Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 2 - Work in progress
Outline of chapter
2.1 This chapter explains amendments in Schedule 2 to this bill which clarify the taxation treatment of payments and receipts in respect of work in progress. The amendments do not cover partly completed goods (e.g. of manufacturers) which are normally brought to account as trading stock. The amendments will ensure that amounts in respect of work in progress that are assessable to the recipient, are deductible to the payer, and therefore are not effectively taxed a second time in the hands of the payer when they complete the work and bill the clients.
Context of amendments
2.2 Work in progress is work (but not goods) that has been partially performed but not yet completed to the stage that a recoverable debt has arisen in respect of the work. Commonly, a recoverable debt will arise when the work is billed, so work in progress will be work that has not yet been performed to a billable stage.
2.3 As a result of various court decisions, the taxation treatment of amounts paid or received in respect of work in progress has given rise to the potential for the taxation of the same amount twice, albeit in the hands of different taxpayers.
Example 2.1
Michael, Robyn and Emma carry on a practice as solicitors in partnership but Emma decides to leave the partnership. On 30 June 2002 the partnership is dissolved and Emma is paid $100,000 for her interest in the partnership, $60,000 of which is in respect of work in progress. Under the current law, the $60,000 would be assessable as ordinary income to Emma. However, it is not deductible to Michael and Robyn, even though when they complete the work and bill the clients, those amounts will be fully assessable. This effectively taxes the $60,000 twice - once in Emmas hands on leaving the partnership, and again in Michael and Robyns hands when the amounts are actually billed to the clients.
2.4 In
Crommelin v DC of T
(1998)
39 ATR 377
,
98 ATC 4790
the Federal Court followed the decisions in previous cases (
Jamieson v IRC (NZ)
(1974)
4 ATR 327
,
74 ATC 6008
;
Stapleton v FCT
(1989)
20 ATR 996
,
89 ATC 4818
) and held that a payment received by a partner retiring from a partnership for his share of the work in progress of the partnership was assessable income according to ordinary concepts. The Federal Court also held that there was no need for an express agreement that a specific amount be paid in respect of work in progress, as long as that amount is capable of being identified as being paid for that reason.
2.5 Also, in
Coughlan v FC of T
91 ATC 4505
the Federal Court held that, where there was a change in the partners of an accounting firm, an amount paid by the new partnership in respect of the work in progress of the old partnership was a non-deductible capital amount.
2.6 The Commissioner previously dealt with this anomaly in the case of an exiting partner by an administrative practice set out in Taxation Ruling IT 2551 (Sale of interest in a professional partnership: Amounts paid to retiring partners on account of work in progress). The ruling clarified that the Commissioner did not seek to tax the same amount twice. It stated that where an amount in respect of work in progress is included in the assessable income of an outgoing partner, it should be shown in the accounts of the reconstituted partnership as an advance to the outgoing partner. The ruling stated that no deduction would be allowable. However, as work in progress is completed and billed, the amounts billed would not be treated as income of the partnership to the extent that they are attributable to the advance.
2.7 The Commissioner withdrew Taxation Ruling IT 2551 on 23 September 1998 following the decision in Crommelin v FCT , as the approach taken was no longer tenable at law.
Summary of new law
2.8 The proposed amendments will provide a specific deduction where apayment is made in respect of work in progress. They will also confirm that receipt of a workin progress amount is assessable income. This will remove any potential for double taxation.
2.9 Although the issue of work in progress commonly arises in the context of professional partnerships, the amendments apply generally to situations where payments are made in respect of work in progress. They are not restricted to partnership situations.
Detailed explanation of new law
Definition of work in progress amount
2.10 A work in progress amount has been defined in subsections 25-95(3) and (4) of the ITAA 1997.
2.11 Under this definition an amount will be a work in progress amount to the extent that it satisfies the criteria in paragraphs 25-95(3)(a) and (b). The use of the expression to the extent that means that, although a larger lump sum amount may be paid in some situations, it must be apportioned between that part of the amount that is a work in progress amount and that part that is not. To the extent that an amount is a work in progress amount, the rules about assessability and deductibility contained in these amendments will apply. [Schedule 2, item 5, subsection 25-95(3)]
2.12 The conditions in paragraphs 25-95(3)(a) and (b) are that an entity agrees to pay the amount to another entity, and that the amount can be identified as being in respect of work (but not goods) that has been partially performed by the recipient for a third entity, but not yet completed to the stage where a recoverable debt has arisen in respect of the work. [Schedule 2, item 5, paragraphs 25-95(3)(a) and (b)]
2.13 It is a requirement that the work has been partially performed by the recipient of the amount for a third entity. This eliminates the possibility that a payment made by the entity for whom the work is being performed would satisfy the definition of a work in progress amount, and therefore potentially be deductible under these provisions. It is generally envisaged that the entity who pays an amount for work in progress will attempt to complete the work and bill the entity for whom the work is being performed. It is recognised however, that the work may not be completed, or billed for, in all cases.
2.14 As defined for the purposes of the ITAA 1997, work in progress does not cover work in progress that is goods, for example, the work in progress of a manufacturer. Partially completed goods are generally brought to account as trading stock of the manufacturer of the goods. A work in progress amount also does not include an amount paid for a partially completed structure such as a building.
2.15 A payment for shares in a company or units in a unit trust will not be a work in progress amount even if the value of work in progress was taken into account in valuing the shares or units.
2.16 The work in progress amount is defined in terms of work that has been performed but which has not yet been completed to a stage where a recoverable debt has arisen. Once a legal entitlement to payment for the work arises and a debt is created, the amount can then be brought to account as a receivable of the entity to whom the payment is owed.
