Income Measurement and Taxation in Real Estate] 3 rr Chapter objectives: Nature of ‘business Revenue Cost of sale Inventories Investments IAS and BAS 11: construction contracts Borrowing costs Maximize capital gain Low-income housing tax credit Real estate business, particularly construction of buildings and bridges usually take more than one year and therefore income and expenditure of a project may spread beyond one year. In such cases revenue and expenses are allocated among more than one year. Whereas in case of products these are completed in one year and actual revenue and expenses are clearly identified with that year and therefore yearly profit or loss determination is easier. But in real estate yearly completion state has to be estimated and accordingly revenue and. expenses are allocated to that year. Estimates of project income and. Project costs are reviewed periodically. The effect of changes to estimates is recognized in the financial statements of the period in which such changes are determined. Thus in real estate profit or loss determination is more an estimate compared to other products and services,Advanced Issues in Taxation Nature of the business sakes allotment of the plots and apartments aheag of commencement of land reclamations, development and Construction of apartments. The companies receive money against such allotments on installments basis during the span of two to six ‘years. The amount is booked under ‘advance on allotment’ as current liability. Revenue ig recognized by reference to the stage of completion of the project at the end of the accounting period. Real estate industry m: Inventories Inventories represent stock of land, apartments, shops and office spaces. These can be underdeveloped land, work-in-process, developed inventory and construction materials. These are valued at lower of cost and market as per accounting standard. Cost is measured usually at average cost. Revenue Revenue is recognized as per IAS 18 which says that revenue is recognized until economic benefits will flow to the business entities and are reliably measured, It is measured project by project and then added to arrive at the total revenue of a particular year. Revenue associated with apartment sale shall be recognized by reference to the stage of completion of the apartment at the end of the reporting period. Cost of sale Cost of an apartment project includes all costs to bring the asset to a working condition or intended use. Costs of dismantling and removing items in the previous condition are also included in the costs of the new Property. Borrowing costs directly attributable to construction or production of an asset that necessarily takes a substantial period are capitalized and allocated as expense construction. Other borrowing costs whic! Project are expensed in the Housing Limited is in various years under . ‘h are not directly related to 4 Period they occur. Cost of sale of Eastem- Income Measurement and Taxation in Real Estate opening stock of underdeveloped land Add purchase of underdeveloped land Less stock of underdeveloped land Consumption of land during the period Opening stock of construction materials ‘Add development and construction materials Materials consumption during the year ‘Add direct expenses Total cost transferred to work in process (W-I-P) ‘Add opening W-I-P Less closing W-I-P Cost of finished inventory Add opening finished inventory Less closing finished inventory Cost of sale IAS and BAS 11. Construction Contracts 173 Profit is measured by estimating costs and revenue by percentage of completion basis, that is, accrual basis. In case of estimated loss, it is immediately recognized in the current year rather than allocating its costs and expenses over the period of construction. ‘An example Profit by percentage completion method, 2017 Estimated costs to complete Actual costs to date Total estimated costs Percentage complete in 2017 _(275000/1100000) Total contract price Estimated gross profit Profit to date 25% Income tax expense @25% TK825000 275000 1100000 25% 1500000 400000 100000 25000 iAdvanced Issues in, 174 Way lion f Projects with Completion Stage and Revenue List of nen : is completion stage of cach project is estimated like Projegt ae The oe Project 2: 60% complete, Project 3: 25% complete ; ete, : - , comp! 1 4, 0,03Y% complete. Then revenue is recognized project we eee of completion. The total of the revenue of all ag per sta Projects together is shown in the income statement. Before IAS 11 Before IAS 11, profit in real estate business was determined by the above accrual basis or by cash basis, that is, there was discretion, Under cash basis, revenue was recognized when the project Was complete. So accrual accounting was not followed during the Period from beginning until the end completion of projects. Cash basis however does not show the real performance of a Project in the intermediate periods. Use of Estimates and Judgments The preparation of financial statements require management to make judgment, estimates and assumptions that affect the application of accounting policies and the reported amounts of its assets, liabilities, income and expenses and disclosure of the contingent assets and liabilities at the date of the financial statements, Actual results may differ from those estimates, Estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are Tecognized in the period in which the estimates are revised and in any future periods affected. Measurement and Recognition An item of Property, initi = Plant and equipment qualifying for recognition 8 Y Measured at its Cost. Cost comprises expenditure that is ONIncome Measurement and Taxation in Real Estate 175 directly attributable to the acquisition of the assets. The cost of self- cpsructed asset includes the following: the cost of materials and direct labor; any other costs directly attributable to bringing the assets to a working condition for their intended use; and when the company has an obligation to remove the asset or restore the site, an estimate of the costs of dismantling and removing the items and restoring the site on which they are located. Borrowing Costs Borrowings are classified into both current and non-current liabilities. In compliance with the requirements