Edited version of your written advice

Authorisation Number: 1051334297423

Date of advice: 22 February 2018

Ruling

Subject: Long term construction contracts – timing of deductions

Question

When are the amounts which are retained by the taxpayer and referred to as ‘retentions payable’ in the circumstances described, incurred for the purposes of claiming a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) under the estimated profits basis approach?

Answer

Under the estimated profits basis approach as set in Draft Taxation Ruling TR 2017/D8 Income tax: treatment of long term construction contracts, the question as to when the ‘retentions payable’ amounts are incurred for the purposes of claiming a deduction under section 8-1 does not arise.

Under the estimated profits basis approach, deductions attributable to the ‘retentions payable’ amounts would have been taken into account in the process of determining the Notional Taxable Income.

Relevant facts and circumstances

The taxpayer is a builder of large scale commercial and residential projects.

In undertaking the construction projects, the taxpayer engages other businesses to provide goods and services in relation to each project (referred to in this ruling as subcontractors). The taxpayer undertakes “long-term construction projects” as defined in paragraph 2 and 3 of Draft Taxation Ruling TR 2017/D8.

It is common place in the building and construction industry that amounts are retained as security by the head contractor (either by way of cash retention or bank guarantee) from payments to subcontractors.

In accordance with this practice and pursuant to terms of the contract entered into by the taxpayer and the subcontractor, the taxpayer withholds set amounts from the subcontractor invoices. These amounts (referred to as ‘retentions payable’) are not released to the subcontractor until after practical completion of the project and also after the expiry of the defect rectification period.

At each income year end, the taxpayer recognises the amount that is owed to the subcontractors by way of retentions as a current liability on its balance sheet. These amounts are not deposited into any special purpose bank account on behalf of the subcontractor.

Generally, the retained amount is a specified percentage of the invoiced amount.

The retained amounts are generally released to the subcontractor by the taxpayer in the following manner:

● half of the retained amounts is released at practical completion of the work performed by the subcontractor:

● The balance is released at the end of the defect rectification period.

The process for the retention of amounts from a subcontractor is that the subcontractor issues a claim by way of invoice to the taxpayer each month that the subcontractor undertakes its part of the project. On each claim for work performed an amount is deducted from the claim representing the retention amount pursuant to the subcontractor agreement with the taxpayer.

At the time of practical completion of the subcontractor’s works the subcontractor and the taxpayer enter into a deed of release which sets out the amounts owing to the subcontractor, inclusive of retentions.

Contract

The terms of the contract between the contractor, being the taxpayer and the subcontractor sets out the terms governing the security (including retention monies) provided by the subcontractor.

Under the terms of the contract, the contractor (taxpayer) is to have recourse to the security in certain circumstances – for instance where the subcontractor is in breach of any material obligation under the subcontract.

The contract provides for the reduction and release of security held by the contractor (taxpayer) at the time of issue of the certificate of practical completion and the final certificate.

Under the terms of the contract, any security held by the contractor (taxpayer) which is retention moneys is held in trust until contractor or subcontractor is entitled to receive them.

The taxpayer adopts the ‘Estimated Profits Basis” to report its assessable income in relation to its long term construction projects

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 provides that an amount of loss or outgoing can be deducted from a taxpayer’s assessable income to the extent that it is incurred in gaining or producing their assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing their assessable income.

Draft Taxation Ruling TR 2017/D8 Income tax: treatment of long term construction contracts explains the methods acceptable to the Commissioner for returning income derived and recognising expenses incurred in long term construction projects. TR 2017/D8 incorporates the views which were expressed in Taxation Ruling IT 2450 Income Tax: recognition of income from long term construction contracts. IT 2450 was withdrawn on 18 October 2017.

Relevant to this private ruling are the Commissioner’s views set out in paragraph 17 and onwards of TR 2017/D8 which explain the principles and practices associated with applying the estimated profits basis approach to returning income and recognising expenses from long term construction contracts for income tax purposes.

