Income Measurement and

Taxation in Real Estate 13

Chapter objectives:
Nature of business
Revenue Cost
of sale
Inventories
Investments
IAS and BAS I l : constmction 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.
Taxation
172

Nature of the business

Real estate industry makes allotment of the plots and apartments
ahead 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

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years. The amount is booked under 'advance on allotment' as current
liability. Revenue is recognized by reference to the stage of
completion of the project at the end of the accounting period.

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 in various years under
construction. Other borrowing costs which are not directly related to a
project are expensed in the period they occur. Cost of sale of Eastern
Housing Limited is
Opening stock of underdeveloped land xxx
Add purchase of underdeveloped land xxx
Less stock of underdeveloped land xxx
Consumption of land during the period
Opening stock of construction materials
Add development and construction materials xxx
Materials consumption during the year

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 Income Measurement and Taxation in Real Estate 173
Add direct expenses xxx
Total cost transferred to work in process (W-I-P) xxx
Add opening W-I-P xxx
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
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 TK825000
Actual costs to date 275000
Total estimated costs 1100000
Percentage complete in 2017 (275000/1100000) 25%
Total contract price 1500000
Estimated gross profit 400000
Profit to date 25%
100000
Income tax expense @25%
25000
T axation

List of Projects with Completion Stage and Revenue

The completion stage of each project is estimated like Project I:
80%. complete, Project 2: 60% complete, Project 3: 25% Complete,

and Project 4: 0.03% complete. Then revenue is recognized project

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 Advanced Issues in
wise as per stage of completion. The total of the revenue of all
projects together is shown in the income statement.

Before IAS 11

Before IAS Il, 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 recognized in the
period in which the estimates are revised and in any future periods
affected.

Measurement and Recognition

I An item of property, plant and equipment qualifying for
recognition is initially measured at its cost. Cost comprises
expenditure that is
directly attributable to the acquisition of the assets. The cost of
selfconstructed 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

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 Income Measurement and Taxation in Real Estate 175
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
constt-uction 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 fttnds.

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, irrespective
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
Taxation 176

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expected tax payable or receivable on the taxable income or loss for the
year, using the tax rates enacted at the reporting date and any adjustment
to tax payable in respect of previous years.

Deferred tax

Deferred tax is recognized in compliance with BAS 12 "Income Taxes",

providing for temporary differences between the carrying 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 reduced 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 asset, provision for income tax as current liability, tax expense
in income statement, and income tax paid in cash flow statement. Further
information is shown in notes.

Eastern Housing Ltd. Balance Sheet, 2016

Assets
Current assets:
Deferred tax TK4.3 million Equity and Liabilities
Current liabilities:

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 Income Measurement and Taxation in Real Estate 177
Provision for income tax 16.9 million

Income Statement, 2016

Expenses:
Income tax expense
Current tax TKI 18.8 million
Deferred 1.3 Total 120.1

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) 0.4
Provision for income tax 28.2
Total charges in the income statement 118.8

Note 6
Deferred tax
Book Tax base Difference
Provision for gratuity TK25 m TK25 m
Fixed assets (4662) (4649) (13)
Provision for warranty 4.5 4.5
Total difference
17
Tax rate 25%
Deferred tax liability (asset)
Provision for income tax:
Taxation

TK9.2
118.8
128

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108
20

(deferred tax TK4.2 adjusted, so the balance is higher than 16.9 in

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 constucted 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 to
90% of the eligible cost of the buildings. The occupants must have
income below certain maximum levels, and rent is restricted based on
the occupants' income. Because of limitations on the ability of
individuals to utilize the Federal credit, the primary investors in these
projects are typically large companies (frequently banks, because of the
added incentive of getting credit under the Community 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

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 Income Measurement and Taxation in Real Estate 179
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
I.XYZ Housing Ltd has the following assets in the balance sheet
Investment in land at cost TKIOOO 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
(i) 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.

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