11 January 2018 EY Tax Alert Jaipur ITAT rules on revenue recognition as per Percentage of Completion Method for advances received from customers Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. Executive summary This Tax Alert summarizes a ruling of the Jaipur Income Tax Appellate Tribunal (ITAT) dated 22 December 2017 in case of Vastukar Township Pvt. Ltd. [1] (Taxpayer) on the issue of the appropriate revenue recognition policy to be adopted by a taxpayer engaged in real estate development business. In the present case, the Taxpayer was engaged in the development and sale of plots of land to customers. The Taxpayer had two specific circumstances: (a) Category 1 - full consideration received under registered sales deed, but development work pending to be fully executed and (b) Category 2 advances received from customers (more than 10% of total sale value) under the plot buyer s agreement but sale deed not registered. The Taxpayer followed the revenue recognition policy of (a) Percentage of Completion Method (POCM) for Category 1 (i.e. recognizing revenue on deferred basis based on the progress of the development work despite full receipt from customers) and (b) not recognizing revenue for Category 2 until sale deed is registered by relying upon the Guidance Note on Accounting for Real Estate Transactions issued by the Institute of Chartered Accountants of India (ICAI GN) for both categories. The Tax Authority disputed this method of revenue recognition and asserted that full revenue should be recognized for Category 1 since revenue is fully collected and POCM to be followed for Category 2 based on total sale revenue. [1] Vastukar Township Pvt. Ltd. v. DCIT (ITA No. 105/ JP/ 2017)
Page 2 The ITAT upheld the Taxpayer s method for Category 1 by holding that even where significant risks and rewards of ownership have been transferred to the buyer under registered sale deed and revenue is fully collected, POCM should be followed since the Taxpayer is obliged to perform contractually agreed development activities on the plots of land. Accordingly, taxation was based on POCM, rejecting the Tax Authority s contention of taxation, based on total sales revenue received. However, for Category 2, the ITAT held that, it is not correct for the Taxpayer to defer revenue recognition merely because sale deed is not registered. On perusal of a sample agreement, the ITAT concluded that significant risks and, rewards of ownership stood transferred to the buyer and hence, on a proper application of ICAI GN, the Taxpayer should recognize revenue as per POCM albeit, in respect of future instalments, on a case-to-case basis, it may defer revenue recognition to the extent there is significant uncertainty in the ultimate collection. Background and facts ICAI GN recommends the accounting treatment for enterprises dealing in real estate as sellers or developer. It requires the taxpayers to make an assessment based on economic substance whether real estate project is akin to construction contract or akin to sale of goods and then apply the accounting principles as relevant to construction contract (AS-7) or sale of goods (AS-9), which, in brief, is as per table below: Particulars If the economic substance of the real estate project is similar to construction contract If the economic substance of a project is not similar to construction contract Treatment Project revenue and project costs to be recognized as per POCM by adopting principles of AS-7 on construction contract Revenue shall be recognized as per the provisions of AS-9 dealing with recognition of revenue on sale of goods and rendering of services i.e. revenue to be recognized on transfer of significant risk and rewards of ownership. the reasonable certainty of ultimate collection of revenue is lacking at the time when all significant risks and rewards of ownership are transferred, revenue recognition is postponed to the extent of uncertainty involved. Thus, if the buyer s aggregate payment or continuing payments provide insufficient evidence of the buyer s commitment to make the complete payment, revenue is recognized only to the extent of realized consideration. In the present case, the Taxpayer was engaged in the development of residential township project viz. development and sale of plots of land to customers in collaboration with two other parties and followed POCM for revenue recognition in accordance with the ICAI GN. However, in its books of accounts as also for tax purposes, it recognized revenue on POCM basis only for Category 1 i.e. where full consideration received under registered sales deed and booked no revenue in case of Category 2 i.e. where partial advance received under plot buyer s agreement (i.e. registered sale deed is not executed). Facts in the present case may be better understood with the help of following illustrative numbers: Category 1: Full consideration received under registered sale deeds Assume that total sales revenue as per registered sales deed is 200, stage of completion of the project is 50%, percentage of cost to sales revenue = 40% Particulars Total sales revenue as per registered sales deed Sales revenue attributable to work done Less: Corresponding cost Profit to be taxed Taxpayer s Tax Authority s ITAT s 200 200 200 100 (200*50%) 40 (100*40%) (100-40) NA 100 (200*50%) 80 (200*40%) 120 (200-80) 40 (100*40%) (100-40) As per the ICAI GN, revenue in case of real estate sales should be recognized on satisfaction of all the following conditions: Transfer of significant risks and rewards of ownership to the buyer No significant uncertainty exists on the amount of sales consideration It is reasonable to expect ultimate collection ICAI GN further provides that, in order to assess the condition of reasonable certainty of ultimate collection, seller should consider the evidence of buyer s commitment to make the complete payment. Where
