Edited version of private ruling

Authorisation Number: 1011458668433

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Ruling

Subject: Long term construction contracts

Question 1

Can A Co utilise the 'estimated profits basis' method, in respect of the XA contract and similar contracts, for determining taxable income under section 4-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Can A Co utilise the 'estimated profits basis' method, in respect of contracts similar to the XB contract, for determining taxable income under section 4-15 of the ITAA 1997?

Answers

Yes

Question 3

If the answer to Question 1 is Yes, can A Co adopt the 'estimated profits basis' of determining taxable income in respect of new contracts, that are similar to, and including, the XA contract, entered into on or after 1 January 2007, under section 4-15 of the ITAA 1997?

Answers

Yes

Question 4

If the answer to Question 2 is Yes, can A Co adopt the 'estimated profits basis' of determining taxable income in respect of new contracts, that are similar to the XB contract, entered into on or after 1 January 2007, under section 4-15 of the ITAA 1997?

Answers

Yes

Question 5

Can A Co change the method of determining taxable income from the 'basic approach' to the 'estimated profits basis' in respect of contracts, that are similar to, the XA contract, in existence before 1 January 2007, under section 4-15 of the ITAA 1997?

Answers

No

Question 6

Can A Co change the method of determining taxable income from the 'basic approach' to the 'estimated profits basis' in respect of contracts, that are similar to, and including, the XB contract, in existence before 1 January 2007, for the purpose of section 4-15 of the ITAA 1997?

Answers

No

Question 7

Where the answer to Question 3, 4, 5 or 6 is Yes, is A Co's method of accounting for long term contracts consistent with the 'estimated profits basis' method for determining taxable income in respect of long term construction contracts for the purpose of section 4-15 of the ITAA 1997?

Answers

Yes

This ruling applies for the following periods:

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2007

Relevant facts and circumstances

The scheme

A Co is the head company of a tax consolidated group (the group).

You develop software based information systems.

Your contracts primarily involve time taken by your software engineers to develop, deliver and commission the software into your client's existing plant. These contracts regularly span a number of income years.

You currently account for these contracts using Australian Equivalent to the International Reporting Standards (AIFRS). Specifically, you apply Australian Accounting Standards Board (AASB) standard 'AASB 111 Construction Contracts'.

You prepare your financial statements in accordance with AIFRS, which are audited annually.

Contracts

You use the following types of contracts:

· cash

· time and materials, and

· fixed price

The underlying contractual obligations contained in those contracts determine the methodology you used to recognise income, costs and profits.

You recognise income and expenditure from your cash and time and materials contracts as derived or incurred respectively.

You recognise income and expenditure from your fixed price contracts by calculating the contract's percentage of completion (POC) and account for the equipment component of your contracts as trading stock.

Examples of your fixed price contracts include:

· purchase orders

· XA System contract (XA contract)

· XB System upgrade contract (XB contract)

Your POC calculation is applied to your medium to large projects that primarily involve labour input.

You propose certain action to remedy any inconsistency between the estimated profits method and your financial accounting methods, including the following:

· management reserve

· provisions for latent defects

· expected losses, and

· provisions for warranty.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 4-15

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Subsection 6-5(3)

Income Tax Assessment Act 1997 Subsection 6-5(4) and

Income Tax Assessment Act 1997 Section 8-1.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

Detailed reasoning

General discussion of the law

Section 6-5 of the ITAA 1997 discusses income according to ordinary concepts.

Subsection 6-5(1) of the ITAA 1997 states that 'Your assessable income includes income according to ordinary concepts, which is called ordinary income'.

Section 4-15 of the ITAA 1997 sets out how to work out your taxable income. This section states that your taxable income is the product of your assessable income less your allowable deductions. In the event that your allowable deductions equal or exceed your assessable income, you do not have a taxable income.

