Principale Issues: 1. Several questions regarding WIP cost determination 2. How should the value of a professional’s work in progress be determined where the work is performed on a contingency basis?
Position: 1. The determination of cost is a question of fact. In CRA’s views, the direct costing method and the absorption method are two acceptable methods of costing. 2. Under paragraph 10(4)(a), the FMV means the amount that can reasonably be expected to become receivable by the business after the end of the year in respect of the WIP. It may, in some cases, be nil.
Reasons: 1. Considering the principles developed in Canderel, a taxpayer has some flexibility as to which method he can choose for carrying out the valuation under subsection 10(1) I.T.A. provided that the method respects the provisions of the Act, the principles emerging from the case law, established “rules of law” and recognized commercial principles.
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Mr. Maurice Mongrain |
2017-070910 Nancy Deslandes, |
May 1, 2018
Dear Mr. Mongrain,
Subject: New rules for work in progress following the Budget
Please find attached our response to a series of questions dealing with the treatment of professionals’ work in progress following the repeal of section 34 of the Income Tax Act.1 These questions were initially posed to us during the Federal Taxation Roundtable at the 2017 Annual Association de planification fiscale et financière Conference. Given certain time constraints, it was agreed that our Directorate would provide its response separately.
You will find below the full content of your request and the response of the Canada Revenue Agency (the "CRA") to that request.
Full content of your request
In general, taxpayers are required to include the value of work in progress ("WIP") when computing their income for taxation purposes. However, taxpayers in certain designated professions (i.e., accountants, dentists, lawyers, physicians, veterinarians and chiropractors) ("Designated Professionals") may choose to exclude the value of WIP when computing their income. The effect of this election is to recognize income when the work is billed ("Billed-Basis Accounting"). Billed-Basis Accounting allows taxpayers to defer taxation, with the ability to recognize the expenses associated with their WIP without including the related revenues.
As part of its March 22, 2017 budget, the federal government proposed to eliminate the ability for Designated Professionals to elect to use billed-basis accounting. This measure will apply to taxation years that begin on or after Budget Day, generally beginning with the 2018 taxation year for individuals and partnerships with a fiscal year ending on December 31.
For tax purposes, professionals' WIP is considered inventory that can be valued at the lower of its cost and fair market value ("FMV").
Paragraph 10(4)(a) of the ITA provides that the FMV of WIP at the end of a taxation year of a business that is a profession means the amount that can reasonably be expected to become receivable after the end of the year in respect of that WIP. In the CRA's view, as a general rule, a service business must measure the value of its WIP based on the hourly rate billed to the customer (see Technical Interpretation 2008-0294011E5 - Election to exclude work in progress).
In contrast, the concept of cost of WIP is not defined in the Act. Our understanding is that the CRA's position with respect to the cost of goods in inventory in the context of the production of tangible goods is that set out in paragraph 12 of Interpretation Bulletin IT-473R - Inventory Valuation ("Interpretation Bulletin IT-473"):
“In the case of inventories of work in process and finished goods, 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, is acceptable as a method of costing inventory, but the method used should be the one that gives the truer picture of the taxpayer's income. Prime costing, a method in which no overhead is allocated to inventory, is not accepted for income tax purposes as a method of costing inventory.”
On the question of determining the cost of WIP in the context of a service business, commentators have stated that:
“The cost of work in progress of professionals, and of some non-professionals, is complicated by the fact that many services are provided by members of a partnership or by a sole practitioner who performs the work personally.
Partnerships and sole proprietors do not incur expenses for a partner’s time or a proprietor’s work, and no amount for the unbilled time of a partner or a proprietor is included in the cost of the work in progress. Further, under general accounting and tax principles, the cost of work in progress does not include fixed or variable overhead expenses, such as secretarial and general office expenses. Consequently, the cost of work in progress related to services consists primarily of disbursements and salaries paid to professional or quasi- professional employees. ’’ (see Arnold et al, Timing and Income Taxation: the principles of income measurement for tax purposes, Canadian Tax Foundation, 2nd ed, 2015, p. 610). »
Questions to the CRA
- Could the CRA provide details on the method(s) that could be used by Designated Professionals to determine the cost of their WIP? Among other things, in the view of the CRA, is the position of the authors Arnold et al. quoted above that, in a service business context, the cost of WIP is limited to the salaries and disbursements directly related to the provision of the services in question, an acceptable one?
- Could the CRA provide details on the meaning of the expression "applicable share of overhead expense properly chargeable to production" to which reference is made in paragraph 12 of Interpretation Bulletin IT-473?