Page 3 Particulars Total sales revenue as per plot buyer s agreement Sales revenue realized during the year Sales revenue attributable to work done Less: Corresponding cost Profit to be taxed Category 2: Partial advance received under plot buyer s agreement Assume that total sales consideration recoverable from customers is 400, partial advance received from customers is 300, stage of completion of the project is 50%, percentage of cost to sales revenue = 40% Taxpayer s Tax Authority s ITAT s 400 400 400 300 300 300 Nil 150 (300*50%) Nil (cost incurred to be carried forward as work-inprogress) (150*40%) Nil 90 (150-) 150 (300*50%) (150*40%) 90 (150-) As illustrated above, the Taxpayer recognized income only with respect to Category 1 while filing its return of income and booked no profit in respect of Category 2 income. The Tax Authority rejected the books of accounts of the Taxpayer and recalculated the profit. For Category 1, the Tax Authority held that since entire ownership in plot has been transferred to the buyer, total sales revenue net of corresponding cost should be recognized as revenue and not on POCM basis. For Category 2, the Tax Authority held that the terms and conditions of the plot buyer s agreement deed make it clear that the buyer is obliged to honor the payments in instalments and, thus, both the parties are bound by the agreement even though possession will be handed over to the buyer in future. Accordingly, since substantial advance booking amounts were received from buyers and there was no significant uncertainty in case of real estate sales, the Tax Authority applied POCM in respect of Category 2 with reference to advance received from customers. Being aggrieved, the Taxpayer preferred an appeal to the First Appellate Authority (FAA). The FAA concluded from the terms and conditions of the plot buyer s agreement that all the significant risks and rewards of ownership were transferred to the buyer at the time of execution of the agreement. In case of Category 1, the FAA accepted the Taxpayer s position and applied POCM for revenue recognition since the Taxpayer has to execute the balance development work in respect of these plots. However, in case of Category 2, the FAA held that as per the ICAI GN, revenue as per POCM is to be applied with reference to total sales consideration recoverable from customers and not advance actually received (viz. 400 in the above illustration under Category 2 and not 300) since significant risks and rewards of ownership have been transferred to buyers at the time of executing agreement. Pursuant to above, the Tax Authority preferred an appeal to the ITAT in respect of reduction in income in case of revenue from Category 1 and the Taxpayer preferred an appeal before the ITAT in respect of revenue recognition under Category 2. Issues In respect of Category 1, whether revenue should be recognized for entire sales revenue and not on POCM basis where significant risks and rewards have been transferred to the buyer? In respect of Category 2, whether revenue should be recognized on POCM basis where advance received exceeds 10% of the total consideration despite registered sale deed not being executed? ITAT s ruling Category 1: Full consideration received under registered sale deeds The ITAT ruled in Taxpayer s favor and adopted the following reasoning for holding that revenue from Category 1 should be recognized on POCM basis after allowing credit for revenues already recognized in the earlier years: It is true that all the significant risks and rewards of ownership have been transferred to the buyer and the Taxpayer retains no effective control over the real estate to constitute ownership. It is also true that there is no significant uncertainty on the amount of consideration and its collection since the same has been fully recovered prior to signing of the sale deed. However, the economic substance of the transaction i.e. sale of plots of land along with development of internal common facilities within the township reveals that the Taxpayer is obliged to perform the specified development activities on the plot of land even though the sale deeds have been executed in favor of buyers. There is no separate identifiable consideration for development activities but the fact remains that unless the common facilities are developed and made functional, the plots of land cannot be put to intended use by the buyer. Thus, revenue should be recognized on proportionate basis as and when the developmental acts are performed.
