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Put your accountant and lawyer clients on notice: the next few years are going to be extra painful.

In an effort to accelerate – not increase – tax revenues, the 2017 federal budget is going to eliminate what’s known as billed-basis accounting.

Section 34 of the Income Tax Act had allowed professionals who complete work over months or even years to defer taxation on that income until the entire project was completed and billed. Such professionals include accountants, dentists, lawyers, medical doctors, veterinarians and chiropractors.

For instance, let’s say your lawyer client worked on a case over both the 2016 and 2017 tax years. If she did $10,000 worth of work in tax year 2016 and $25,000 worth in 2017, under the old rules, your client could have elected to defer that $10,000 worth of work (known as work in progress, or WIP) to be included in her income in 2017, not 2016. (In turn, the $25,000 worth of work in 2017 could have been deferred to 2018, and so on.)

Budget 2017 proposes to eliminate that election so she is taxed on WIP in the year she does the work, not the year in which the work is completed and billed. This proposal is supposed to net the government $425 million over three fiscal years, and will affect taxation years that begin on or after March 22, 2017.

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Cash-flow crunch

The change overhauls how a large swath of the professional community pays tax.

“Most professional accounting and law firms use the election,” says Kim Moody, director of Canadian tax advisory for Moodys Gartner. “Otherwise, there can be a significant detachment from the cash [paid by clients] to the tax.”

Alexandra Spinner, partner at Crowe Soberman LLP, agrees.

“For the accounting and legal community, this is absolutely going to be a big cash-flow hit,” she says. That’s because there’s a mismatch between when the work is billed and when the professional must pay tax. It’s possible the professional may not have enough cash on hand to cover her taxes owing.

Further, says Spinner, people who use the election have planned to take a tax hit in retirement, but not during their work years. That’s because, under the old rules, “When your business is growing and your WIP is increasing each year, you’re always getting a correspondingly larger WIP deduction,” allowing you to keep deferring tax. “If you’re retired or your business is shrinking and your WIP is decreasing, you end up with an income tax hit.”

Specifically for retirees, “When you retire, you would bring your prior-year WIP deduction into income, but you would not claim a new deduction against it, because you would have no WIP [since you’re not working].” You’re paying tax on two years’ worth of income in that last year.

Under the proposed rules, “people are going to have to catch up very quickly,” she says, and find the cash to pay an extra year’s worth of tax now.

Moody also points out that some small accounting and law firms don’t even record WIP, so they’ll need to overhaul their systems. “They should take a close look at their current accounting practices and revenue recognition processes.”

Spinner says professionals will have to value their WIP at the end of each fiscal year at the lower of cost or fair market value. If a professional thinks the client won’t pay, “you’ll be able to write it down to fair market value.”

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What clients can do now

Some good news: Spinner doesn’t see this proposal affecting doctors, vets, dentists and chiropractors as much as it will lawyers and accountants. Also, since the election only allowed for tax deferral, not tax elimination, professionals will technically not be worse off in the end.

And there is one way to lessen the hit: “I would encourage [unincorporated lawyers and accountants] to incorporate their practices prior to the inclusion of the WIP,” says Spinner. That way, “at least they can pay tax on the WIP at corporate tax rates as opposed to personal tax rates.” In Ontario, that means paying 26.5% instead of 53.5%.

But that will be small comfort for affected clients, who have gotten used to – and planned around – the old rules. “It’s going to catch people by surprise,” she says.

Not only that, clients will likely be miffed to hear that this administrative headache won’t even give the government more revenue; it simply speeds up tax collection. But, with at least a $25.5-billion deficit projected for 2017-2018, every little bit helps.

Aside from the quicker inflows, Moody doesn’t see a clear policy reason for the proposal. “My guess is there is going to be a significant backlash,” he says. “This, combined with the small business deduction change last year? The professional community is being targeted.”

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Transitional rules

For the first taxation year that begins on or after Budget Day, the budget states that “50% of the lesser of the cost and the fair market value of work in progress will be taken into account for the purposes of determining the value of inventory held by the business under the Income Tax Act.

“For the second, and each successive, taxation year that begins on or after Budget Day, the full amount of the lesser of the cost and the fair market value of work in progress will be taken into account for the purposes of valuing inventory.”

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Originally published on Advisor.ca

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