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The object of this article is to
deal with certain aspects of income tax pertaining to construction
business. It is not intended to cover all the aspects as there are
other articles in this special issue, e.g. there are separate articles
on presumptive taxation, development agreements, etc in respect of
construction or real estate-development activity. I have attempted
to touch upon the following points:
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Treatment of land cost (introduction
by partner, conversion into stock in trade etc. )
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Capital Asset vs. stock in trade
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Valuation of Work in progress,
Job completion method vs. Percentage Completion Method and Variations
thereof.
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Statutory disallowances
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Various Tax incentives (including
80-IB)
- Accounting and taxation of construction business
often pose serious problems due to the following factors –
- There are various methods of accounting – cash
vs. mercantile; completed contract vs. progressive completion;
- Projects usually range over a long period –
often more than one or two years and there is an element of uncertainty
in determination of profits.
- Various events are to be reconciled with each
other-viz. entering into of agreements, execution of agreement ,
handing over of possession, progressive payments, concepts of FSI,
TDR, roles of builder – developers vis-à-vis contractors.
- Amounts involved are usually quite high and
even a small error in judgment may have serious repercussions.
- Accounting standards also elude simplicity.
- Motivations of Revenue Authorities are also
vicious.
Nevertheless,
one has to face the reality. Hence, this exercise to find practical
interpretations.
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Treatment of land cost
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The deals of purchase of land
are seldom simple and straight forward.
Payments are partly in money and partly in kind – say giving
constructed flats, shops, etc. There are litigations; tenants
to be settled, encroachments to be removed, Government restrictions
to be cleared, interests on borrowings for purchase of land, stamp
duty and registration fees; and so on. Grants of additional FSI,
purchase of TDR etc. create further complications.
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The cost of the land is added
to the total cost of project proportionate to the construction
completed vis a vis the total construction.
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Introduction of land by the
Partner –
In case the plot of land is introduced by the partner as his
capital contributions, as per section 45(3), the value of asset
recorded in the books of accounts of the firm is to be taken as
the full value of consideration received or accrued as a result
of the transfer of land. As a corollary, the same will be treated
as cost in the hands of the firm.
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Many times, the land is purchased
where there are already unauthorized dwelling units. Certain amount
of compensation or similar other cost is required to be incurred
for clearing such encroachments. Such costs form part of the cost
of the land.
- Capital asset vs. stock in trade
- Conversion of land held as capital asset
into Stock-in trade [Section 45 (2)]
In many cases, an individual who holds a large area of land
converts it into stock–in–trade and carries on business of construction/development.
In such an event, the market value of land on the date of conversion
will be considered and capital gains will be computed. However,
these capital gains will be chargeable to tax when such land is
developed/constructed and sold. In case, such sale spreads over
more than one year, capital gains pro-rata will be chargeable to
tax. Correspondingly, for determining business income, such market
value on the date of conversion would be regarded as cost.
- In the construction industry, land is considered
as stock-in-trade. Ordinarily, therefore, the question of capital
gain does not arise on sale of land. Hence, Question of Sec. 50
C does not arise.
- Valuation of Work in progress, Job completion
method vs. Percentage Completion Method and Variations thereof
- In the completed contract method, the profit
from the project as such is effectively accounted for only in the
year in which the project is substantially completed. If some minor
or insignificant part of the project is remaining, this cannot be
a valid reason to postpone the tax liability. In practice, at the
end of the year, the work-in-progress is simply carried forward
at cost. However, the overheads, which cannot be directly attributed
to the project cost, have to be debited to profit and loss account.
This may result into a loss, which may be carried forward. In the
year of completion of project, the profit on the project will be
accounted for and the accumulated losses will be offset. When there
is only one project, the situation appears to be rather anomalous.
However, when there are several projects getting completed in different
years, the fact does not become very glaring. There is insistence
by I. T. department not to follow this method as income is deferred
to the subsequent year.
- In percentage completion method, there is a
risk. One may account for the estimated profit on the progress of
completion from year to year. However, when the project is completed,
it may have resulted in a loss or a profit which is less than what
is submitted earlier. Unfortunately, there is no remedy to the over-payment
of taxes in the earlier years. Therefore, there is a tendency to
adopt the completed contract basis. When there are a number of projects
at varied completion stages, the loss can be offset against the
profits of others. But in a single project, this method may pose
problems.
- Section 145 recognises only two methods, viz.
Cash or Accrual. The methods described in preceding paragraphs viz.
completion or progressive - have to be fitted into either cash or
mercantile. It is more or less settled that these methods can be
called as a variant of mercantile method.