The meaning of derived

Subsection 6-5(2) of the ITAA 1997 provides:

If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Subsection 6-5(4) of the ITAA 1997 provides:

In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

Therefore, an amount (including an amount which has been received), will not be included in assessable income for an income year, unless it has been derived during that year.

Apart from subsection 6-5(4) of the ITAA 1997, there is no further legislative guidance as to the timing of income derivation. As such, we will now consider the application of case law and taxation rulings to your situation.

In Brent v. Federal Commissioner of Taxation (1971) 125 CLR 418; 71 ATC 4195; (1971) 2 ATR 563, the High Court said at CLR 428; ATC 4200; ATR 570:

It has become well established that unless the Act makes some specific provision on the point the amount of income derived is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which is calculated to give a substantially correct reflex of the taxpayers true income (The Commissioner of Taxes (South Australia) v The Executor, Trustee and Agency Company of South Australia Limited (Cardens case) (1938) 63 CLR 108; 1 AITR 416; (1938) 5 ATD 98).

In Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612, (1969) 15 ATD 298; 69 ATC 4049 (the Henderson Case) Windeyer J said:

.. I think that services rendered for fees do not result in income derived ... until the fees are either paid or payable. This, of course, may be before an account for payment is rendered. For example, a physician may be entitled in law to be paid for attendances upon his patient before his treatment of him for his illness has been completed and he has sent him a bill. What he is thus entitled to be paid forms part of his income calculated in an earnings basis ... for work done ...Money is not, I think, earned income until it is in law recoverable as a debt ...'

His honour continues:

services may create debts before a bill is sent to the debtor. But services rendered do not produce taxable income until they create a debt.

On appeal from the Henderson Case, Barwick CJ extended that a recoverable debt should be included as earnings when:

the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned, then it or they will be income derived in the period of time in which it or they have become recoverable.

Barwick CJ clarified the meaning of recoverable later in His judgement as 'the point at which income is derived by the performance of services'.

In Barrett & Ors v. FTC 92 ATC 4275 (Barratt's case), Gummow J. said:

No doubt a debt that is presently recoverable by action generally will be an amount "derived" in the relevant sense by the creditor. The creditor will have a present right to receive the amount in question, something both earned and quantified, without the presence of any element of contingency or defeasibility. At the other end of the scale, where the right of the taxpayer is contingent, there will be no derivation before the contingency is satisfied'. Nor will there be derivation if the debt is yet to be quantified ...'

In Taxation Ruling TR 98/1 Income Tax: Determination of Income; Receipts versus Earnings, the Commissioner states that whether there is, in law, a recoverable debt is a question to be determined by reference to the contractual arrangements that give rise to the legal entitlement to payment, the general law and any relevant statutory provisions (refer paragraph 11).

In order to determine when the amounts in question were derived as income it is necessary to apply the legal principles of derivation provided in common law and the Commissioner views expressed in various rulings to the terms of the contracts relating to each amount respectively.

The meaning of incurred

The meaning of 'incurred' is not a defined term. The courts have considered the meaning of 'incurred' in relation to various cases, however have not defined the term.

The Commissioner has considered various court cases that have addressed the meaning of 'incurred' and set out his view in relation to whether an amount is incurred for the purposes of section 8-1 of the ITAA 1997 in Taxation Ruling TR 97/7.

In TR 97/7 we use the courts propositions to help outline the scope of defining a loss or outgoing as being incurred. Paragraph 6 of TR 97/7 lists some general rules, which have been provided by the courts, to assist in determining whether a loss or outgoing has been incurred. Those rules include:

(a) taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

(b) a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

(c) a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

(d) whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

(e) in the case of a payment made in the absence of a presently existing liability(where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid.

Long term construction contracts

The preamble of Taxation Ruling IT 2450 introduces its existence as being the result of representations made to the Australian Taxation Office (ATO) by taxpayers engaged in long term construction projects, following income tax audits of a number of companies engaged in such activity.

