This article discusses AASB 15 and the significant impact it will have on a range of industries including construction, telecommunications, software development and licensing, and real estate.
In December 2014, the Australian Accounting Standards Board released standard AASB 15 Revenue from Contracts with Customers (the Australian equivalent of the international standard IFRS 15) which becomes effective for reporting periods after 1 January 2018 (1 January 2019 for not-for-profit entities).
AASB 15 will have a significant impact for a range of industries including construction, telecommunications, software development and licensing, and real estate. Typically, taxpayers in these industries will have features, including that they:
- provide customers with bundled products and services;
- provide their customers with warranties/rebates; and
- have contracts that will have revenue that can vary significantly.
Currently the Commissioner of Taxation (the Commissioner) sets out his approach to the recognition of income from long term construction contracts in Taxation Ruling IT 2450. The ruling sets out the acceptable methods of determining taxable income, being:
- the basic approach; and
- the estimated profits basis.
Overview of TR 2017/D8
On 18 October 2017, the Commissioner released Draft Taxation Ruling TR 2017/D8 which provides the Commissioner’s view (unchanged to that in IT 2450) on the taxation of income under long term construction contracts.
The Commissioner confirms in the draft ruling that income under a long-term construction contract must only be recognised under either the basic approach and the estimated profits basis method. The Commissioner does not accept that the completed contracts method can be used when calculating income from a long term construction contract.
When and if the ruling is finalised and issued, it is proposed to apply from 1 January 2018.
What is a long term construction contract?
A long term construction contract refers to contract under which construction work extends beyond one year of income, or if less than 12 months, straddles over two or more income years.
A long term construction contract does not involve the sale and supply of what is ordinarily regarded as trading stock.
Under the basic approach, the Commissioner is of the view that assessable income includes not only progress and final payments actually received in a year, but also amounts billed or entitled to be billed to customers in a year for work carried out and certified as acceptable by the relevant party.
Under this approach, income is taxable in the year of receipt. As such, upfront payments and progress payments are assessable in the year of receipt. The key issue that arises under this approach is when the income is actually derived and whether the receipt of income should be regarded as unearned income on the Balance Sheet.
Estimated profits basis
The estimated profits basis permits a taxpayer to spread the ultimate profit or loss over the years taken to complete the contract, provided the basis is reasonable. The ultimate profit or loss is effectively the notional taxable income expected to arise for a particular contract and that which is spread over the number of years to complete the contract (the method of allocating the notional taxable income will depend on the nature of the contract e.g. for a fixed price contract, the notional taxable income will need to be determined each year).
This method is acceptable as long as it is reasonable and in accordance with accepted accounting practice. The income is calculated on a notional taxable income basis which is determined on the progress of the contract.
Interaction with AASB 15
The estimated profits basis is similar to AASB 15, however, appropriate adjustments must be made for income tax purposes.
Under the estimated profits basis, income is assessable during the period of the contract, while AASB 15 alters this approach with income only being measured when the entity satisfies a performance obligation in relation to the contract.
As a result, AASB 15 does not necessarily bring into line the accounting recognition of revenue with the tax law. The effect of this is that income that is derived for tax purposes may not be recognised as accounting income under AASB 15 and subsequently these amounts will be reported on the Balance Sheet and not on the Profit & Loss Statement.
AASB 15 will require recognition of revenue when the good or service is provided, which is in contrast to how income is recognised under the estimated profits basis.
For contracts where there is a retention clause for a percentage of the contract price until the maintenance period has elapsed, these retention amounts should not be included in assessable income until either the taxpayer receives them or is entitled to receive them.
The estimated profits basis permits a taxpayer to spread the ultimate profit or loss over the years taken to complete the contract, provided the basis is reasonable.
The ultimate profit or loss is effectively the notional taxable income expected to arise for a particular contract and that which is spread over the number of years to complete the contract (the method of allocating the notional taxable income will depend on the nature of the contract e.g. for a fixed price contract, the notional taxable income will need to be determined each year).
The issue of the draft ruling provides a timely reminder of the potential differences that can arise in the recognition of income for tax and accounting purposes. The potential of recognising assessable income for tax purposes earlier than that income is recognised for accounting purposes will impact cash flows and a detailed review of new and existing contracts should be considered in light of AASB 15.