Page 4 Category 2: Partial advance received under plot buyer s agreement The ITAT noted the following defenses of the Taxpayer for non-recognition of revenue under Category 2 Significant risks and rewards of ownership have not been transferred to the buyer since if the buyer defaults in depositing instalment amounts for two instalments, the Taxpayer can cancel the agreement and forfeit the earnest money, recover interest on delayed payment etc. Transfer of plot by the buyer shall be at the sole discretion of the Taxpayer and needs prior written approval. Also, possession of plot shall be handed over to the buyer only after receiving entire sales consideration. Non-recognition of revenue for this category was the consistent policy followed by the Taxpayer since past. However, the ITAT rejected the above arguments and held that significant risks and rewards stood transferred to the buyer under the plot buyer s agreement and hence, amount received as advance from buyers should be recognized as revenue on POCM basis. Further, in case of subsequent instalments, on a case to case basis, revenue recognition can be postponed to the extent of uncertainty involved. It adopted the following reasoning for its conclusion: A cumulative reading of the clauses in the sample plot agreement such as strict adherence to the payment schedule by the buyer, buyer s liability to pay for any external or peripheral services provided by any Government reveal that price risk, being one of the significant risk, has been fully transferred by the Taxpayer to the buyer. Also, any external regulatory risk by way of any direction or action of the State Government/ Local Authority has also been passed to the buyer by the Taxpayer. Buyer has been allotted a specified plot of land and also has a right to sell or transfer his interest in the property after taking prior written approval of the Taxpayer. However, such approval is merely a regulatory mechanism and it does not specifically restrict buyer s right in terms of handling or transferring interest in property to a third person till the time entire sales consideration has been paid. There is no uncertainty regarding the quantum of sales consideration that will be derived from the sale of plot of land. continuing payments by the buyer provide insufficient evidence of the buyer s commitment to make complete payment, revenue should be recognized only to the extent of actual realization provided other conditions for revenue recognition are satisfied. In the present case, the Taxpayer has not realized the full value of consideration at the time of signing of the agreement and in absence of any specific fact finding by the Tax Authority, a reasonable presumption can be drawn that the ultimate collection of the full value of sales consideration with reasonable certainty is lacking. Even though the Taxpayer has consistently not offered income on partial advance received under plot buyer s agreement, it is an admitted position that the Taxpayer is otherwise regularly following POCM for revenue recognition from the subject real estate activity. Having consistently followed POCM, the Taxpayer cannot refrain from offering income in respect of advance received from customers. Not recognizing income on advance received would rather tantamount to following Project Completion Method instead of POCM. Since significant risks and rewards of ownership have been transferred to the buyer, the consideration received in the form of advance money from customers to the extent of stage of completion has accrued to the Taxpayer. The Taxpayer s reliance on decision of the Delhi HC in Paras Buildtech India Pvt. Ltd. v CIT (2016) 382 ITR 630 (Del) is misplaced. The Delhi HC in that case held that where the advances received during the year have not been offered to tax since Project Completion Method is followed, the same was a recognized method of accounting. However, the said decision cannot be applied in the present case since the Taxpayer is following POCM. Since revenue from registered sale deeds under Category 1 has been recognized to the extent of work completed, the same principle is equally applicable in case of advance received from buyers to maintain consistency and given the fact that basic parameters for recognition of revenue have been fulfilled even under Category 2. Mere fact that sales deed was not executed in respect of Category 2 would not entitle the Taxpayer to deviate from its regular method of accounting being POCM. With respect to the condition of reasonable certainty of ultimate collection, the Taxpayer needs to assess the condition in each individual buyer s case taking into account any default committed by the respective buyer. Where there is no certainty on ultimate collection, revenue recognition can be postponed to the extent of uncertainty involved. ICAI GN also specifies that where the aggregate or
Page 5 Comments The present ITAT ruling clarifies that even if significant risks and rewards of ownership (predominantly comprising price risk) are transferred under a binding agreement and if real estate developer adopts POCM for recognition of revenue, only proportionate revenue attributable to the work done needs to be offered to tax even if entire sales consideration has been received by the taxpayer at the time of execution of sales deed. Further, even in respect of advances received from customers (without execution of registered sales deed), revenue needs to be offered on POCM basis if other conditions of revenue recognition are fulfilled. Revenue recognition can be postponed in case of subsequent instalments only to the extent there is no reasonable certainty of ultimate collection. According to ITAT, such treatment would be in consonance with ICAI GN. Incidentally, the Government also has released draft ICDS [2] on Real Estate Transactions for tax computation which is largely aligned to the ICAI GN. Taxpayers need to keep tab on final ICDS as may be notified in future. [2] ICDS refers to Income Computation and Disclosure Standards applicable to certain taxpayers for computation of income chargeable under the heads profits and gains from business and profession and income from other sources.
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