Edited version of private ruling

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Ruling

Subject: Returning income from long term construction projects

Question 1

Can the taxpayer change the methodology of determining taxable income for new long term construction contracts entered into during the particular income year ended 31 December 20XX under the Estimated Profits approach from the 'billings basis' to the 'costs basis' for the purpose of section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Can the taxpayer change the methodology for determining taxable income for existing long term contracts as at 1 January 20XX on a go forward basis, with a net tax adjustment being made in the consolidated tax return for the year ended 31 December 20XX to bring in line contract life to date profit applying the 'costs basis' for the purpose of section 6-5 for the ITAA 1997?

Answer

No

Relevant facts

The taxpayer holds long term construction contracts with a project duration which can be over 10 years.

For the purposes of compiling its Annual Financial Statements, the taxpayer adopts the percentage of completion approach to recognise income and profit. Under this approach, income for a period is measured by the degree of progress toward completion multiplied with the total sales value of the contract. The degree of progress toward completion is based on total costs incurred to date over total costs to be incurred on the contract. Profit expected to be realised on contracts are based on the estimates of total contract sales and costs at completion. Total contract sales values is the addition of contract price, contract options, charge order, claims and contract provisions for penalties and incentive payments.

The taxpayer elected to assess for income tax purposes its income and profit based on the 'Estimated Profits' approach pursuant to Taxation Ruling IT 2450 Recognition of Income From Long Term Construction Contracts.(IT 2450). The percentage of completion is currently determined using the 'billings basis', that is, the proportion the invoices raised on a project in each year bears to the total sales value of the project.

Consequently a percentage of completion approach is applied for both accounting and tax purposes, however historically the manner in which the percentage of completion has been determined has differed. A percentage of estimated total costs has been used for accounting while a percentage of billings has been used for tax.

The taxpayer believes that the historical approach for tax purposes of calculating assessable income no longer accurately reflects the true derivation of profit from a project. The terms of new long term construction contracts entered into by the taxpayer will be structured such that the taxpayer will receive more upfront/advanced payments, rather than progress payments as in the past. Accordingly, the billings basis is no longer likely to accurately reflect the percentage of completion of such contracts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Reasons for decision

Question 1

Summary

The taxpayer can change the method of calculating its income for new long term construction contracts entered into during the income year ended 31 December 20XX under the Estimated Profits approach from the 'billings basis' to the 'costs basis' for the purpose of section 6-5 of the ITAA 1997

Detailed reasoning

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

In IT 2450, the Commissioner indicates that the Estimated Profits basis is an acceptable method for accounting for long term construction contracts.

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, that is, 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.

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.

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.

In your case the approach historically applied for tax purposes to calculate the percentage of completion under the Estimated Profits approach using the 'billings basis' no longer accurately reflects the true derivation of profit from a project and applying the 'cost basis' is more appropriate to your circumstances. IT 2450 allows you under the Estimated Profits approach to adopt the 'costs basis' of determining taxable income in respect of your new long term contracts entered into during the income year ended 31 December 20XX.

Question 2

Summary

The taxpayer cannot change the methodology for determining taxable income for existing long term contracts as at 1 January 20XX on a go forward basis, with a net tax adjustment being made in the consolidated tax return for the year ended 31 December 20XX to bring in line contract life to date profit applying the 'costs basis' for the purpose of section 6-5 for the ITAA 1997.

Detailed reasoning

Prior to the 1 January 20XX your method for determining taxable income for long term contracts was the 'billings basis' under the Estimated Profits approach. 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 similar 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 'billings basis' to the 'costs basis' in respect of long term contracts that were in existence before 1 January 20XX. The taxable income of your existing contacts must continue to be determined using the 'billings basis' until they are completed.