HAR § 18-235-38-06.03 — Construction contractors

(a) These rules apply to a taxpayer that uses the percentage of completion method or the completed contract method to account for income from long-term contracts (construction contracts covering a period in excess of one year from the date of execution of the contract to the date on which the contract is finally completed and accepted). (1) Every taxpayer shall determine how much of the taxpayer’s income for the year constitutes nonbusiness income, and how much constitutes business income, under section 235-21, HRS, and the rules that interpret that section. (2) Nonbusiness income is directly allocated to Hawaii under sections 235-25 to 235-28, HRS, and the rules that interpret those provisions. (3) For a taxpayer using the percentage of completion method described in subsection (d)(2), the taxpayer’s business income (including income from long-term contracts that is allocable to the year) is apportioned to Hawaii using the three-factor formula in section 235-29, HRS, where the factors are modified as follows: (A) The rules in subsection (d)(4) apply to the property factor, in order to take into account the taxpayer’s investment in a construction project in progress; (B) The rules in subsection (d)(5) apply to the payroll factor; and (C) The rules in subsection (d)(6), including subsection (d)(6)(B), apply to the sales factor in order to take into account receipts from long-term contracts. (4) For a taxpayer using the completed contract method described in subsection (d)(3): (A) The taxpayer’s business income (not including business income from long-term contracts) is apportioned to Hawaii using the three-factor formula in section 235-29, HRS, where the factors are modified as follows: (i) The rules in subsection (d)(4) modify the property factor to take into account the taxpayer’s investment in a construction project in progress; (ii) The rules in subsection (d)(5) apply to the payroll factor; and (iii) The rules in subsection (d)(6), including subsection (d)(6)(C), apply to the sales factor in order to take into account receipts from long-term contracts; and (B) Business income from each long-term contract is separately apportioned as follows: (i) Income from each long-term contract completed during the year is apportioned to Hawaii using the method described in subsection (e), which uses a weighted average of the factors determined under subparagraph (A) for each year the contract was in progress; (ii) If the taxpayer dissolves, withdraws, or otherwise ceases doing business in Hawaii during the year, income from each incomplete contract shall be taken into account and apportioned to Hawaii using the method described in subsection (f), which uses a weighted average of the factors determined under subparagraph (A) for each year the contract was in progress; or (iii) Otherwise, income from each long-term contract that is not completed during the year is not taken into account in that year. (5) The sum of: (A) The items of nonbusiness income directly allocated to Hawaii under paragraph (2), and (B) The amount of business income apportioned to Hawaii under paragraph (3) or (4), is the amount of the taxpayer’s income that is subject to net income tax by Hawaii. (b) For definitions, rules, and examples for determining business and nonbusiness income, see section 235-21, HRS, and the rules that interpret that section. (c) For general rules of accounting, definitions, and methods of accounting for long-term construction contracts see sections 446 (relating to methods of accounting generally) and 460 (relating to the general requirement HRS §235-38 §18-235-38-06.03 that the percentage of completion method be used) of the Internal Revenue Code of 1986, as amended, as operative under chapter 235, HRS; and Treasury Regulations section 1.451-3. (d) The following rules apply to apportionment of business income. (1) Business income is apportioned to Hawaii by a three-factor formula consisting of property, payroll, and sales regardless of the method of accounting for long-term contracts elected by the taxpayer. The total of the property, payroll, and sales percentages is divided by three to determine the apportionment percentage. The apportionment percentage then is applied to business income to determine the amount apportioned to Hawaii. (2) Under the percentage of completion method of accounting for long-term contracts, the amount to be included each year as business income from each contract is the amount by which the gross contract price corresponding to the percentage of the entire contract that has been completed during the income year exceeds all expenditures made during the income year in connection with the contract. In so doing, account must be taken of the material and supplies on hand at the beginning and end of the income year for use in each long-term contract. Example: A taxpayer using the percentage of completion method of accounting for long-term contracts entered into a long-term contract to build a structure for $9,000,000. The contract allowed three years for completion and, as of the end of the second income year, the taxpayer’s books of account, kept on the accrual method, disclosed the following: Receipts Expenditures End of 1st income year $2,500,000 $2,400,000 End of 2nd income year 4,500,000 4,100,000 Totals $7,000,000 $6,500,000 In computing the above expenditures, consideration was given to material and supplies on hand at the beginning and end of each income year. It was estimated that the contract was 30 per cent completed at the end of the first income year and (because of change orders given during the second income year) 80 per cent completed at the end of the second income year. The amount to be included as business income for the first income year is $300,000 (30 per cent of $9,000,000 or $2,700,000, less expenditures of $2,400,000, equals $300,000). The amount to be included as business income for the second income year is $400,000 (50 per cent of $9,000,000 or $4,500,000, less expenditures of $4,100,000, equals $400,000). If a taxpayer has made the election under section 460(b)(5) of the Internal Revenue Code (under which a taxpayer does not take into account income with respect to a contract under the percentage of completion method until the income year as of the close of which at least 10 per cent of the estimated total contract costs have been incurred), then with respect to each contract to which the election is effective: (A) The property, payroll, and sales factors shall be computed as set forth in