Tax Changes Impacting Professional Corporations Agenda Several - PowerPoint PPT Presentation

Tax Changes Impacting Professional Corporations

Agenda Several substantial changes to Federal income tax legislation impacting professionals since 2016: • Specified partnership income (“ SPI ”) and specified corporate income (“ SCI ”); • WIP rules for professionals; • Investment income grind to small business limit (“ SBD ”); • Refundable tax regime; and • Tax on split income (“ TOSI ”) 2

New Rules for Partnerships

̶ ̶ ̶ Old SBD Rules • Original SPI rules targeted only the use of partnerships to multiply access to small business limit. Effectively, CRA’s position was “one business, one business limit”. Corporate partners of a partnership share a single business limit in respect of the partnership, with their share being $500,000 x their percentage share of partnership earnings from an active business. A professional corporation whose sole active business was their interest in a professional partnership would often be entitled to a portion of this limit significantly less than their income allocation from the partnership. Several different structures were typically used to plan around the old SPI rules.

Old SBD Rules Partner Partner Partner PC PC PC Professional Partnership

Old SBD Rules Professional Profesional Professional Mgmt Co. PC Mgmt Co. PC PC Mgmt Co. Services Professional Partnership

̶ SPI and SCI – New Rules • Rules introduced for taxation years starting on or after March 22, 2016 New concept of “specified corporate income”. o SCI carve-out: a corporation (“ SCI-Corp ”) income from provision of goods and services to a private corporation (“ Recipient ”) in which SCI-Corp, SCI-Corp’s shareholder or another non- arm’s length person holds an interest, unless all or substantially all of SCI-Corp’s income is earned from arm’s length customers.  SCI-Corp’s carved-out income is not entitled to SBL, unless Recipient assigns portion of own SBL to SCI-Corp. Prevents use of stacked or sister corporations to access small business limit by having a holding company or sister company charge management fees to the professional corporation which holds the partnership interest.

SPI and SCI– New Rules • New concept of “designated member” of a partnership. ‒ A designated member of a partnership is a CCPC that provides services or property to a partnership, where: o it is not a member of the partnership; and  one of its shareholders holds a direct or indirect interest in the partnership; or  the CCPC does not deal at arm’s length with a person who holds a direct or indirect interest in the partnership, unless the CCPC earns all or substantially all of its income from arm’s length customers • Designated members of a partnership only have access to “specified partnership business limit” to the extent that corporation which is a member of the partnership assigns a portion of its “specified partnership business limit” to the designated member.

̶ Impact of New SPI and SCI Rules • Most structures undertaken based on “old” pre-March 21, 2016 rules will no longer produce desired result. • Professionals who are members of a partnership will see their access to the small business limit in respect of their active business income from the partnership (regardless of how derived or corporate structure) severely limited. • Some planning alternatives still remain however, these may carry significant tax risk or result in tax tail wagging the business dog. Even without SBD, PC’s still allow for substantial tax deferral (27% vs 48%). Note: SBD has only ever been a deferral, not a permanent tax saving.

WIP for Professionals

̶ What is Work in Progress? • No comprehensive definition of “work in progress” in the Income Tax Act (the “ Act or ITA ”). • Paragraph 11 of CRA Archived IT-457R states that WIP must be given its ordinary meaning, i.e. “ partly finished goods or services which are in the process of completion and have not reached the stage where the taxpayer is required to include an amount in income pursuant to paragraph 12(1)(b) ”. ITA 12(1)(b) requires income inclusion when an amount is “receivable”, which occurs legally on invoicing.

Current Legislative Scheme for WIP • Section 9 requires profits be determined under well-accepted principles, under which opening and closing inventory are taken into account. • Section 10 governs recording of inventory. • Section 34 provides election to exclude WIP for certain professions.

Professionals’ WIP - Inventory • ITA 10(5) - Without restricting the generality of the section, a) …work in progress of a business that is a profession is, for greater certainty, inventory of the taxpayer, … ‒ General principles of what constitutes “inventory” still governs, unless explicitly specified. ‒ “For greater certainty” suggests professional’s WIP = inventory under general principles even without ITA 10(5)(a).

Measurement Options • ITA 10(1) – For the purpose of computing a taxpayer’s income for a taxation year from a business… inventory shall be valued at the end of the year at the cost at which the taxpayer acquired the property, or its fair market value at the end of the year, whichever is lower, or in prescribed manner. ‒ Two choices: o Lower of “cost” or fair market value (“ FMV ”), or o A “prescribed manner”.

“Prescribed Manner” Measurement • ITR 1801 – … for the purpose of computing the income of a taxpayer from a business, all the property described in all the inventories of the business may be valued at its fair market value. ‒ Rather than lower of cost or FMV, taxpayer may choose to measure inventory simply at FMV.

̶ ̶ ̶ What is “Cost”? • Uncertainty regarding “correct” approach to measure “cost” of acquiring WIP for a professional firm. Judgment required. • While “cost amount” is defined in the ITA, no definition for “cost”. • Where the ITA does not provide specific guidance, Canderel should be relied on. Method used to determine cost should be consistent with case law, well-accepted business principles and provides an accurate picture of the taxpayer’s profit for the year. Generally, an approach consistent with GAAP will be acceptable where not overridden by specific provisions of the ITA.

CRA’s View on Costing of Inventory • CRA’s Archived IT-473R (1998) [paragraph 12]: “… inventories of work in process … 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.”

̶ ̶ ̶ CRA’s View on Costing of Inventory (Cont’d) • CRA VIEWS 2018-0743031E5 “our position expressed in paragraph 12 of Interpretation Bulleting IT-473R has not changed” “the total cost of professional labour including employee benefits should form part of the cost of WIP” “when a taxpayer chooses the direct costing method, fixed overheads do not have to be included in the cost of WIP. Consequently, in such a case, costs related to the rental of office space or premises would not have to be included in the cost of WIP because they constitute fixed overheads.”

Is the Cost of the Partner/Proprietor Part of “Cost”? • CRA VIEWS 2018-0743031E5 ‒ “ when a partner or owner of a business that is a profession contributes to WIP, no amount representing the partner's or proprietor's time needs to be included in the cost of the WIP.” This interpretation does not contemplate situations where the partner’s time is charged to the partnership as a separate free from a non-partner corporation.

̶ ̶ ̶ ̶ Approaches to Measuring Cost Therefore, “cost” of WIP should include: • Material • Direct labour • Applicable share of overhead: Direct costing (variable overheads to inventory); or Absorption costing (allocates both variable and fixed overheads to inventory). • Direct costing is substantially less involved and will result in lower cost of WIP, which should maximize deferral (within confines of CRA administrative policy) • For accountants and lawyers using direct costing, most of WIP’s cost should relate to salaries, wages and benefits of staff charged to the engagement. Get this right and WIP cost unlikely to be materially “wrong” • For example, determine hourly cost of each employee and multiply by hours charged to engagement to determine cost in WIP • Alternatively, could take “revenue” in WIP (i.e. hours x charge out rates), and back out average percentage of charge-out rate that relates to profit and fixed overhead Most substantial direct overhead – supervision and management – is baked right into WIP already