Central to these representations is the basis of returning income derived under long term construction projects. The representations allege inconsistent treatment across ATO sites, that is, a method of returning income accepted in one site has been specifically rejected in another.

At the time, the ATO was concerned about the way income from long term construction contracts had been returned by a number of taxpayers in the construction industry and sought direction in the matter.

Taxation Ruling IT 2450 restates the principles and practices which are to apply in bringing to account for income tax purposes income derived from long term construction contracts.

IT 2450 defines that long term construction contracts are contracts relating to construction work where construction extends beyond a year of income. This was consistent with the definition of 'construction contract' in the former Statement of Accounting Standards - Accounting for Construction Contracts - Australian Accounting Standard 'AAS 11 Construction Contracts'. AASB 1009 is the equivalent standard for corporations that are required to prepare financial statements in accordance with Part 3.6 of the Corporations Law and that meet certain criteria.

AAS 11 has been replaced by the Australian Accounting Standards Board (AASB) as 'AASB 111 Construction Contracts', which was released in July 2004. The AASB has since compiled this standard as an Australian Equivalent to the International Accounting Standards Board (IASB) standard lAS 11.

Generally AASB 111 applies to annual reporting periods that begin on or after 1 January 2009 that end on or after 30 June 2009. However certain conditions outline the application of this standard to income periods ending prior to 1 January 2009.

It is noted that certain content of AAS 11 has changed in translation to AASB 111, in particular the omission of certain words from the definition of 'construction contract'. However, the words omitted are considered to have no material impact upon the outcome of this ruling, which relates to the income period beginning 1 January 2007.

Paragraph 24 of IT 2450 provides clarification of the relationship between accounting standards and income tax law:

It is now well established that accounting standards and practices cannot supplant the terms of the income tax law which must be considered in determining whether income tax deductions are allowable. It is equally well established that the income tax law does not permit income tax deductions for claims for costs or losses which may be expected to arise in performance of long term construction contracts. It is only losses and outgoings which are incurred during a year of income which may be allowed as income tax deductions.

Paragraph 13 of IT 2450 states that whichever of the acceptable methods of determining taxable income from long term construction contracts is adopted by a taxpayer it is to be applied consistently to all years during which the particular contract runs and to all similar contracts entered into by the taxpayer.

Paragraph 14 of IT 2450 provides that the selected method is to apply in respect of all long term construction contracts entered into after 1 July 1987. However, where taxpayers have been determining taxable income from existing contracts on differing acceptable methods - this practice may continue until those contracts are complete.

Eligibility as long term construction contracts

Taxation Ruling IT 2450 provides guidance on the taxation treatment of income from long term construction contracts. The nature of long term construction contracts covered by the ruling are described in paragraph 11 as:

Long term construction contracts are contracts relating to construction work where construction extends beyond a year of income. This is in accord with the definition of 'construction contract' in the Statement of Accounting Standards - Accounting for Construction Contracts - AAS 11 - issued by the accounting profession. The word 'construction' is used in its normal accepted sense. Income from long term construction contracts would include: income from construction of buildings, bridges, dams, pipelines, tunnels and other civil engineering projects; income from related activities such as demolition, dredging, heavy earth moving projects, etc.; and income from the construction of major plant items including ships and transport vessels. It would also include income from similar contracts in associated fields, e.g. air conditioning contracts, major electrical wiring or rewiring contracts, major refurbishment of hotels, stores, etc., major construction management contracts, etc..

Australian Accounting Standards Board (AASB) standard AASB 111 is the current equivalent of AAS 11 as referred to in IT 2450.

The meaning of the term 'construction contract' in IT 2450 appears to be equivalent to the principles underlying AASB 111, such that you may apply the ruling on the same basis that you apply the accounting standard.

