Revised Accounting Standard 7- ‘Construction Contract’ is applicable to only contractors and not to builders and real estate consultants. Accordingly, the Project Completion Method consistently followed by the taxpayer for recognising revenue in the books of accounts cannot be regarded as an unreasonable.
Recently, the Mumbai bench of the Income-tax Appellate Tribunal (the Tribunal) has held that the Accounting Standard (AS) 7 – ‘Construction Contract’ (revised) issued by the Institute of Chartered Accountants of India (ICAI) is applicable only to contractors and not to builders and real estate developers. Accordingly, the Project Completion Method followed by the taxpayer for recognising revenue in the books of accounts cannot be regarded as an unreasonable. Further, the tax department cannot change the method of accounting as any change would be a tax neutral.
Background:- The ICAI issued Accounting Standard (AS) 7 – ‘Construction Contract’ in the year 1983 which was later on revised in the year 2002. The AS 7 laid down the principles of accounting for ‘construction contracts’ in the financial statements of the Contractors. As per the revised AS 7 the accounting was to be done as per percentage/ progressive completion method.
In response to a query rose, on applicability of revised AS 7 to a real estate developer, before the Expert Advisory Committee (EAC) formed by the ICAI, the EAC observed that the pre revised AS 7 specifically mentions about its applicability to enterprises undertaking construction activities on their own which would include real estate developer. However, the revised AS 7 is applicable only to Contractors.
Facts of the Case
• The taxpayer was engaged in the business of redevelopment of tenanted property. The taxpayer was following the Project Completion Method of accounting since its inception in the assessment year 1995-96 and the income of the project was offered for taxation in the year of completion of the project. The expenditures incurred on a project were accumulated under the head ‘construction work-in-progress’ and in the final year of completion it was taken as expenditure.
• For the Assessment Year 2005-06, the taxpayer computes its taxable income following Project Completion Method. However, the Assessing Officer (AO) recomputed income based on the percentage/progressive completion method prescribed by AS 7. The Commissioner of Income-tax (Appeals) [CIT(A)] uphold the AO’s action and held that the revised AS 7 was applicable to taxpayer.
• The taxpayer relied on the opinion of the EAC and contended that revised AS 7 issued in the year 2002 was not applicable to the taxpayer since it does not apply to builders and real estate developers. Further, the same method of accounting followed in earlier years had been accepted by the tax department.
• The taxpayer contended that it has been consistently following the Project Completion Method of accounting since its inception and has accordingly offered to tax the entire income in the next assessment year i.e. Assessment Year 2006-07. Further, before AS 7 was issued by the ICAI, the Mumbai Tribunal in the case of Champion Construction Company v. ITO  5 ITD 495 (Mum) had accepted the Project Completion Method as an appropriate method of computing income.
• The taxpayer also relied on the Guidance Note on ‘Recognition of Revenue by Real Estate Developers’ issued by ICAI in 2006. The taxpayer contended that Guidance Note read with the Agreement of Sale, executed by the taxpayer, it is clear that the risks and the rewards of ownership have not been transferred to the buyer and it retains effective control of the property. The reliance was also placed on the decision of the Bangalore Tribunal in the case of Prestige Estate Projects (P) Ltd. v. DCIT  33 DTR 514 (Bang).
Tax department’s Contentions
• The tax department contended that AS 7 was applicable to builders and contractors and revenue recognition has to be done as per AS 7 read with AS 9.
• As per the Guidance Note on ‘Recognition of Revenue by Real Estate Developers’ issued by the ICAI the taxpayer is bound to declare income during the year since the Agreements to sale entered by the taxpayer was partly complete and the risks was already passed.
• The Tribunal observed that the pre revised AS 7 issued by ICAI in the year 1983, specifically included enterprises undertaking construction activities on their own and as such to builders and real estate developers. However, such specific inclusion is missing in the AS 7 revised in the year 2002. The Tribunal also went through the opinion given by the EAC on the applicability of AS 7 and held that the revised AS 7 does not apply to builders and real estate developers.
• The method followed by the taxpayer cannot be called as an unreasonable method and any change in the method is revenue neutral. Further, the tax department cannot change the method of accounting which was accepted by it over the years.
• The Tribunal observed that the Bangalore Tribunal in the case of Prestige Estate Projects (P) Ltd. held that the Government has not specified AS 7 in Section 145 of the Act and the taxpayer developer had been regularly, under a bonafide belief, employing Project Completion Method which is an accepted method of accounting. Accordingly, the AO cannot reject the accounts of the taxpayer under Section 145(3) of the Act.
• The Tribunal relied on the decision of the Mumbai Tribunal in the case of Champion Construction Co. and held that it would be appropriate to offer income tax in the year in which 80 percent of the construction was completed. Since the taxpayer admittedly completed only 53.95 percent of the construction it cannot be said that the taxpayer has substantially completed the project so as to recognise income under the Project Completion Method of accounting.
• The Tribunal also relied on the decision of the Bombay High Court in the case of CIT v. Tata Iron & Steel Co. Ltd. where it was held that the method of accounting followed by the taxpayer company cannot be said to be unreasonable, and that in such a case, even if a better method could be visualised, the method consistently followed should be accepted.
• Accordingly, the Tribunal allowed the taxpayer’s contention to follow Project Completion Method and recognise the revenue accordingly in the year of project completion. The Tribunal refrained from deciding as to whether any revenue has to be recognised in the relevant assessment year based on the Guidance Note issued by ICAI considering the agreement to sale entered into by the taxpayer.
This is a welcome decision by the Mumbai Tribunal wherein it has been held that revised AS 7 is not applicable to real estate developers and accordingly, the Project Completion Method is not an inappropriate method for accounting for the real estate developers.
The Tribunal also held that in the case of Project Completion Method it would be appropriate to offer income in the year in which 80 percent of the construction was completed. The Mumbai Tribunal in the case of Parekh Properties (P) Ltd. v. ACIT  1 SOT 124 (Mum) had 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 seems proper that the income should be taxed in the year in which 75 percent of the total area constructed by the taxpayer was sold.
It is pertinent to note that, recently, the Mumbai Tribunal in the case of Awadhesh Builders v. ITO  37 SOT 122 (Mum) had held that in the case of real estate developers following Project Completion Method, the revenue should be accounted as per revised AS 9 ‘Revenue Recognition’. Accordingly, in such cases income had to be accounted when the legal title of the property passes to the buyer or when seller entered into agreement for sale and handed over possession of real estate to the buyer under the agreement.
Further, the Supreme Court in the case of CIT v. Realest Builders & Services Ltd  170 TAXMAN 218 (SC) has held that the tax department needs to provide facts and figures that the impugned method of accounting adopted by the taxpayer results in underestimation of profits for changing the method of accounting under Section 145 of the Act. Otherwise, it will be presumed that the entire exercise is revenue neutral.