Tax Planning Considerations for Long-Term Construction Contracts: Implications and Definitions
Tax planning considerations may arise when dealing with a long-term construction contract, defined as a contract where construction work extends beyond one year of income or a contract that spans two income years, even for fewer than 12 months.
The word “construction” takes its ordinary meaning but can also apply to the construction of major plant items. This can include (but is not limited to) boats, other transport vessels and large machinery. It can also include service contracts like air conditioning, electrical and refurbishment contracts for sites like hotels or shops.
The Australian Tax Office (ATO) had increasingly become concerned with methods which deferred the taxing point of income and/or profits under these long-term contracts as business owners were increasingly trying to defer the income to be taxed until a later year.
In Taxation Ruling TR 2018/3, the ATO affirms the view they have practised in the past that the completed contracts method remains unacceptable. This method deferred the taxing point of the income or profit until the completion of the contract, whilst some businesses had also claimed expenses during the period before the completion.
ATO’s suggested methods
- The “Basic Approach” – where all progress and final payments received in a year are included in assessable income and deductions are allowed to the extent permitted by law when they are incurred.
- The “Estimated Profits Approach” – any method of accounting for the ultimate profit, which allocates the profit fairly and reasonably over the contract period, will be acceptable.
Basic Approach:
- Progress and final payments – include amounts received and billed or billable under the contract. A taxpayer cannot defer the assessment of contract income by refraining from or postponing billing.
- Up-front payments – are assessable income. There may be situations where this payment may be assessable over a more extended period. For example, if the payment was to enable the purchase of equipment.
- Retention clauses – amounts retained under a retention clause are not assessable until received or are entitled to be received.
- Work in progress – is generally not assessable as the property would belong to the client, as the contractor has the right to sue for the work done.
- Expected costs – are generally not deductible. Only costs and expenses incurred are allowable deductions.
Estimated Profits Basis:
- Accounting standard – AASB 15 – revenue from customer contracts is like the estimated profits basis. However, adjustments must be made for income tax purposes.
- Costs considered – only costs likely to be incurred over the contract period are deductible, based on the taxpayer’s experience in the construction industry e.g., materials and labour. Costs that are not deductible or are not deductible until incurred include:
- A management reserves
- Additional costs due to wet weather
- Industrial disputes
- Methods of allocating notional taxable income – seek to recognise notional taxable income to reflect the progress of a contract.
Both these methods are based on the basic principle of income tax law, that liability to income tax is an annual event, so an appropriate amount of the profit must be returned as taxable income each year of the project. The ATO has made it quite clear the deferring of taxable income until the end of the contract will not be tolerated.
If you have long-term contracts mentioned above, and they straddle two financial years, please contact your client manager to discuss your situation.
Kreston Stanley Williamson
*Correct as of January 2021
*Disclaimer – this article has been produced by Kreston Stanley Williamson as a service to its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas in this article, you must seek specific advice relating to your particular circumstances. Liability is limited by a scheme approved under professional standards legislation.
