Developers' & Contractors' Tax and accounting base reconciled

The Tax Department in their Interpretative Circular 53, issued on 12th of October 2021, are abolishing Circular 1987/21 “Real Estate Developers & Contractors” as from 01/01/2022.

Circular 1987/21 had regulated for over 3 decades now (!!!) the timing of profit recognition for tax purposes for 3 main types of business activities:

1. Land development-site separation
2. Fixed price contracts-3rd party and
3. Development projects.

As from 01/01/2022, Developers and Contractors (D&C) will no longer be able to choose between the two methods, laid down in the 1987’s Circular, for computing their taxable income, being the:

a) Substantially completed method or the

b) Percentage of completion method.

As a consequence, taxpayers could not anymore defer revenue recognition, for long term projects, which straddle two or more tax years, to that point in time, when stage of completion reaches either 50% or 90% respectively.

Starting from 01/01/2022 D&C will have to apply Interpretative Circular 15/2021 for ‘new projects’ whilst for ‘old projects’, maturing in 2022-2024 may still if they opt to do so, to continue to apply Circular 1987/21, subject to the transitional provisions stated below.

Circular 15/2021, issued on 15th of May 2021, aligns the tax treatment of revenue recognition for long term construction projects with the accounting treatment as stipulated by IFRS15 ‘Revenue from Contracts with Customers’.

To this end, the Tax Office is adopting the standard’s single, principle-based 5-step model as an acceptable method of determining taxable income for long term construction contracts.

As per this model the point of revenue recognition is the point when a performance obligation (’promise’) is satisfied, which may occur at a point in time or over time.

IFRS 15 specifies that to recognise revenue over time the customer must control the asset as it is created or enhanced. Since 01/01/2018, revenue recognition is based on the transfer of control of goods or services to a customer, rather than when just transfer of risks and rewards takes place.

Under IFRS 15, an entity must determine for each performance obligation whether control is transferred over time or at a point in time. If control is not transferred over time, the default position is that the performance obligation is satisfied at a point in time.

Determining when control is transferred requires judgement. Indicators to be considered in determining the point in time at which control of the good or service passes to the customer may include:

• Whether the entity has a right to payment

• Whether the customer has obtained legal title to the asset.

• Whether the entity has transferred possession of the asset to the customer

• Whether the customer has significant risks and rewards of ownership of the asset

• Whether the customer has accepted the asset.

Determining when revenue is to be recognized over time or at a point in time

Before the enforcement of IFRS 15 (01/01/2018), IFRIC 15, Agreements for the construction of real estate, provided guidance on whether a real estate development contract was in the scope of IAS 11 (a construction service) or IAS 18 (delivery of a good).

Revenue for development units, falling within the scope of IAS 18, was recognised when the risks and rewards of ownership of the units passed, which often coincided with the transfer of legal title or the passing of possession to the buyer. (‘at a point in time’)

For contracts that fell within the scope of IAS 11, Revenue had been recognised as the construction activity was progressing to completion. (‘over time’)

Its’ all history now with both IAS18 and IAS11 and interpretations being replaced by IFRS15.

As mentioned earlier, under IFRS15 revenue is recognized when a performance obligation is satisfied, which occurs when control of a good or service is transferred to the customer.

D&C will have to recognise revenue and pay tax accordingly over time if ANY of the following three (3) criteria are met:

a) Customer consumes benefits as entity performs.

b) Customer controls asset as it is created or enhanced. (e.g. building on customer land)

c) The asset being created has no alternative use to the entity AND right to payment for performance completed to date exists. (e.g. off-plan apartment sales)

If the above requirements to recognise revenue over time are met, an entity could measure progress of satisfying the performance obligations using a method that best depicts performance. Methods for recognizing revenue when control transfers over time include:

• Input method (contracts costs to date as a % of total costs)
• Output method (work certified to date)

The output method uses direct measurement of value to the customer of the goods or services transferred to date. This includes using the appraisal of results achieved, milestones reached or units produced or delivered, e.g. when three floors of a ten floor building have been constructed 3/10 of revenue are recognized.

The input method uses the entity’s efforts or inputs to the satisfaction of a performance obligation. This includes using the resources consumed, labour hours expended, costs incurred, time lapsed or machine hours used, e.g. when €100k of costs have been incurred out of an estimated total project cost of €1.000k you recognise 10% of revenue.

Circular 1987/21 will continue to be applied for the tax year 2021 and as from 2022 (see below for the transitional provisions) the computation of taxable income will become fully compatible with the accounting treatment as prescribed by IFRS 15.

The guideline provides that the tax treatment of income recognized under IFRS 15 should be consistent with the accounting treatment, both for IT purposes and for the computation of SDC on DDD. As the new Circular reconciles the two set of books no adjustments are required either for IT or SDC purposes.

Transitional provisions

The Circular contains a grandfathering clause which enables taxpayers to continue applying the old Circular up until 31/12/2023 with respect to ‘old projects’ Only.

‘Old projects’ are defined as those for which construction work took off either during or before 31/12/2021.

Any unrecognized income up until 31/12/23, as a result of the taxpayer making use of the transitional provisions, will have to be recognised in full in 2024. The temporary tax provisions for the imposition of additional tax due to low temporary assessment will apply to that year’s profits.

Taxpayers will be able to adopt the transitional provisions for the years 2022 and 2023 by making the election on their tax return. Taxpayers may also elect to apply the old circular for only 2022.

Tax considerations?

Profits for ‘old projects’ that satisfy the ‘overtime- conditions’ may flow to tax computation at an earlier stage, unless taxpayer makes use of transitional provisions.

For ‘new projects’ (those commencing after 01/01/2022) profits will be subject to tax as performance obligations are satisfied in line with the Standard.

Any adjustments to the opening position of retained earnings at 01/01/18 resulted from the adoption of the standard will be taken into account in 2018 for both IT and SDC on deemed distribution.

No SDC implications on the deeming dividend provisions for later periods.

That’s all for now

See you next time