In particular, IT 2450 refers to

…income from similar contracts in associated fields, e.g. air conditioning contracts, major electrical wiring or rewiring contracts, major refurbishment of hotels, stores, etc., major construction management contracts…

This is considered similar to paragraph 5 of AASB 111 which extends the definition to '…contracts for the rendering of services which are directly related to the construction of the asset for example, those for the services of project managers and architects…'

Section 3 of AASB 111 Construction Contracts defines a 'construction contract' as:

[A] contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.

Section 4 provides the following examples of a single asset: bridge, building, dam, pipeline, road, ship or tunnel. Examples of the combination of assets described above include those for the construction of refineries and other complex pieces of plant or equipment.

For the purposes of the standard, section 5 provides that construction contracts include:

(a) contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and

(b) contracts for the destruction or restoration of assets, and the restoration of the environment following the demolition of assets.

Recognition of long term construction income

IT 2450 states that there are two acceptable methods for recognising income from long term construction contracts, these are as follows.

The basic approach

Paragraph 15 of IT2450 describes the 'Basic Approach' as follows:

As stated in CM 639 the basic approach is that all progress and final payments received in a year should be included in assessable income and income tax deductions allowed for losses and outgoings to the extent permitted by the income tax law. The approach seeks to treat taxpayers engaged in the long term construction industry in the same manner as any other taxpayer in business.

In practice, construction income is brought to account under the ordinary 'derivation' rules, which apply to all taxpayers. Under this method, the general rule is that all progress and final payments billed during a particular year of income are required to be brought to account as income.

Similarly, tax deductions are allowed for losses or outgoings when they are incurred (i.e. where a present liability exists) for tax purposes.

IT 2450 provides further commentary in relation to derivation of income under the 'Basic Approach' at paragraph 16:

…The reasoning of the High Court in Henderson v. FCT, 70 ATC 4016; 1 ATR 596 makes in absolutely clear that assessable income arising from long term construction contracts includes not only progress and final payments actually received in a year but also amounts billed or entitled to be billed to customers in a year for work carried out and certified as acceptable for payment by the appropriate architect, engineer, surveyor or other person authorised in the contract for that purpose…

The estimated profits basis

Paragraph 25 of IT 2450 describes that the estimated profits basis permits a taxpayer to spread the 'ultimate profit or loss' on a long term construction project over the years taken to complete the contract provided the basis is reasonable and is in accordance with accepted accountancy practices.

Paragraph 26 of IT 2450 discusses the meaning of 'ultimate profit or loss' and provides that it refers to the overall taxable income expected to arise from a particular contract. In particular, it requires the total receipts expected to be received under the contract to be regarded as assessable income and income tax deductions to be allowed for expected losses and outgoings to the extent permitted by the income tax law on the assumption that the losses and outgoings would actually be incurred over the period of the contract.

Ultimate profit or loss is in effect notional taxable income expected to arise under a particular contract and it is the notional taxable income which may be spread over the years taken to complete the contract.

Paragraph 31 discusses the acceptable methods of allocating notional taxable income over the years taken to complete a long term construction contract. In particular, that the method to be used is dependant on the nature of the contract. Further, that:

In a cost plus contract, i.e. a contract where the contractor is to be paid for agreed cost plus a percentage or fixed fee, the amount of notional taxable income to be included in assessable income in each year will be determined by ascertaining the percentage that notional taxable income bears to agreed cost and applying the percentage to costs incurred in a year.

Paragraph 32 of IT 2450 provides the following methods, as provided by paragraph 11 of the Accounting Standard AAS 11, that the Commissioner accepts as appropriate in determining notional taxable income:

(a) physical estimates or surveys by engineers and architects of the work performed to date;

(b) the cost basis - calculating the proportion that costs incurred in each year bear to the estimated total costs of the contract;

(c) the billings basis - calculating the proportion that billings or entitlement to billings in each year bears to total billings.

The Commissioner is prepared to accept any other method that achieves the same broad result as long as the method is applied consistently.