- In cash as well accrual method, one cannot take
a dogmatic or extreme view. Thus, merely because advances are received,
there may not be any element of income even in cash system. On the
other hand, if a builder enters into agreement for sale of flats
and receives part advances, he need not account for the entire sale
merely on the basis of such agreements. One has to decide the correct
profitability from year to year in the facts and circumstance of
the case.
- It is interesting to note that when a contract
is inclusive of materials and the materials are supplied by the
contractee, the profits u/s 44 AD are to be estimated only on net
labour payment. (Circular No.684 dtd. 10-6-1994). On the other hand,
tax u/s 194C is to be deducted on the entire contract value (Circular
No.295 dt. 6-3-1981 F.No.275/56/79 - IT13)
- The quantum of profits to be offered to tax
often poses problems, since project extends over more than one year.
There are cases where the books of account are rejected by the AO
and profits are estimated; still the depreciation, interest, salary,
bonus payable to the partner as provided in Section 40(b), should
be deducted. The CBDT circular dated 31-8-1965 also states that
depreciation must be deducted from the estimated profits. (Jain
Construction Co. – 156 CTR 290 Raj)
- Many times builder receives the advances
exceeding Rs. 40 lacs. However, in the Profit & Loss Account,
profit is computed by taking difference between opening Work-In-Progress
(WIP), expenses incurred during the year and the market value of
closing WIP. The question arises whether Tax Audit is necessary?
Sales, Turnover and Gross receipts,
though not defined in Income-Tax Act, 1961, have to be considered
in commercial sense. The Guidance Note on Tax Audit under section
44AB published by the Institute of Chartered Accountants of India
has also expressed this view. Further, the Hon’ble Supreme court
in Challapalli Sugars Ltd. (98 ITR 167) (SC) has accepted
that normal rules of accountancy and commercial sense should prevail
unless there is a different provision in the Act.
The Gross Receipts should include
all the receipts which are assessable as income. It should not
include advances which are not includible in the Computation of
Income.
Section 145(1) provides that
profits/gains should be computed as per the method of accounting
followed by the assessee. Thus, the method of accounting should
also be considered.
The value of WIP in the construction
industry can not be considered as sales/turnover. (B. K. Jhala
& Associated – 69 ITD 141-Pune).
The receipt of advance does not
pass on the property in the flats/units.
In
view of this, it can be said that in the above case, provisions
of Tax Audit may not be applicable. This also implies that the
receipts of advances by themselves do not give rise to profits
or income.
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Method of Accounting
The assessee was a builder who sold two buildings in two assessment
years. In the third year, there were major receipts from the projects.
The assessee offered the income of all the three years in the
third year since he was following Project Completion Method. The
AO estimated the income for the first two years. It was also argued
by the Revenue that the assessee was not a builder but was only
a financier/Supervisor of the building. The land was also not
transferred to the assessee.
The tribunal held that the assessee
was entitled to follow the project – completion method and estimation
of profits for first two years was deleted. [Happy Home Developers
vs. Asstt. CIT-115 Taxman 309 – (Mum) (Mag)].
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The assessee was engaged in the
business of development of land and sale of plots. It sold some
plots during the year. However, no profit was offered to tax on
the ground that the assessee was following single venture method
of accounting.
It was held that though section
145 permits the adoption of the method of accounting for the income
computed under the head Business Income and Income from other
sources, the method which allows the assessee to defer the accrued
income of a particular year to future year, can not be said to
be a proper method of accounting. It will come in the way of section
4 since such profits would not belong to the last year. (Greater
Ashok Land & Dev. Co. (P) Ltd. vs. Asstt. CIT – 79 ITD 595
– Delhi).
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The assessee was builder, following
project completion method. The AO did not accept the assessee’s
method and assessed income on the basis of percentage of work
completed. The CIT(A) accepted the method of accounting and remitted
back the matter since not even 60% of FSI was constructed.
The ITAT, Mumbai held that though
there is no general rule for the specific percentage of the total
area of the project which should be considered to be substantially
completed, it seemed proper that the income should be taxed in
the year in which 75% of the total area constructed by the assessee
was sold. (Parekh Properties (P) Ltd. vs. Asstt. CIT – 2003
SOT 124 –Mum).
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Retention money – Treatment
while computing the total income and tax liability
Often the question arises whether retention amount should
be offered to tax due to the fact that such receipt is contingent
upon various factors. Since the receipt is uncertain, it is logical
that the same should be offered to tax as and when received. In
case the retention amount is not received, the TDS amount
on the retention money may have to be forgone. It is worth noting
that the old Accounting Standard (AS-7) permitted both the treatments
namely recognition of Income on accrual basis or on receipt basis.
However, the revised AS-7 is silent on this issue.
- Statutory Disallowances
The following statutory disallowances are more commonly attracted
in the construction business.
Sec. 40A (3): The very
nature and magnitude of transactions is such that payments of expenditure
in cash exceeding Rs. 20,000/- become almost inevitable.
