Edited version of your written advice

Authorisation Number: 1012940721802

Date of advice: 4 February 2016

Ruling

Subject: Recognition of income and expense from long term construction project

Question

Is it appropriate for the Trustee of the Trust to use the 'estimated profit basis' outlined in Taxation Ruling IT 2450 Income Tax: recognition of income from long term construction contracts to determine the assessable income and allowable deductions related to the construction project in determining its net income in accordance with subsection 95(1) of the Income Tax Assessment Act 1936?

Answer

Yes.

This ruling applies for the following periods:

1 July 2014 - 30 June 2015

1 July 2015 - 30 June 2016

1 July 2016 - 30 June 2017

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1. ABC Pty Ltd (ABC) owns intellectual property (IP) in an invention of machinery and has been granted a patent in relation to this invention.

2. Under an agreement with the Trustee, ABC grants to the Trustee an exclusive licence to use, manufacture, sell and hire the machinery world-wide.

3. The Trustee applied for funding from a government agency to assist in developing and manufacturing the first unit of machinery (First Unit). Funding was approved under a funding agreement signed by the Trustee and the government agency (Funding Agreement).

4. The purpose of the Funding Agreement is for the government agency to provide funding to support a proposed project to develop and manufacture the First Unit (Project). The first Unit will take more than one income year to complete.

5. The amount of funding payable by the government agency is specified in the Funding Agreement and will be paid to the Trustee in instalments on the completion date of each of the milestones set out in the Funding Agreement (Milestones).

6. A claim for payment for the relevant instalment will be submitted by the Trustee with a certification that the payment criteria for the relevant Milestone specified in the Funding Agreement have been met together with any supporting documentation and evidence required for that instalment.

7. On completion of the Project, the First Unit will be sold.

Accounting treatment

8. The Trustee prepares its financial statements in accordance with Australian Accounting Standard Board (AASB) Accounting standard AASB 111 Construction Contracts (AASB 111).

9. Income and expenses associated with the Project are recognised under the principles in AASB 111. The Trustee utilises the percentage of completion method in accordance with AASB 111 and will calculate the percentage of completion based on physical estimates of work performed to date.

10. Based on the Milestones in the Funding Agreement a determination of the stage of completion is possible with significant certainty over the life of the Project and is considered the most reliable method.

11. Revenue and expenses associated with the Project will be recognized as revenue and expenses with reference to the stage of completion at the end of an income year.

Tax treatment

12. Net income or loss for an income year will be allocated on the basis of the percentage of the total funding that has been received for each Milestone in the same manner as the accounting treatment.

13. The Trustee will calculate its net income or loss using the same method over the life of the Project.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Subsection 95(1)

Reasons for decision

Under subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936) the net income of a trust is the total assessable income of the trust estate calculated as if the trustee were a resident taxpayer in respect of that income, less all allowable deductions.

Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that your assessable income includes income according to ordinary concepts.

Under subsection 6-5(2) of the ITAA 1997 your assessable income includes ordinary income you derive directly or indirectly from sources in or out of Australia, during the income year if you are an Australian resident.

Paragraph 10 of Taxation Ruling TR 2006/3 Income Tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business (TR 2006/3) states that a government payment to assist a business to continue operating, except where the payment is for agreeing to give up or sell part of the profit yielding structure, is included as assessable income of the recipient under section 6-5 or 15-10 of the ITAA 1997. TR 2006/3 continues to state at paragraph 12 that a payment to assist with business operating costs or liabilities is ordinary income in the hands of the recipient and is assessable under section 6-5 of the ITAA 1997.

The funding from the government agency to the Trustee is, therefore, ordinary income under section 6-5 of the ITAA 1997.

Under subsection 8-1(1) of the ITAA 1997 the Trustee is entitled to deduct from its assessable income any loss or outgoings to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

and none of the exceptions under subsection 8-1(2) of the ITAA 1997 applies.

Long term construction contract

Taxation Ruling No. IT 2450 Income Tax: recognition of income from long term construction contracts (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 long term construction contracts as contracts relating to construction work where construction extends beyond a year of income. This was consistent with the definition of 'construction contract' in the Statement of Accounting Standards - Accounting for Construction Contracts - AAS 11. AAS11 has now been replaced by the Australian Accounting Standard Board (AASB) as Accounting Standard AASB 111 Construction contracts (AASB 111).

Paragraph 11 of IT 2450 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, IT 2540 refers to income from similar contracts in associated fields such as air conditioning contracts, major electrical wiring or rewiring contracts, major refurbishment of hotels….

The construction of the First Unit under the Project extending more than one income year is a construction project and constitutes a long term construction contract for the purpose of IT 2540.

IT 2450 states that there are two acceptable methods to determine taxable income from long term construction contracts, the 'basic approach' and 'the estimated profit basis'. IT 2450 discusses the requirement for consistent application of the methods in paragraph 13:

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. Taxpayers who are companies in the one group should adopt the same method of determining taxable income.

Paragraph 25 states that the 'estimated profit 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 that the basis is reasonable and is in accordance with accepted accounting practices.

The Trustee proposes to recognise income and expenses associated with the Project in accordance with AASB 111. Based on the Milestones in the Funding Agreement the outcome of the Project can be estimated reliably and a determination of the stage of completion is possible with significant certainty over the construction period.

The Trustee will determine the stage of completion using physical estimates of the work performed to date.

Paragraph 32 of IT 2450 suggests the methods that are acceptable to the Commissioner:

(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 cost of the contract;

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

Any other method which achieves the same broad result would also be acceptable.

The 'physical estimate' method used by the Trustee would recognise notional net income in an income year in a manner that reflects progress of the Project. Therefore, the Trustee can use the 'estimated profit basis' outlined in IT 2450 to recognise assessable income and allowable deductions related to the construction of the First Unit under the Project in determining the Trust's net income in accordance with subsection 95(1) of the ITAA 1936.