of IAS/BAS - 23 “Borrowing Costs,” borrowing costs directly attributable to the acquisition, construction or production of an asset that necessarily takes a substantial period of time to get ready for its intended use or sale are capitalized (transferred to the construction work-in-progress) as part of the cost of the respective assets. All other borrowing costs are expensed in the period they occur. Borrowing costs consist of interest and other costs that an entity incurs in connection. with the borrowing of funds. Income tax Income tax comprises both current tax and deferred tax expense. Current tax As per section 53FF of the Income Tax Ordinance (ITO) 1984, it is made compulsory for the real estate business entities to pay, inespective of profit or loss, income tax as per prescribed rate per Square meter of the apartments at the time of their registration under Section 82C of ITO 1984. Provision for income tax has been made at Prevailing corporate tax rate @ 25% besides income taxed under the above sections as per provision of the ITO 1984. Current tax is theN Advanced Issues in a Taxa, 176 ‘tion ivable on the taxable income ayable or recelval : OF log ane oie ie tax rates enacted at the reporting date and e e year, \djustment to tax payable in respect of previous years, a Deferred tax Deferred tax is recognized in compliance with BAS ~ 12 “Income Taxes”, providing for temporary differences between the camying amounts of assets and liabilities for financial reporting purposes and amounts used for taxation purposes. Deferred tax is measured at the tax rates that are expected to be applied to the temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the date of statement of financial Position, Deferred tax assets and liabilities are offset if there is a legally enforceable right to offset current tax liabilities and assets, and they relate to income taxes levied by the same tax authority on the same taxable entity. A deferred tax asset is recognized to the extent that it is probable that future taxable profits will be available against which the deductible temporary difference can be utilized. Deferred tax assets are reviewed at each date of statement of financial Position and are Teduced to the extent that it is no longer probable that the related tax benefit will be realized, Disclosure Tax related information is shown in three financial statements, deferred tax as a current ass of set, provision for income tax as current liability, tax expense in in come statement, and income tax paid in cash “Tow statement. Further information is shown in notes,rr me Measurement and Taxation in Real Estate Inco 177 astern Housing Ltd. Balance Sheet, 2016 nt assets: Deferred tax . TK4,3 million Equity and Liabilities Current liabilities: provision for income tax 16.9 million income Statement, 2016 Expenses: Income tax expense oan TKI18.8 million Deferred iG 120.1 Cash Flow Statement Cash Flow Statement 0 Cash flow from operating activities: Income tax paid TK 108 million Notes Note 33 Tax paid at the time of sale of registration (advance income tax) TK90.2 million Tax paid for purchase of land - Tax deducted at source (TDS) 04 Provision for income tax 28.2 Total charges in the income statement 1188 Note 6 Deferred tax Book Tax base Difference Provision for gratuity TK25m - TK25 m Fixed assets (4662) (4649) (13) Provision for warranty 4.5 = 45 Total difference 17 Tax rate 25% Deferred tax liability (asset) 42 Provision for income tax:Advanced Issues in Taxati ion 178 TK9.2 Opening 1188 Charge during the year 128 Total | 108 Less tax paid 20 Closing balance the balance is higher than 16.9 in (deferred tax TK4.2 adjusted, 80 Balance Sheet) Maximize Capital Gains Capital gain tax is 15% whereas corporate tax is 25% for a PLC, 35% for a private company, and 0 to 30% for a partnership firm. So a real estate business will try to get maximum benefit of lower capital gain tax. The sale of land that is held for investment purposes will qualify for long-term capital gains treatment if the land has been held for more than one year prior to the sale, whereas the sale of land that is held as inventory by the seller will be subject to tax at the higher ordinary income tax rates. A parcel of real estate that is purchased as an investment and held for more than one year, without improvement, will qualify for long-term capital gains treatment, whereas a large number of lots that are sold by a development entity that has constructed major improvements in a subdivision will be considered inventory with the sales subject to tax at the higher ordinary income tax rates. Low-income housing tax credits In order to encourage developers to build, manage and maintain affordable rental housing for lower income persons, The USA Federal tax credit is generally 9% per year of the eligible cost of the buildings each year for a 10-year period, i.e, a total Federal tax credit equal t 90% of the eligible cost of the buildings. The occupants must have income below certain maximum levels, and rent is restricted based 0” the ‘occupants’ income. Because of limitations on the ability of individuals to utilize the Federal credit, the primary investors in thes? the ace Piety large companies (frequently banks, because of incentive of getting credit under the Communityer Income Measurement and Taxation in Real Estate 179 Reinvestment Act). The state credit, which does not necessarily have to be allocated to the same investor as the Federal credit, is often allocated to individuals or insurance companies. Question 1, How is real estate business accounting different from the accounting of a manufacturing business? 2. How is profit determined in a real estate business? 3. How is cost of sale determined in a real estate business? 4, What is special about tax planning for a real estate company? Exercise 1.XYZ Housing Ltd has the following assets in the balance sheet Investment in land at cost TK1000 million’ Inventory of completed projects: 2500 sft flats TK200m 600 sft flats 400m Both the products are sold at 13% profit on cost How can the company get maximum tax benefits? Assume that tax laws (@ will introduce tax credit of 5% for low-income housing projects, and (ii) will allow capital gain tax instead of corporate tax rate for investments.