Explanation to sec.37 :
Payments of protection money, speed money etc are the open secrets
of the construction business. These may attract disallowance on the
ground that the payments are for a purpose
which is an offence or which is prohibited by law.
Sec. 40 (a) : Payments
to non-residents without TDS. This may be relevant if land is purchased
from an NRI; or where foreign experts are hired (e.g. Construction
of bridges, dams, etc)
Sec.
43B: Statutory and other payments like interest to Banks; as contemplated
in sec. 43B, if not paid within prescribed time, will be disallowed.
Works Contract Tax may also be a sizeable amount.
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Tax Incentives
Section 80 IA & 80 IB give tax incentives to the construction
business. These incentives are discussed below -
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Concession for infrastructure
facilities
Under the provisions of section 80-IA, roads, highways, bridges,
airports, ports and rail systems are treated as infrastructure
facility and the enterprises engaged in developing or operating
and maintaining or developing, operating and maintaining such
infrastructure are eligible to a tax holiday for five years and
a deduction of 30% of profits for the next five years. The enterprise
claiming such benefit has to enter into an agreement with the
Central or State Government or a local authority or any other
statutory authority, by which it has to transfer such facility
to the Government or public authority after the specified period.
In order to give boost to the
investment in surface transport, water supply, water treatment
system, irrigation project, sanitation and sewerage system or
solid waste management systems, Section 80IA has been amended
to provide that such an enterprise can avail of the tax holiday
consecutively for any ten years out of twenty years beginning
from the year in which the undertaking begins operating the infrastructure
facility.
In the case of other infrastructure,
namely, for airport, port, inland port and inland waterways, section
80-IA has been further amended so that ten year tax holiday can
be availed of in a block of initial fifteen years.
The condition that such infrastructure
facility should be transferred to the Central Government, State
Government or local authority has also been removed. However,
an agreement with such authorities for construction of the infrastructure
would have to be entered into.
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Tax holiday to the Undertaking
engaged in development of housing projects
Section 80-IB (10) provides that if the undertaking develops
and builds housing projects approved by the local authority before
31-3-2005, 100% of the profits derived from such project will
be allowed as deduction. In this case, following points need to
be noted-
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The date of completion of
project is not relevant.
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If part of the project is
sub-contracted, such sub-developer may not be eligible for
deduction u/s 80-IB(10).
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The project is on the size
of a plot of land, which has a minimum area of one acre. The
area of plot may spread over more than one location and still
will be eligible for deduction, provided it is indivisible
and approved as one project.
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Construction of shopping
center/commercial space - Since shopping center/commercial
space is integral and necessary part of the housing project,
construction of it should not create any difficulty in getting
deduction.
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A dilemma has arisen on account
of the recent amendment which in fact liberalizes the provisions
by extending the date of approval to 31.03.2005. The question
is as to whether the benefit which was lost in view of old
deadlines (approval before 31-3-2001 and completion before
31-3-2003) can now be revived? What happens to the intervening
years? It is submitted that in view of equity and fairness
,the benefit should not be denied and CBDT should issue a
suitable circular.
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Other Issues
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In some cases, the flats etc.
unsold are distributed among the partners and the firm is dissolved.
In the case of V. Chandraprakasa Nadar & Co. (107 Taxman
31-Madras), it was held that closing stock which is distributed
to the partners on dissolution of the firm is to be valued at
market value on the date of dissolution and hence when some of
the partners in the dissolved firm come together and form a new
firm, opening stock of new firm has to be valued at the market
price.
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There was a controversy whether
construction activity amounts to manufacture and whether it would
be eligible for the benefit of Investment Allowance. However,
the Hon’ble supreme Court in the case of N. C. Budharaj &
Co. (204 ITR 412) (SC), held that investment allowance is
not available to construction activity.
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Redevelopment of old societies
In Mumbai, there are number of old housing societies. These
societies demolish the old structure and construct the new one.
TDR is purchased for construction of the additional area. This
additional area is sold and cost of construction of the new structure
is met. This activity of the housing society can be considered
as business activity and the profit should be computed accordingly.
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Applicability of Section 50C
Section 50C applies only to capital assets and not to stock
in trade . Since the profit from construction activity is income
under the head profits/gains from business, the provisions of
Section 50C will not be applicable .
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In case, old property is taken
for development, a reconciliation between the tenants who are
rehabilitated and those who are given flats, may be demanded by
the AO to establish the genuineness of tenants,.
- Conclusion
There are numerous such issues many of which are not yet resolved.
When one controversy appears to be resolved, fresh controversies arise
due to some amendment or some decision. The attempt therefore is not
to answer all controversies but to draw the attention of the readers
to their existence.
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