Proposed changes to small business tax: What it means to lawyers
TAX ALERT |
This article originally appeared on The Lawyer’s Daily website published by LexisNexis Canada Inc.
The 2017 federal budget introduced new tax rules to the Canadian legislative framework. While many of us may understand the general sense of these changes, the impact they will have on lawyers and law firms may be less clear. In our practice as managers in our firm’s tax group, we have numerous clients who will be affected. With this article, we aim to clarify the impact of three particular changes on lawyers and law firms and provide guidance on the next steps legal professionals can take to meet the new compliance challenges.
The first change that affects lawyers is work in progress (WIP). Changes to the existing WIP rules were announced as part of the federal budget in March and further revised in September. Prior to these proposals, lawyers and law firms were viewed as a special group in the eyes of the tax legislators; they were not obligated to factor WIP into taxable income until it was billed.
According to the Canadian Bar Association, the deduction rules were initially put into place in recognition of the challenges legal professionals face in valuing WIP, as what the lawyer eventually bills is contingent upon events often beyond a lawyer’s control, such as delays by the court, the ability of clients to pay fees, and court orders.
It came as a surprise to us when the government changed its stance on WIP for taxation years ending on or after March 22, 2017. Under the new rules, the deferral of this income will be reduced and eventually eliminated over the next five years. The new rules do not apply to contingent fee arrangements.
As described above, the valuation of WIP is tricky. What constitutes WIP for a professional is not clearly defined, so lawyers and law firms will need to follow best practices to discover its value. As the Canadian Bar Association notes, unlike physical assets that can be taken in an incomplete state, completed by a third party and brought to market, a lawyer’s WIP is not transferable for value. If an hourly rate is attached with historical metrics, this will certainly make things easier; however, practices vary from firm to firm. Not all practitioners may track time attached to an hourly rate. Additionally, how is the value of a partner determined? Is it an amount based on hourly rates or drawings from the firm?
We hope the CRA will provide more administrative guidance on WIP valuation. In the meantime, we recommend getting in touch with your accountant to determine how changes to WIP rules will specifically affect your law practice.
The remaining two issues relate to the four contentious proposed changes related to private corporations released in July; while two have been curtailed, two proposed changes will be moving forward. These will affect law professionals significantly. Firstly, changes to the income splitting rules — essentially, the expansion of the kiddie tax to adult family members, effective Jan. 1, 2018. Secondly, changes to the taxation rules surrounding passive investments, with no effective date in sight.
Where income splitting is concerned, while we are still awaiting revisions to the draft legislation, law firms with structures involving family members will be most affected, as dividends may now be taxed at the highest rate. The current guidance we have from the Department of Finance is that dividends that are “sprinkled” must be reasonable vis-à-vis the contribution the individual makes to the firm. Again, the issue lies with valuation — what is the value of the contribution of these family members to the law firm? Until we receive clarity from Finance, our recommendation is to do as much income splitting as possible this year — 2017 will be the last year it is allowed under the current rules.
Proposed taxation changes of passive investments in a private corporation will affect incorporated lawyers with investment income. A private corporation is subject to a significantly lower tax rate than a high income-earning unincorporated individual. Thus, the corporation would have more after-tax surplus funds to invest in passive assets. While the rate of return generated may be the same, a private corporation will have access to greater upfront capital compared to an unincorporated individual. The government wishes to narrow the gap by increasing the tax on passive investment income earned on invested after-tax active business earnings.
In response to public feedback, the government announced in October that the proposed tax increase would only apply on a go-forward basis to passive income that exceeds an annual threshold of $50,000. The draft legislation relating to passive investments will be released as part of the 2018 federal budget.