- Can the CRA specify which components are to be included in the calculation of the cost of work in progress? For example, should the cost of indirect labor and certain general expenses (such as rent and other indirect costs) be taken into account?
- Can the CRA specify how the cost of labour is to be calculated? Should it be calculated based on paid hours, hours worked or hours billed?
- In the situation where a partner of a partnership participates in file work, is there a cost attributable to the time spent by the partner on the file?
- Is there a cost associated with time charged to a client's file by a shareholder-manager who is only remunerated by way of dividend? What if the shareholder is paid a minimal salary (say, $5,000) and the balance as dividends?
- How should the fair market value of work in progress be determined in the case where a lawyer agrees to be paid on the basis of a percentage of a client's award? As long as the case has not been decided, it is impossible for the lawyer to know whether the client will succeed and, therefore, the amount to be billed remains unascertainable.
CRA response
General Principles
The Supreme Court of Canada reviewed the concept of profit in Canderel Ltd v. The Queen,2 and stated, inter alia, the following principles:
- The determination of profit is a question of law;
- In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer’s profit for the given year.
- The taxpayer is free to adopt any method which is not inconsistent with the provisions of the Income Tax Act, established case law principles or “rules of law” and well-accepted business principles.
- On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the ITA, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.
In computing income from a business, a taxpayer must generally take into account the taxpayer’s work in progress. In this regard, subsection 10(5) provides that the work in progress of a business that is a profession is inventory. As a result, inventories of work in progress must, pursuant to subsection 10(1), be valued at the end of the year at their cost at which the taxpayer acquired such property or its fair market value at the end of the year, whichever is lower, or in a prescribed manner.
Where a taxpayer determines the cost of acquisition of work in progress or its FMV, the principles stated in Canderel must be taken into account.
Cost of acquisition of work in progress
The determination of the cost of acquisition of work in progress is a question of fact. Indeed, the ITA does not provide any specific method for determining the cost of acquisition of work in progress.
In this respect, paragraph 12 of Interpretation Bulletin IT-473R3,3 which was referred to in the question, still represents the CRA’s position.
In brief, the two methods of determining the cost of work in progress described in that paragraph, whether the direct costing method or the absorption costing method, take into account variable overheads in determining the cost of work in progress.
With respect specifically to the cost of labour of professionals, the CRA is of the view that these costs, including of employee benefits, should also be included in the calculation of the cost of work in progress.
However, where a taxpayer chooses the direct cost method, the taxpayer is not required to include fixed overhead costs in the cost of work in progress. Consequently, in such a case, the costs associated with renting office space or premises would not be required to be included in the cost of the work in progress since they constitute fixed overhead costs.
Furthermore, where a partner or owner of a business that is a profession contributes to the work in progress, the amount representing this contribution is not to be included in the cost of such work.
Fair market value of work in progress
As for the FMV of work in progress, paragraph 10(4)(a) providess, subject to certain exceptions, that the FMV of at the end of a taxation year of a business that is a profession means the amount that can reasonably be expected to become receivable in respect thereof after the end of the year.
Where a designated professional enters into an agreement to render services for contingency fees, some or all of the fees may not become ascertainable until after the taxation year in which the designated professional provided the services under the terms of the agreement. In these circumstances, the FMV of such work in progress of the designated professional at the end of the taxation year would be nil.
However, it has been brought to our attention that, in certain situations, it is possible, at the end of the year, to establish an amount that can reasonably be expected to be received after the end of the taxation year in respect of that work. In such a case, the CRA is of the view that the FMV of such work in progress should then correspond to this amount.
Conclusion
The valuation of work in progress is essentially a question of mixed fact and law. Considering the principles set out in Canderel, a taxpayer has some flexibility as to the method chosen for such a valuation provided that this method respects the provisions of the Act, the principles of jurisprudence, the case law, and well-accepted business principles.
Ultimately, the objective of the method the taxpayer chooses is to enable the taxpayer to obtain a accurate picture of the taxpayer’s income for the year. The taxpayer must, in case of reassessment, be able to demonstrate this.
We hope that this fully answers your request.
Best regards,
Michel Lambert, CPA, CA, M. Fisc.
Manager
Employment Income Section
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy and
Regulatory Affairs Branch
c.c. Ms. Annie Lamoureux
1R.S.C., 1985, c. 1 (5th Supplement), as amended (the "ITA").
2 [1998] 1 S.C.R. 147 ("Canderel").
3 CANADA REVENUE AGENCY, Interpretation Bulletin IT-473R ARCHIVED "Inventory Valuation", December 21, 1998.