ICDS III : Construction Contracts - Income Tax - Ready Reckoner - Income Tax

ICDS III : CONSTRUCTION CONTRACTS This Income Computation and Disclosure Standard should be applied in determination of income for a construction contract of a contractor. A construction contract is contract negotiated for the construction of an asset or a combination of assets. A construction contract, by nature entails time and resources. A construction contract may be negotiated for the construction of a single asset. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. Construction contracts are formulated in a number of ways which, for the purposes of this Income Computation and Disclosure Standard, are classified as fixed price contracts and cost plus contracts. Some construction contracts may contain characteristics of both a fixed price contract and a cost plus contract, for example, in the case of a cost plus contract with an agreed maximum price. For example: A contract for rendering of services would be a construction contract provided the service contract is directly related to the construction of the asset. A contract for destruction or restoration of assets, and the restoration of the environment following the demolition of the asset is also to be regarded as a construction contract . This clause covers contracts of demolition of buildings, breaking of ships, clearing of debris after train accident or mining accident. Fixed price contract:- It is a construction contract in which consideration for the construction work is pre-determined subject to an adjustment / revision due to cost escalation clauses. It has two types of fixed price contracts. The first type is where the contract price is agreed upon as a fixed amount. The second type of fixed price contract is where the contract price is determined based on a unit-of-measure. This type of a contract is generally entered where it is feasible to measure the underlying asset in terms of units. For example road construction contract. In a road construction contract it is possible to agree to the price on a per kilometer basis. 1. Combining and Segmenting Construction Contracts:- The requirements of this ICDS are to be applied separately to each construction contract. However, in certain circumstances, it would be necessary to apply the ICDS to the separately identifiable components in order to reflect the substance of a contract or a group of contracts. A single construction contract covering a number of assets would have to be segmented into separate contracts if the stipulated conditions are cumulatively satisfied which is - separate proposals have been submitted for each asset each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset the costs and revenues of each asset can be identified. A group of contracts, whether with a single customer or with several customers, should be treated as a single construction contract when - the group of contracts is negotiated as a single package the contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin the contracts are performed concurrently or in a continuous sequence. Where a contract provides for the construction of an additional asset at the option of the customer or is amended to include the construction of an additional asset, the construction of the additional asset should be treated as a separate construction contract when - the additional asset differs significantly in terms of design, technology or function from the asset or assets covered by the original contract the price of the additional asset is negotiated without regard to the original contract price. 2. Contract Revenue:- Contract revenue shall be recognised when there is reasonable certainty of its ultimate collection. The expression reasonable certainty would mean that the contractor should recognize contract revenues only if there is no doubt about collection of such revenues. Contract revenue shall comprise of:- the initial amount of revenue agreed in the contract, including retentions and variations in contract work, claims and incentive payments to the extent that it is probable that they will result in revenue and they are capable of being reliably measured. The ICDS however stipulates that the retention monies are part of the contract revenue. In applying the percentage of completion method, the income recognition should factor retention amounts also as contract revenue. The ICDS states that amount of retentions constitutes contract revenue. The issue is with regard to the year in which such revenue satisfied the test of accrual. It is held that a contractor cannot be said to have earned the retentions u/s 5 of the Act unless the conditions stipulated in the contract are satisfied or defects are rectified. No enforceable right arises till the conditions are satisfied or defects are rectified. Till such time the right to receive vis- vis retentions is contingent in nature. [CIT v P C Constructions (P) Ltd] [ 2009 (7) TMI 35 - MADRAS HIGH COURT ] Note: Where contract revenue already recognised as income is subsequently written off in the books of account as uncollectible, the same shall be recognised as an expense and not as an adjustment of the amount of contract revenue. 3. Contract Costs:- Contract costs shall comprise of costs that relate directly to the specific contract such as labour costs, cost of materials, depreciation on plant and machinery, plant and machinery hiring charges, sub-contractor charges, architect fees, soil testing charges, etc. costs that are attributable to contract activity in general and can be allocated to the contract. AS 7 contains examples of costs such as insurance, costs of design and technical assistance not related to a specific contract, and construction overheads such other costs as are specifically chargeable to the customer under the terms of the contract. These include administration costs and research costs which are agreed to be reimbursed by the contractee. allocated borrowing costs in accordance with the Income Computation and Disclosure Standard on Borrowing Costs. These costs shall be reduced by any incidental income, not being in the nature of interest, dividends or capital gains, that is not included in contract revenue. Note: Contract costs that relate to future activity on the contract are recognised as an asset. Such costs represent an amount due from the customer and are classified as contract work in progress. 4. Recognition of Contract Revenue and Expenses :- Contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date. The recognition of revenue and expenses by reference to the stage of completion of a contract is referred to as the percentage of completion method. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed. The stage of completion of a contract shall be determined with reference to the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or surveys of work performed; or completion of a physical proportion of the contract-work. A contractor could choose any one of these criteria to determine the stage of completion of contract. Progress payments and advances received from customers cannot be adopted as a criterion for determining the stage of completion of contract. When the stage of completion is determined by reference to the contract costs incurred upto the reporting date, only those contract costs that reflect work performed are included in costs incurred upto the reporting date. Contract costs which are excluded are: contract costs that relate to future activity on the contract and advance payment to sub-contractors. During the early stages of a contract, where the outcome of the contract cannot be estimated reliably contract revenue is recognised only to the extent of costs incurred. The early stage of a contract shall not extend beyond 25 % of the stage of completion. Allowance of losses:- As per AS 7 expected losses shall be recognized in the financial statements and not in proportion to percentage of completion of contract. Similar prescription is absent in the ICDS. ICDS states that only the actual losses (and not expected losses) are to be recognized. ICDS I also says that expected losses shall not qualify as a deduction unless otherwise specifically permitted under any ICDS.Thus only actual losses are allowable under the ICDS. The actual loss made by the tax payers would be eligible for the deduction in compliance with the provision of section 28 or 37 of the Income tax Act . One will also have to make a distinction between incurred loss and expected loss. ICDS only prohibits allowability of expected loss and not an incurred loss. 5. Changes in Estimates:- The percentage of completion method is applied on a cumulative basis in each previous year to the current estimates of contract revenue and contract costs. Where there is change in estimates, the changed estimates shall be used in determination of the amount of revenue and expenses in the period in which the change is made and in subsequent periods. The change in estimate would not affect the contract revenue and costs recognized in the prior years For example: AB Pvt Ltd enters into a construction contract with XY Pvt Ltd during FY 2016-17 for constructing a wind mill. The contract revenue and contract costs estimated at the time of entering the contract are ₹ 10 crores and ₹ 8.5 crores respectively. The contract revenue and costs are revised on account of escalation in prices of wind turbine to ₹ 10.5 crores and ₹ 9 crores respectively in the subsequent year (FY 2017-18). The effect of the change in estimates of contract revenue and contract costs would have to be given effect in the AY 2018-19 [relevant to FY 2017-18] and subsequent AYs. Contract revenue and costs offered to tax in AY 2017-18 (relevant to FY 2016-17) would remain unchanged. 6. Disclosure:- A person shall disclose the amount of contract revenue recognised as revenue in the period; and the methods used to determine the stage of completion of contracts in progress A person shall disclose the following for contracts in progress at the reporting date, namely- amount of costs incurred and recognised profits (less recognised losses) up to the reporting date the amount of advances received and the amount of retentions