The first step under the estimated profits basis approach is the calculation of the notional taxable income arising from a contract. The next step is allocating the contract’s notional taxable income over the years taken to complete the contract. Both of these steps are discussed below.

Calculation of notional taxable income

It is explained in TR 2017/D8 (paragraphs 17 to 19) that under the estimated profit basis approach, a taxpayer is permitted 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, is in accordance with accepted accountancy practices and appropriate adjustments are made for tax purposes.

Importantly, the ‘ultimate profit or loss’ refers to the overall taxable income expected to arise from a particular contract. 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 tax law on the assumption that the losses and outgoings would actually be incurred over the period of the contract.

In effect, the ‘ultimate profit or loss’ of an entity is the 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.

Allocation of notional taxable income to each income year

The methods for allocating the notional taxable income over the years taken to complete the long term construction contract are explained in paragraphs 28 to 31 of TR 2017/D8. Each method seeks to recognise the notional taxable income in a manner that reflects the progress of the contract. The particular method adopted by an entity will depend upon the nature of a contract. Whatever method is adopted by an entity, it needs to be applied consistently across all of the years in which the contract runs and for all similar contracts.

TR 2017/D8 notes that the notional taxable income arising from a contract may need to be adjusted from year to year over the life of the contract as the estimates of income and costs change according to expectations held at the end of each year.

It is further noted that adjustments to prior years’ income tax assessments may be required under subsection 170(9) of the ITAA 1997 upon completion of the contract for example where the ultimate taxable income is more or less than the notional taxable income included over the years of the contract; or where the yearly allocation of the notional taxable income is not correct – see paragraphs 36 to 41 of TR 2017/D8.

In calculating the notional taxable income only costs that are identified as likely to be incurred over the period of the contract and which are properly deductible are taken into account. Costs can only be deducted if they are well documented and specifically identified as an event likely to occur during the period of the contract – see paragraphs 23 to 26 of TR 2017/D8.

Taxpayer’s circumstances

In the present circumstances, it is accepted that payment by the taxpayer for work performed by a subcontractor/s on a construction project is a deductible expense under section 8-1 of the ITAA 1997 as it a loss or outgoing incurred in gaining or producing the taxpayer’s assessable income or, in carrying on the taxpayer’s business for the purpose of gaining or producing its assessable income.

Consequently, under the estimated profits basis approach the estimated amount of costs for work performed by subcontractor/s over a period of a contract would be treated as a deductible expense which would be taken into account in arriving at the notional taxable income amount or ‘ultimate profit or loss’ that is expected to arise from a particular contract. As mentioned above, the estimate for subcontractor/s costs will need to be well documented and specifically identified for these costs to be treated as deductible expenses under the estimated profits basis method.

The notional taxable income thus determined would be spread over the years taken to complete that contract, in accordance with the method of allocation of the notional taxable income adopted by the taxpayer subject to further adjustment/s at the end of each income year as expectations change about the underlying estimates of income and expenses. For instance, the estimate of subcontractor’s costs may need to be varied up if for example, there is an increase in material costs.

Therefore, in effect as the estimated profits basis approach focusses on the end-result i.e notional taxable income and the underlying estimates of forecasted expenses and income, the question around when amounts, which are later withheld from payments of subcontractor/s invoices, pursuant to the taxpayer’s contractual obligations i.e the retentions payable amounts do not arise.

Accordingly, under the estimated profits basis approach, the retentions payable amounts will form part of the estimate for subcontractor/s works that is likely to be incurred over a period of contract. These estimated costs in turn are taken into account in calculating the notional taxable income of a contract.

The treatment of the retentions payable amounts in this manner is consistent with the approach taken by the Commissioner in TR 2017/D8 at paragraph 20 regarding the treatment of such payments as up-front payments, advance progress payments or amounts retained by the customer pursuant to a retention clause. Under the estimated profits basis, no adjustments are made in respect of these payments as these amounts will form part of the estimated total receipts and thus notional taxable income (cf. ‘basic’ approach – paragraphs 10 to 13 of TR 2017/D8).

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