Other considerations in applying the estimated profits basis

Taxation Determination TD 94/65 discusses whether a 'management reserve' can be taken into account when calculating notional taxable income under the estimated profits basis of returning income from long term construction contracts.

TD 94/65 provides that only actual costs that are identified as likely to be incurred over the period of the contract and which are properly deductible are taken into account in calculating notional taxable income.

Further, costs of materials and labour are examples of properly deductible costs. However, general claims for a 'management reserve' or for 'additional costs arising from wet weather, industrial disputes, etc.' are not sufficiently informative about the actual costs involved to be properly deductible.

It is not sufficient to make a general claim for unspecified costs likely to arise on the happening of some future event. The calculation of notional taxable income needs to be more exact. The likely effect those future events will have on actual deductible costs must be quantified.

IT 2450 provides at paragraph 27, that it is permissible to take into account a reasonable amount for probable costs in remedying defects during the maintenance period.

Taxation Determination TD 94/87 discusses how an estimated 'ultimate loss' arising under a contract is to be recognised, where the estimated profits method of recognising income from long-term construction contracts is adopted in accordance with IT 2450.

TD 94/87 provides that the estimated contract loss is to be spread over the period taken to complete the contract in a manner that reflects the progress of the contract. This is consistent with the basic principle of income tax law that the liability to income tax is an annual event, and therefore only income and losses that have been derived or incurred in an income year are brought to account.

Consistency of method

Paragraph 13 of IT 2450 states that whichever of the methods is adopted by the taxpayer it must be applied on a consistent basis to 'all years during which the particular contract runs and to all similar contracts entered into by the taxpayer'. In addition, it is also stated that 'taxpayers who are companies in the one group should adopt the same method of determining taxable income'.

Paragraph 14 of IT 2450 allows that where taxable income of existing contracts has been determined using a different acceptable method, the taxable income of those contracts may continue to be calculated using that method until the completion of the respective contract.

Question 1

Detailed reasoning

Application of the law to your circumstances

You enter into significant contracts which can often span several years. For accounting purposes, you recognise income and profits from these contracts under accounting standard AASB 111. You state that it is accepted practice in the industry that long term contracts such as those undertaken by you fall within this standard, and are accounted for as such in audited financial accounts.

As is stated in paragraph 24 of IT 2450 accounting standards and practices cannot supplant the terms of the income tax law which must be considered in determining whether income tax deductions are allowable. In addition, that the income tax law does not permit income tax deductions for claims for costs or losses which may be expected to arise in performance of long term construction contracts. Further, it is only losses and outgoings which are incurred during a year of income which may be allowed as income tax deductions.

Therefore, your application of AASB 111 in your financial statements does not necessarily indicate that the same method can be applied in calculating your taxable income. In order to apply methods within that standard for the calculation of taxable income, it must be demonstrated that your contracts are in fact 'long term construction contracts' according to the principles set out in IT 2450.

Your contracts for the provision of the XA system are contracts in relation to specific assets.

As part of your contracts you provide systems, to enable various assets to function for the purpose of which they are designed. Further, you will provide the installation, service, support and training in respect of the XA system.

The XA system is integral and interdependent with other systems, structure and assets within the plant, where some of those systems, structure and assets may be provided by separate contractors.

In consideration of your circumstances in relation to paragraph 11 of IT 2450, activity under your contracts relates to equipment and systems that are integral to the successful operation of particular assets for the purpose which they are employed, therefore they are integral to the construction of the major asset.

Further, the activities you are performing under your contracts do not appear to be sales and supply over time of what would ordinarily be considered trading stock. Therefore paragraph 12 would not act to exclude these contracts from the application of IT 2450 in determining your taxable income.

It is considered that your XA contract and similar contracts involving the provision, installation, service and training in relation to specific assets, where construction extends beyond a year of income, constitute long term construction contracts for the purposes of IT 2450.

