Edited version of private advice

Authorisation Number: 1051823165583

Date of advice: 1 April 2021

Ruling

Subject: Long term construction contracts

Question 1

Would the Machinery Contracts be considered 'long term construction contracts' under Taxation Ruling TR 2018/3 Income Tax: tax treatment of long term construction contracts?

Answer

Yes

Question 2

Where question 1 is answered 'yes', for Machinery Contracts where a right to payment exists throughout the contract term, would the estimated profits basis be an allowable methodology under which to recognise the associated income and expenses?

Answer

Yes

This ruling applies for the following period

1 July 20XX to 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The Company (Company A) is a privately held company.

The group specialises in the design, manufacture and supply of mineral processing solutions and associated machinery for the mining industry. Many of the machines are offered in fully mobile or semi-mobile designs.

Many of the machines manufactured are bespoke with adjustments made to the design to fit a customer's specific site and circumstances.

The machinery is manufactured on site. Given the size of the projects, the contracting arrangement ordinarily starts with a Contract for Supply of Equipment (a Machinery Contract) being signed by both parties. After the engagement terms are agreed a specific scope of work is prepared for each machine ordered.

The manufacture of a machine can take between 6 - 24 months, including installation, acceptance testing and monitoring phase (as required under the contract).

The value of the machinery can be anywhere from $XXX,XXX to $XX,XXX,XXX.

The Machinery Contracts are ordinarily scoped on a cost-plus basis and include a detailed estimate of the expenditure required to manufacture the machine.

Machinery Contract terms can be negotiated with the clients, however, there are two main types of contract terms for the manufacture of machinery:

•         Distinct performance obligations which trigger the right to payment when milestones are met; and

•         A right to payment exists throughout the term of the contract.

Additional information was supplied supplying an Example Machinery Contract: Manufacture and Supply Contract (Without installation), amongst other information. This information and attachments form part of these facts.

Expenditure Estimates/Pricing

The detailed expenditure estimate is not made available to the customer and therefore do not form part of the contract terms. However, the price is determined by Company A on a cost-plus basis, with a breakdown of the contract price provided to the customer.

As per the example contract provided, the quoted price includes the cost of all labour, management, supervision, services, personnel, plant and equipment, materials, logistic costs, profit and overheads.

Performance Obligations

The Contractors General Obligations, Design Obligations and Manufacturing Obligations are outlined within the standard terms of the agreement.

Rights to Payment

A right to payment exists throughout the contract- where the contract is terminated, the contractor is entitled to a portion of the contract price due for the work executed prior to the date of termination but not yet paid, including the cost of materials ordered by the contractor.

The general payment conditions and obligations are outlined in the example contract and are based upon a percentage completion basis on set milestones being achieved.:

Contract Specifics/Scope of Work

This example customer has very detailed contract specifics to ensure the equipment fits the site specification. Some of the specification may be considered as identifier for the Company.

The key specifics have been summarised as follows:

•         The Manufacture and supply of X machines with an operating throughput of XXXX tonnes per hour;

•         Quoted sales price - $X,XXX,XXX (GST exclusive);

•         Payment to be received in line with progressive milestone payments; and

•         Period of contract X months (approx. XXXX 20XX - XXXX 20XA).

Appendix X provided supplied the details of clauses within this Contract. Specific relevant clauses not already highlighted are clauses in respect to title and risk.

You have stated that in accordance with the company's financial statements, Company A's revenue recognition policy for manufacturing sales is as follows:

"Revenue is recognised as distinct performance obligations when delivered or where the contract results in services that have a right to payment. For contract revenue that has a right to payment that exists, a percentage completion basis will be applied."

The treatment of the contracts with distinct performance obligations is in line with standard derivation principles outlined in section 6-5 of the ITAA 1997. The timing of this revenue is not in question.

The question arises in relation to the Machinery Contracts for which a right to payment exists throughout the project but is not derived until such time that a milestone is met. For accounting purposes, this income is recognised on a percentage completion basis under AASB 15 Revenue from Contracts with Customers.

The chosen method must be applied consistently to all income years over which the specific contract runs and any contracts of a similar nature (including service or maintenance contracts).

You state that the estimated profits basis would be the most reasonable approach as it is similar to the AASB 15 standard with the appropriate adjustments made for tax purposes.

Estimated Profits Basis Methodology - Percentage Completion

In the case of Machinery Contracts, each machine is costed in detail during the contracting phase. As such, the percentage completion basis is prepared on the basis of:

Percentage Completion = Expenses incurred in a financial year

•                                    Total estimated costs

The percentage completion is then applied to the total sales value of the Machinery Contract, allowing a reasonable portion of the gross profit margin to be recognised throughout the project.

Company A has implemented a number of controls to ensure the percentage completion reasonably represents the status of the project. Prior to approval, the calculated percentage is presented to the project team for each Machinery Contract to confirm whether the outcome is a reasonable allocation. Once incorporated, the calculations are reviewed by Company A's auditors while completing the year end audit.

Upon preparation of the tax return, the percentage calculations are reviewed again from a tax perspective to confirm that all expenses have been incurred under section 8-1 of the ITAA 1997 (or any other relevant tax provision). Where expenses have not been incurred for tax purposes, the necessary adjustments are made in the tax reconciliation such that the taxable income accurately reflects the tax position of the company.

You note that where there are no tax adjustments necessary, the estimated profits basis will allow Company A to recognise the revenue for Machinery Contracts in line with the AASB 15 standard.

