed or unbilled is included in income. However, previous work in progress at the year-end of a professional corporation could be excluded from income via an election under Section 34 of the Income Tax Act. This unbilled work was effectively excluded from income and was taxed when the amounts were billed.
What has changed?
For professional corporations with tax years beginning after March 21, 2017 changes to how work-in-progress (WIP) is accounted for have changed. For most professionals, the rules will be relevant to their tax year beginning January 1, 2018.
What is the impact?
Work in progress that was previously deferred is now subject to tax in the year that it is earned. The implications can be significant as tax may have to be paid on income that has not yet been collected which could cause cash flow issues to some businesses.
There is a general phase-in of the changes under section 10(14.1) of the Income Tax Act (ITA) so that unbilled work in progress is brought into income over a five-year transitional period. For example, at the end of the first year 20% of the unbilled income is taxable, end of the second year 40% is taxable, end of the third year 60% taxable, and so on.
Are there exceptions?
There are some exceptions to the change in rules such as for unbilled work where billing is contingent upon an outcome. The typical example of this is a personal injury lawyer who can only bill a client if their case is successful. In these situations, the taxation of work in progress could effectively be deferred to a subsequent period when the case is settled.
How do I value my work in progress?
Work in progress is considered inventory for tax purposes. Inventory is valued for tax purposes at the lower rate of cost and fair market value under section 10(1) of the ITA. For most professionals, the cost of WIP will be lower than the fair market value of the services they provide.
What to include in the valuation of WIP can be difficult due to the numerous costs that comprise a professional’s time. Indirect costs such as general office costs or indirect overheads do not need to be included. The owner’s time spent does not have to be included in the cost. However, other direct costs need to be included in the cost.
Where can I get help to ensure my work in progress is accounted and valued correctly?
Robert Ng, CPA has experience working with specialty consulting firms in valuing and reporting WIP on a monthly basis. If your business needs assistance in setting up a method to track and value WIP to meet your tax compliance obligations at year-end please contact us today.