Therefore you are entitled to utilise the 'estimated profits basis' method, in respect of the XA contract and similar contracts, for determining taxable income under section 4-15 of the ITAA 1997.

Question 2

Detailed reasoning

Application of the law to your circumstances

You enter into significant contracts which can often span several years. For accounting purposes, you recognise income and profits from these contracts under accounting standard AASB 111. You state that it is accepted practice in the industry that long term contracts such as those undertaken by you fall within this standard, and are accounted for as such in audited accounts.

As is stated in paragraph 24 of IT 2450 accounting standards and practices cannot supplant the terms of the income tax law which must be considered in determining whether income tax deductions are allowable. In addition, the income tax law does not permit income tax deductions for claims for costs or losses which may be expected to arise in performance of long term construction contracts. Further, it is only losses and outgoings which are incurred during a year of income which may be allowed as income tax deductions.

Therefore, your application of AASB 111 in your financial statements does not necessarily indicate that the same method can be applied in calculating your taxable income. In order to apply methods within that standard for the calculation of taxable income, it must be demonstrated that your contracts are in fact 'long term construction contracts' according to the principles set out in IT 2450.

Your contracts to deliver XB systems are contracts for the provision, upgrade, installation, service and training in relation to specific assets.

The upgrade involves the design, development and installation of systems that enable various assets to function for the purpose of which they are designed.

In addition, you will provide the refurbishment or replacement of certain systems and equipment. Further, you are to provide integration of existing systems with new equipment as well as training, service and support for the continued operation of the XB system.

Your circumstances indicate that you are carrying out a major refurbishment of an existing asset. The XB contract and similar contracts are long term construction contract as defined in IT 2450. The contracts relate to construction work where construction extends beyond more than one year. In terms of the examples given in the IT 2450, the contract can be viewed as a similar contract in an associated field, namely the provision of a system for a major item of plant.

In consideration of your circumstances in relation to paragraph 11 of IT 2450, activity under your contracts relates to equipment and systems that are integral to the successful operation of particular assets for the purpose which they are employed, therefore they are integral to the construction of the major asset.

Further, the activities you are performing under your contracts do not appear to be sales and supply over time of what would ordinarily be considered trading stock. Therefore paragraph 12 would not act to exclude these contracts from the application of IT 2450 in determining your taxable income.

Your contracts for the provision, upgrade, installation, service and training in relation to specific assets, where construction extends beyond a year of income, constitute long term construction contracts for the purposes of IT 2450.

Therefore you are entitled to utilise the 'estimated profits basis' method, in respect of the XB contract and similar contracts, for determining taxable income under section 4-15 of the ITAA 1997.

Question 3

Detailed reasoning

The Commissioner has formed the view in Question 1 that your XA contract and similar contracts are long term construction contracts.

Accordingly, you may apply Taxation Ruling IT 2450 when determining your taxable income and are eligible to apply either the 'basic approach' or the 'estimated profits basis'.

IT 2450 discusses the requirement for consistent application of these methods. In particular, paragraph 13 of IT 2450 states that whichever of the methods is adopted by the taxpayer it must be applied on a consistent basis to 'all years during which the particular contract runs and to all similar contracts entered into by the taxpayer'. In addition, it is also stated that 'taxpayers who are companies in the one group should adopt the same method of determining taxable income'.

Paragraph 14 of IT 2450 allows that where taxable income of existing contracts has been determined using a different acceptable method, the taxable income of those contracts may continue to be calculated using that method until the completion of the respective contract.

IT 2450 does not prohibit changing methods of determining taxable income, merely that the application of a method must be made consistently between like contracts and consistently over the life of those contracts.

In the practical application of this view, where it is more appropriate to use a particular method to determine taxable income that is different to the method previously applied, any change must be applied consistently to new contracts entered into within a given income year. You can not apply a different method to existing contracts.