You consider this policy should be an allowable methodology as:

•         It spreads the gross profit margin across the project timeline on a reasonable basis where a right to payment under the Machinery Contract exists throughout the contract's term;

•         It is in line with accepted accounting practices (AASB 15) and is approved by the company's auditors

•         It is reviewed specifically from a tax perspective to ensure all expense amounts are actually incurred; and

•         The reasonableness is confirmed by multiple parties to ensure there is no shortfall in amounts.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 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 section 8-1

Reasons for decision

Question 1

Summary

It is considered that the Machinery Contracts, where the contract extends beyond a year of income (either extending for over a year or a period less than a year which straddles two income years) constitute a long term construction contract for the purposes of TR 2018/3.

Detailed Reasoning

TR 2018/3 Income tax: tax treatment of long term construction contracts (TR 2018/3) outlines the Commissioner's view on the income tax treatment of long term construction contracts.

TR 2018/3 defines 'long term' construction work as that which extends beyond one year of income. This definition encompasses contracts which run for less

than 12 months but straddle two income years. The Machinery Contracts in question are undertaken between 6 - 24 months and, therefore, would meet the definition of 'long term' under TR 2018/3.

For the purposes of TR 2018/3, 'construction' takes its ordinary meaning. That is, "the process or method of building or making something, especially roads, buildings, bridges, etc." As outlined in paragraph 2 of TR 2018/3, "Income from long term construction contracts would include: ... income from the construction of major plant items."

Paragraph 2 of TR 2018/3 provides that income from long term construction contracts would include income from construction of buildings, bridges, dams, pipelines, tunnels and other civil engineering projects and income from construction of major plant items including ships and transport vessels. In particular, TR 2018/3 refers to income from similar contracts in associated fields such as air conditioning contracts, major electrical wiring or rewiring contracts, major refurbishment of hotels....

Paragraph 3 excludes the following from being a long term construction contract:

A long term construction contract does not include a contract for the sale and supply of what may ordinarily be regarded as the sale of trading stock, for example, it does not include a contract for the supply and installation of office furniture in a new building even though the furniture may need to be assembled upon delivery

In consideration of your circumstances in relation to paragraph 3 of TR 2018/3, activity under the Machinery Contracts relates to supply and installation of 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 plant, in your circumstances major plant for use on a mining site.

That is, the machinery manufactured by Company A is considered to be fundamental to the operation of their customers' mine sites. On this basis, the machinery manufactured by Company A would be considered to constitute major plant items and, therefore, the manufacture of the machinery would meet the definition of 'construction' as outlined in TR 2018/3.

Further, the activities you are performing under the Machinery Contracts do not appear to be sales and supply over time of what would ordinarily be regarded as trading stock. Therefore, paragraph 3 would not act to exclude the Machinery Contracts from the application of TR 2018/3 in determining your taxable income.

This paragraph would appear to suggest that if an item was trading stock then it would be excluded from the operation of TR 2018/3. The example given in TR 2018/3 of delivering and installing items of furniture (trading stock) progressively over a period of time does not align with the nature of the long term construction of the heavy mining equipment and the testing and installation thereof.

As the construction of the mining machinery and associated testing and installation over a period of time can be considered as representing the manufacture of major plant components and, therefore, aligning with the nature of those acceptable items, it is reasonable to conclude that the Commissioner intended TR 2018/3 to apply to contracts of the nature of the Machinery Contracts.

Therefore, it is considered that the Machinery Contracts involving the design, manufacture and supply of mineral processing solutions and associated machinery, where the contract extends beyond a year of income, either extending for over a year or a period less than a year which straddles two income years, constitutes a long term construction contract for the purposes of TR 2018/3.

Question 2

Summary

Yes, you may adopt the 'estimated profits basis' in respect of the Machinery Contracts, where a right to payment exists throughout the contract term, to recognise the associated income and expenses.

Detailed Reasoning

The Commissioner has formed the view in Question 1 that the Machinery Contracts are long term construction contracts.

Accordingly, you may apply TR 2018/3 when determining your taxable income and are eligible to apply either the 'basic approach' or the 'estimated profits basis'.

Paragraph 5 of TR 2018/3 states:

5. The principles and practices which apply in recognising for income tax purposes, income derived from and expenses incurred in long term construction contracts are:

(a) All progress and final payments received in a year are to be included in assessable income and income tax deductions allowed for losses and outgoings to the extent permitted by law. [See Basic approach ]

(b) Notwithstanding (a) any method of accounting which has the effect of allocating, on a fair and reasonable basis, the ultimate profit or loss on a contract over the years taken to complete the contract will be acceptable. [See Estimated Profits Basis ]

TR 2018/3 discusses the requirement for consistent application of these methods. In particular, paragraph 6 of TR 2018/3 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'.

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 cannot apply a different method to existing contracts.

It is considered that your percentage completed methodology aligns to the estimated profits basis as it "permits a taxpayer to spread the ultimate profit or loss on a long term construction project over the years taken to complete the contract, the basis is reasonable, is in accordance with accepted accountancy practices and appropriate adjustments are made for tax purposes."

This policy is considered to qualify as an allowable methodology because:

•         It is a method of accounting which has the effect of allocating, on a fair and reasonable basis, the ultimate profit or loss on a Machinery Contract over the years taken to complete the contract;

•         It spreads the gross profit margin across the project timeline on a reasonable basis;

•         It is in line with accepted accounting practices (AASB 15) and is approved by the company's auditors;

•         It is reviewed specifically from a tax perspective to ensure all expense amounts are actually incurred; and

•         The reasonableness is confirmed by multiple parties to ensure there is no shortfall in amounts.

Therefore, you may adopt the 'estimated profits basis' in respect of the Machinery Contracts, entered into on or after 1 XXXX 20XX, where a right to payment exists throughout the contract term, to recognise the associated income and expenses.

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