2.17 The amount must be able to be identified as an amount in respect of work that has been performed but not yet completed to the stage where a recoverable debt has arisen. A work in progress amount need not be specified in a contract between the parties. A work in progress amount may be able to be identified by looking to all the surrounding circumstances, including working documents or accounts demonstrating how the amount was calculated.
2.18 In some situations payments may be made in respect of work in progress at one or more future points in time. This may occur when an amount is specified in an agreement, but paid in instalments over time. One or more of those instalments may be paid after the work has been completed. The amendments provide that an amount does not stop being a work in progress amount because it is paid after a recoverable debt has arisen in respect of the completion of the work. [Schedule 2, item 5, subsection 25-95(4)]
2.19 If the amount specified in the agreement can be identified as being in respect of work in progress, then each time a payment of part of this amount is paid, it will also be in respect of work in progress. In this case, each time part of the amount is paid, it will be deductible in the income year in which it is paid (subject to the rules about timing of a deduction for a work in progress amount in subsections 25-95(1) and (2)). This is the case even if the work has been completed before the amount is paid.
2.20 Parties may also agree to make payments in respect of work in progress at future points in time based on a formula. In this case, no amount is specified, rather, a method of calculating the quantum of each payment is provided. When each amount is quantified it will still be an amount in respect of work in progress if the original formula is intended to provide for an amount or amounts in respect of work in progress. This is so, even if the work has been completed and billed by the time the amount(s) is calculated and paid. The amount(s) is not deductible until the income year in which it is paid (and is subject to the rules about timing of a deduction for a work in progress amount in subsections 25-95(1) and (2)).
2.21 The amendments apply to taxpayers whether they return their income on a cash basis or an accruals basis. The potential for double taxation arises even if both the payer and the payee account for their income on a cash basis.
Method of calculating the value of work in progress
2.22 The provisions do not provide a method for valuing a work in progress amount. This is a commercial decision between the parties.
Deductibility of work in progress amounts
2.23 Section 25-95 provides a deduction for a work in progress amount that a taxpayer pays. [Schedule 2, item 5, section 25-95]
2.24 The payment of a work in progress amount will be deductible in the income year in which it was paid, to the extent that, as at the end of that income year:
- •
- a recoverable debt has arisen in respect of the completion or partial completion of the work to which the amount related; or
- •
- you reasonably expect a recoverable debt to arise in respect of the completion or partial completion of that work within 12 months after the amount was paid.
[Schedule 2, item 5, subsection 25-95(1)]
2.25 At the end of the income year in which a party pays a work in progress amount, the party should evaluate when a recoverable debt for the completion or partial completion of the work in progress to which the payment relates, is likely to arise.
2.26 To the extent to which a recoverable debt for the completion or partial completion of the work in progress to which the payment relates, cannot reasonably be expected to arise within 12 months of the date of the payment, that amount will be deductible in the following income year. [Schedule 2, item 5, subsection 25-95(2)]
2.27 If none of the work in progress amount is deductible in the income year in which the payment is made, the entire amount is deductible in the following income year. This is the case even if no recoverable debt is expected to arise in the future.
2.28 This deferral of a deduction is required to make the tax treatment of the payment more accurately reflect the economic outcome of the payment. Where part of the payment relates to gaining assessable income of a future income year, part of the deduction should also be deferred to that later year. However a simplified approach has been taken to defer the deduction for only one income year, in recognition of the compliance costs that would be involved in matching the deduction to the income year in which each individual item of work was billed. This full matching approach was previously required by the Commissioners administrative practice, set out in Taxation Ruling IT 2551.
Example 2.2
David runs an accounting practice as a sole trader. On 25 August 2002, David accepts an offer from Tom and Tina to buy the practice. As part of the agreement Tom and Tina will pay David $10,500 for the work in progress of the practice. This amount is set out in the agreement, along with various other amounts for the assets of the practice. Tom and Tina then carry on the accounting practice as a partnership.
On 30 June 2003, $3,000 of the work in progress as at 25 August 2002 has already been billed to clients, and of the remaining work related to the payment made to David, $5,000 of it could reasonably be expected to be completed and billed by 25 August 2003. Therefore, $8,000 of the payment will be deductible in the 2002-2003 income year. The remaining $2,500 will be deductible in the following income year (2003-2004).
2.29 The term you reasonably expect requires the payer to have the expectation (that a recoverable debt will arise within 12 months) and that the expectation is objectively assessed. For an expectation to be reasonable it must be more than a mere possibility, and could be based on a number of factors including deadlines imposed by the client, external factors such as court hearing dates, stage of completion of the work and progress payments built into the contract for the work.
Assessability of work in progress payments
2.30 A work in progress amount that is received will be included in the assessable income of the recipient under section 15-50 of the ITAA 1997. It will be assessable income in the income year in which it is received. [Schedule 2, item 3, section 15-50]
2.31 If a work in progress amount is paid and that payment gives rise to a deduction under section 25-95, any later recoupment of any of that work in progress amount will be included in the taxpayers assessable income under the rules contained in Subdivision 20-A of the ITAA 1997. [Schedule 2, item 4, subsection 20-30(1)]
Application and transitional provisions
2.32 The proposed amendments will apply to amounts paid on or after 23 September 1998. This is the date on which Taxation Ruling IT 2551 was withdrawn. The amendments will be beneficial to taxpayers as they will prevent any potential for double taxation. [Schedule 2, item 7]
Consequential amendments
2.33 Sections 10-5 and 12-5 of the ITAA 1997 will be amended to include sections 15-10 and 25-95 in the respective summary tables. [Schedule 2, item 1, section 10-5 and item 2, section 12-5]