Therefore, you may adopt the 'estimated profits basis' of determining taxable income in respect of new contracts, that are similar to, and including, the XA contract, entered into on or after 1 January 2007, under section 415 of the ITAA 1997.

Question 4

Detailed reasoning

The Commissioner has formed the view in Question 2 that your XB contract and similar contracts are long term construction contracts.

Accordingly, you may apply Taxation Ruling IT 2450 when determining your taxable income and are eligible to apply either the 'basic approach' or the 'estimated profits basis'.

IT 2450 discusses the requirement for consistent application of these methods. In particular, paragraph 13 of IT 2450 states that whichever of the methods is adopted by the taxpayer it must be applied on a consistent basis to 'all years during which the particular contract runs and to all similar contracts entered into by the taxpayer'. In addition, it is also stated that 'taxpayers who are companies in the one group should adopt the same method of determining taxable income'.

Paragraph 14 of IT 2450 allows that where taxable income of existing contracts has been determined using a different acceptable method, the taxable income of those contracts may continue to be calculated using that method until the completion of the respective contract.

IT 2450 does not prohibit changing methods of determining taxable income, merely that the application of a method must be made consistently between like contracts and consistently over the life of those contracts.

In the practical application of this view, where it is more appropriate to use a particular method to determine taxable income that is different to the method previously applied, any change must be applied consistently to new contracts entered into within a given income year. You can not apply a different method to existing contracts.

Therefore, you may adopt the 'estimated profits basis' of determining taxable income in respect of new contracts that are similar to, and including, the XB contract, entered into on or after 1 January 2007, under section 4-15 of the ITAA 1997.

Question 5

Detailed reasoning

The Commissioner has formed the view in Question 1 that your XA contract and similar contracts are long term construction contracts.

Accordingly, you may apply Taxation Ruling IT 2450 when determining your taxable income and are eligible to apply either the 'basic approach' or the 'estimated profits basis'.

IT 2450 discusses the requirement for consistent application of these methods. Paragraph 13 of IT 2450 states that whichever of the methods is adopted by the taxpayer it must be applied on a consistent basis to 'all years during which the particular contract runs and to all similar contracts entered into by the taxpayer'. In addition, it is also stated that 'taxpayers who are companies in the one group should adopt the same method of determining taxable income'.

Paragraph 14 of IT 2450 allows that where taxable income of existing contracts has been determined using a different acceptable method, the taxable income of those contracts may continue to be calculated using that method until the completion of the respective contract.

IT 2450 does not prohibit changing methods of determining taxable income, merely that the application of a method must be made consistently between like contracts and consistently over the life of those contracts.

In the practical application of this view, where it is more appropriate to use a particular method to determine taxable income that is different to the method previously applied, any change must be applied consistently to new contracts entered into within a given income year. You can not apply a different method to an existing contract.

Therefore, you can not change the method of determining taxable income from the 'basic approach' to the 'estimated profits basis' in respect of contracts, that are similar to the XA contract, in existence before 1 January 2007, under section 4-15 of the ITAA 1997.

Question 6

Detailed reasoning

The Commissioner has formed the view in Question 2 that your XB contract and similar contracts are long term construction contracts.

Accordingly, you may apply Taxation Ruling IT 2450 when determining your taxable income and are eligible to apply either the 'basic approach' or the 'estimated profits basis'.

IT 2450 discusses the requirement for consistent application of these methods. Paragraph 13 of IT 2450 states that whichever of the methods is adopted by the taxpayer it must be applied on a consistent basis to 'all years during which the particular contract runs and to all similar contracts entered into by the taxpayer'. In addition, it is also stated that 'taxpayers who are companies in the one group should adopt the same method of determining taxable income'.

Paragraph 14 of IT 2450 allows that where taxable income of existing contracts has been determined using a different acceptable method, the taxable income of those contracts may continue to be calculated using that method until the completion of the respective contract.

