As the saying goes, two things in life are certain - tax and death – yet, when it comes to tax in the building and construction industry, there’s little certain about calculating the correct amount to pay.
Despite the size of the construction industry in New Zealand, the fact that building is one of the oldest occupations in the world and that these tax uncertainties exist, the IRD has no specialised, coordinated approach and there is little likelihood of an IRD policy statement on the industry.
The accounting standards dealing with this have evolved over the last 30 years and there are currently different accounting standards for different sized entities. New accounting standards are currently being developed which will change the accounting rules again. It is not a matter of one rule fits all.
One issue is not whether income will be taxable but when that income should be recognised. There are opportunities for some people to recognise income when invoiced, others to recognise income on a cash basis but, more generally, income is recognised when it is derived. That is when the timing or calculation of recognition of income can be difficult, particularly when dealing with long term construction contracts or those which span your balance date. In limited situations, income can be recognised when the contract is completed but this is usually only when the contract requires payment following completion of the project.
The most commonly recognised method is the percentage of completion method which recognises anticipated contract profits progressively over the term of the contract, provided that the outcome of the contract can be reliably estimated.
One difficulty is whether percentage of completion is measured based on the percentage of costs recorded so far or against the percentage of revenue recorded so far. They both seem a reasonable measure of progress but each results in a calculation of a different profit, particularly on the larger and more complex projects where there are particular rules about when and what can be included in a progress claim.
A major issue arises when the building or construction company is able to make a progress claim for work which may not be done when the claim is raised but will be done by the time the claim is certified. The view of several IRD auditors is that because it is being claimed, it is taxable at that time, but because the underlying costs have not been incurred no deduction is claimable for those resulting in paying tax on profit which does not exist.
The IRD will also recognise a cash receipt basis where instalments are paid based on physical completion stages as revenue when received. Where claims are made monthly, this can result in no income being recognised for work performed in the final month of each financial year as the client has not paid for that work until the month after balance date.
Many companies do not recognise retentions receivable as income until they are received which results in deferring taxable income until later. This is useful for managing cashflow in the short term but does result in a larger tax bill after the contract has been completed or when the retentions are received.
Claiming allowable deductions is subjective and frequently results in long debates with IRD auditors. There are a number of different possibilities and issues which arise.
One situation is where subcontractors put in progress claims at say the 25th of the month, yet the progress claim for the whole contract may be dated at the end of the month. Can a deduction be claimed for the work performed by the subcontractors in the intervening five or six days which has not been invoiced by them? The IRD generally refers to the HW Coyle case which is the best known taxation case law in the industry. The Coyle case generally concluded that progress payments received during one year were income in that year. The difficulty with Coyle, a roofing contractor, was that they did not have any subcontractors and therefore the case did not adequately deal with when and how a deduction is claimed for the costs, particularly in the example of subcontractors cutting off at a different date for that invoicing.
Where the outcome of a contract cannot be estimated reliably, a deduction can be claimed for costs immediately. Revenue is only recognised to the extent that the contract costs are recoverable. This can result in some very unusual outcomes, although should be infrequently applied as most contracts are professionally planned and accurately measured and estimated by the quantity surveyors.
When all of the above factors are combined, calculating work in progress and tax related adjustments at balance date can be fraught with difficulty. I am aware of at least one substantial construction company where the IRD auditor was happy that work in progress not be recognised for tax purposes but that it is not the normal situation.
As tax payers we have an obligation to take reasonable care and to take an acceptable tax position when preparing and filing income tax returns. This is challenging when there is little guidance from IRD, no IRD coordinated policy in this area and we find ourselves somewhat at the mercy of individual investigators when we are eventually selected for an IRD audit.