Canada: Federal Budget – Impact On Law Firms

The Budget contained a change of significance for some professionals including lawyers. The Budget proposes to pull back a long standing deferral that has existed with respect to work in progress (commonly known as "WIP"). Currently professionals are able to exclude WIP from their income.

Practically speaking they include the prior year WIP balance in income and deduct the current year balance to arrive at taxable income. So if WIP balances do not change significantly from year to year it does not have much of an impact, it just means in the first year of business there was a deferral. That deferral is now going to be reversed over the next couple of years.

The concept of WIP and its tax treatment is not easily understood, even by those that have been able to claim the annual deduction. In practice there can be two types of WIP in a professional environment: unbilled work and unbilled disbursements and they are measured in different ways.

Unbilled work is time that has been posted to a client's file but has not yet been billed. For example, a lawyer spends 4 hours working on a client's affairs and bills those 4 hours at a rate of $300 per hour resulting in WIP of $1,200. The $1,200 also gets recorded as revenue by the law firm. If the client has not been billed by year end, the current rules allow the law firm to reduce income by the $1,200. In the following year the law firm includes the $1,200 in income but gets to claim the new year end WIP balance as a deduction. It should be noted that the $1,200 of WIP is a revenue item only, it does not include any costs related to that income. For example, if the lawyer was an employee of the law firm, the cost of the lawyer's wages (let's assume $100 per hour) would be recorded separately and would be a deduction to the law firm. This deferral of revenue, while being able to deduct the cost of generating the revenue, is the deferral that the Budget change is aimed at.

What the Budget does is say that for the first taxation year of a professional (or professional firm) starting after March 21, 2017 (so in a lot of cases it will be the 2018 year) only 50% of the WIP can be deducted from income. In the following year there will be no deduction. Essentially that means that any current WIP balance will have to be included in income over the next 2 years and after that there will be no deferral.

The twist is that the Budget says that WIP can be valued at the lessor of cost and fair value. Fair value is identifiable as being the anticipated amount that will be recovered from the client. But it's a little harder to identify what the cost of WIP is. At this point we don't have any guidance on this issue but, in the example previously noted, we would assume that the cost of the $1,200 of unbilled work would include the lawyer's wages of $400 (4 hours at $100 per hour). If we assume that is the case, the new rule would require the law firm to include $200 in income in the first year and $200 in the second year. Effectively it is removing the deferral that currently exists by being able to deduct the cost of the lawyer's wages but not having to include the related revenue. The difficulty will come when trying to determine the cost of WIP in cases where there are no direct costs related to the work. For example, in the case of a lawyer that is a partner, there is no wage cost so does that mean the cost of the WIP is nil? It remains to be seen.

Essentially, it may mean that this change may not be as significant as it seems at first glance when it comes to unbilled work.

Unbilled disbursements are a different story as they include costs directly related to the client's file such as title search fees, subcontract fees, etc. Let's assume that $200 in disbursements have been incurred for a legal client. Let's also assume that the client has not been billed by year end so the $200 is still sitting in WIP. In many cases the lawyer will claim the $200 as a deduction against income (with the prior year balance being included in income). The difference between the unbilled disbursements and unbilled work is that the unbilled disbursements have not been included in income in the first place. They have simply been included in unbilled disbursements as paid. Once a client is billed the disbursement costs are recovered by the law firm from the client. So in the case of unbilled disbursements, the deduction of WIP represents a significant deferral of income.

As with unbilled work, the Budget change means that unbilled disbursements will have to be included in income over the next 2 years. For some professionals, such as lawyers, that could have a significant impact on their taxable income because unbilled disbursements may be a significant amount in the case of litigation files where a client may not be billed for years (not until the case is settled).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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