IT 2450 does not prohibit changing methods of determining taxable income, merely that the application of a method must be made consistently between like contracts and consistently over the life of those contracts.

In the practical application of this view, where it is more appropriate to use a particular method to determine taxable income that is different to the method previously applied, any change must be applied consistently to new contracts entered into within a given income year. You can not apply a different method to an existing contract.

Therefore, you can not change the method of determining taxable income from the 'basic approach' to the 'estimated profits basis' in respect of contracts, that are similar to the XB contract, in existence before 1 January 2007, under section 4-15 of the ITAA 1997.

Question 7

Detailed reasoning

General discussion of the law

IT 2450 states that there are two acceptable methods for recognising income from long term construction contracts:

· the 'basic approach' whereby construction income is brought to account under the ordinary 'derivation' rules, which apply to all taxpayers. Under this method, the general rule is that all progress and final payments billed during a particular year of income are required to be brought to account as income. Similarly tax deductions are allowed for losses or outgoings when they are incurred (that is, where a present liability exists) for tax purposes

· the 'estimated profits basis', which is an administrative concession, albeit endorsed by the Courts. This method effectively requires the total estimated profit on a contract to be brought to account based upon the percentage of completion at year-end.

Application of the law to your circumstances

Your accounting methods are applied in accordance with accounting standard AASB 111 and the financial accounts are subject to annual audit. You contend that accounting profit calculated under a POC method is equivalent to the estimated profits basis of IT 2450 for tax purposes.

Your POC calculation is based on recognition of ownership and risk transfer to the customer.

Your POC method appears reasonable and consistent with the principles of calculating notional taxable income for a given year of income using the estimated profits basis prescribed within IT 2450.

However, you state that some aspects of your accounting treatment may still require closer consideration for taxation purposes and propose certain action to remedy any inconsistency, which will be discussed in the following paragraphs.

In respect to provisions for latent defects, you state that these costs are also included in the estimate of total costs to complete and would also be claimed on a percentage of completion basis. Your proposed approach appears reasonable and consistent with the application of the estimated profits method as prescribed within IT 2450.

In respect to provisions for warranty, you state that these provisions cover problems arising after delivery that fall under warranty obligations. You propose that these are to be claimed when the relevant amounts are paid out rather than when the provision is booked. Your proposed approach appears reasonable and is consistent with the application of the estimated profits method as prescribed within IT 2450.

In respect to expected losses, you contend that the accounting standards require expected losses on contracts to be brought to accounts as soon as they are expected, and not on a percentage of completion basis. You acknowledge that this may not be consistent with the intent of IT 2450. You therefore propose to identify such projects and bring the loss to account for tax purposes over the life of the contract. Your proposed approach appears reasonable and is consistent with recognition of an estimated ultimate loss as prescribed within TD 94/87 when applying the estimated profits basis in accordance with IT 2450.

In respect to management reserves, you state that this represents your estimation of the costs that may arise during the contract that cannot otherwise be predicted. You have based this on statistical analysis of risks and opportunities within cost estimates, and this is the best estimate of the level of costs associated with unexpected and unpredictable events. You submit that these estimates are no different from any other cost estimate, therefore should be allowed in the calculation of total cost to complete.

However, TD94/65 provides that a claim for unspecified costs in relation to a future event, such as the costs included your 'management reserve', are not sufficient for calculating notional taxable income for returning income from a long term construction contract. Therefore your proposed approach is not consistent with the estimated profits basis prescribed within IT 2450.

In consideration of your circumstances and your proposed method of accounting for long term construction contracts, whilst certain elements appear reasonable and are consistent with the 'estimated profits basis' method for determining taxable income, the method you propose in respect to management reserves is not consistent with the estimated profits method as prescribed within IT 2450.

Therefore, your proposed method of accounting for long term contracts is not consistent with the 'estimated profits basis' method for determining taxable income in respect of long term construction contracts for the purpose of section 4-15 of the ITAA 1997.

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