Deposit on year end to be declared as taxable income

[QRS]

We have a client who uses a deposit system for their clients.

What they basically do is request a deposit to cover the direct costs of the transaction. The final invoice is prepared as soon as the final product has been delivered to the customer, and the remaining portion is then paid by the customer.

For example:

Our client's final invoice is R 100. Cost of the sale is R60. Profit on the transaction is R40. Our client requests a deposit of R60 and pays the costs. No invoice is raised by our client at this point in time. They install the product at their customer, raise an invoice for R 100, and the customer pays the remianing R 40.

The actual sale is only declared when the final invoice is prepared.

We have a problem now, as the timeline from the deposit payment to the final invoice was basically over two financial years. The client's year end is in February. Deposit was received in January 2011, final invoice prepared (and declared for VAT) in March 2011. The deposit received was reflected as a creditor on the Annual Financial Statements for the year ended 28 February 2011.

Sars now bascially wants to include the deposit received as taxable income for the 2011 financial year, and not in the 2012 financial year as it should be.

We have looked
at 24C on the Income tax act 1962 (Act 58 of 1962) - allowance in respect of future expenditure on contracts, which basically states that the income should be included in taxable income, but an expense to the value of the same amount should be allowed as an expense. The problem is that the client already incurred the actual direct costs in the 2011 financial year, so this allowance will not be applicable.

Please advise.





[Dave A]

Am I understanding this right:

SARS is looking for 60% of the final bill being included in the 2011 tax year for income tax purposes?

And you've claimed all the direct expenses in the 2011 tax year?

[QRS]

Yes Dave, that is correct.

[Dave A]

I suggest one bears in mind the tax liability calculation doesn't always run in line with the financial reports. (If that sounds ridiculously condescending, I'm sorry but I don't know your background).

Looking on the bright side, at least you've managed to defer 40% of the income (the bulk of which I assume is profit) into the following tax year

If I understand the situation correctly, the alternative is to assume the project is 60% complete and only claim 60% of the total anticipated cost for the project in the 2011 tax year. The balance could only be claimed for income tax purposes in the 2012 tax year.

(In other words, I suspect you're already ahead of the game here)

[DavidvN]

It seems the reason SARS is taxing you on these deposits is they are applying the matching concept - that being you claim a deduction in the same year as you recognise the income. In your case, it appears as though you are claiming the expenses relating to the contract in the 2012 tax year, but deferring the income to the 2013 tax year. SARS doesn't like that.

You have two options available, depending on when the company is entitled to the revenue with no recourse for a refund of the deposit by the client. Establish when you should recognise the revenue, and then you should recognise the expenses at the same time. However, if the deposit you received is fully refundible to the client at any point in time prior to the contract being complete, then this can not be taxed as revenue (and the related expenses should also not be deductible). When is the company entitled to the deposited funds? Through-out the course of the contract, or only when the contract is completed in full? Establishing when the company is entitled to the revenue will help make this clearer.

The first option available to you would be to utilize the Section 24C allowance given by SARS. In order to do so, you will need to recognise a portion of income as well. Given that the deposit is non-refundible and is actually a disguised "pre-payment" for future work to be performed, SARS deems, in most cases, revenue is received at the sooner of receipt or accrual. The revenue in this case has not been invoiced, but has been received, and therefore must be shown as taxable income. Consequently, you should then be able to recognise the costs of this contract as well. These costs can either be actual costs incurred (if they are proportional to the revenue being recognised), actual costs plus a part S24C allowance claimed, or just a full S24C allowance. Be very careful of recognising 100% contract costs when you've only received a 60% payment. In SARS's view, you should only be entitled to claim 60% of the total contract expenses if it decides to tax you on the revenue.

The second option available would be to show factual evidence that the deposit is exactly that - a deposit. This would mean that during a period prior to completion of the contract, the client has the right to demand the deposit back in full. Essentially, you're working for free while being financed by the deposit. But if things go awry and the client wants their deposit back, you'll have no option but to pay them. If this is the case, prove that to SARS, as this is not revenue and can not be included as revenue as there is a contigency attached to this amount - being if things go wrong, you pay it back. You will need to ensure that you do not deduct any of the contract expenses either, and will need to retain these expenses on the balance sheet until the revenue is recognised.

Essentially what SARS is saying is that you can't claim expenses but not be taxed on the income. It's either all the revenue (accrued or received to date) and all expenses, or neither of the two.

[QRS]

Thank you Dave and David. I really appreciate your assistance.

The client claimed all the expenditure in the 2011 financial year. We will have no other alternative but to include the 60% deposit as taxable income.