this section the same as if the election had not been made; (B) Income from the contract for the 10 per cent year is apportioned to Hawaii using the methodology described in subsection (e), which uses a weighted average of the property, payroll, and sales factors for the 10 per cent year and all prior income years in which the contract was in progress; and (C) Where the taxpayer dissolves, withdraws, or otherwise ceases doing business in Hawaii during a year prior to the 10 per cent year, the taxpayer shall take into account income with respect to the contract, and the income shall be apportioned to Hawaii, using the method described in subsection (f), which uses a weighted average of the property, payroll, and sales factors for all income years in which the contract was in progress. (3) Under the completed contract method of accounting, business income derived from long- term contracts is reported for the income year in which the contract is finally completed and accepted. Therefore, a special computation is required to compute the amount of business income attributable to Hawaii from each completed contract (see subsection (e)). Thus, all receipts and expenditures applicable to those contracts, whether complete or incomplete as of the end of the income year, are apportioned separately from business income derived §18-235-38-06.03 from other sources, such as short-term contracts, interest, rents, or royalties, which are apportioned by the regular three-factor formula of property, payroll, and sales. (4) In general, the numerator and denominator of the property factor shall be determined as set forth in sections 235-30 to 235-32, HRS, and the rules that interpret those provisions. However, the following special rules also are applicable: (A) The average value of the taxpayer’s cost (including materials and labor) of construction in progress, to the extent the costs exceed progress billings (accrued or received, depending on whether the taxpayer is on the accrual or cash basis for keeping its accounts) shall be included in the denominator of the property factor. The value of any such construction costs attributable to construction projects in Hawaii shall be included in the numerator of the property factor. Example 1: Taxpayer commenced a long-term construction project in Hawaii as of the beginning of a given income year. By the end of its second year, its equity in the costs of production to be reflected in the numerator and denominator of its property factor for that year is computed as follows: 1st Y ear 2nd Y ear Beginning Ending Beginning Ending Construction Costs $1,000,000 Progress Billings 600,000 Balance 12/31 - (1/1) $400,000 $400,000 Construction Costs - Total from beginning of project $5,000,000 Progress billings - Total from beginning of project 4,000,000 Balance 12/31 1,000,000 Balance beginning of year 400,000 Total $1,400,000 Average (1/2) (Note 1) - Value used in property factor $ 700,000 Note 1 - It may be necessary to use monthly averages if yearly averages do not properly reflect the average value of the taxpayer’s equity. See section 235-32, HRS, and the rules that interpret that section. Example 2: Same facts as in Example 1, except that progress billings exceeded construction costs. No value for the taxpayer’s equity in the construction project is shown in the property factor. (B) Rent paid for the use of equipment directly attributable to a particular construction project is included in the property factor at eight times the net annual rental rate even though the rental may be capitalized into the cost of construction. (C) The property factor is computed in the same manner for all long-term contract methods of accounting and is computed for each income year even though under the completed contract method of accounting, business income is computed separately (see subsection (e)). (5) In general the numerator and denominator of the payroll factor shall be determined as set forth in sections 235-33 and 235-34, HRS, and the rules that interpret those provisions. However, the following special rules also are applicable: (A) Compensation paid employees which is attributable to a particular construction project is included in the payroll factor even though capitalized into the cost of construction. (B) Compensation paid employees who in the aggregate perform most of their services in a state other than the state to which their employer reports them for unemployment tax purposes, shall nevertheless be attributed to the state in which the services are performed. Example: A taxpayer engaged in a long-term contract in state X sends several key employees to that state to supervise the project. The taxpayer, for unemployment §18-235-38-06.03 tax purposes, reports these employees to state Y where the main office is maintained and where the employees reside. For payroll factor purposes, the compensation is assigned to the numerator of state X. (C) The payroll factor is computed in the same manner for all long-term contract methods of accounting and is computed for each income year even though, under the completed contract method of accounting, business income is computed separately (see subsection (e)). (6) In general, the numerator and denominator of the sales factor shall be determined as set forth in sections 235-35 to 235-37, HRS, and the rules that interpret those provisions. However, the following special rules also are applicable: (A) Gross receipts derived from the performance of a contract are attributable to Hawaii if the construction project is located in Hawaii. If the construction project is located partly within and partly without Hawaii, the gross receipts attributable to Hawaii are based upon the ratio which construction costs for the project in Hawaii incurred during the income year bear to the total of construction costs for the entire project during the income year. Any other method, such as engineering cost estimates, may be used if it provides a reasonable apportionment. Example: A construction project was undertaken in Hawaii by a calendar year taxpayer which had elected one of the long-term contract methods of accounting. The following gross receipts (progress billings) were derived from the contract during the three income years that the contract was in progress. 1st Year 2nd Year 3rd Year Gross Receipts $1,000,000 $4,000,000 $3,000,000 The gross receipts to be reflected in both the numerator and denominator of the sales factor for each of the three years are the amounts shown. (B) If the percentage of completion method is used, the sales factor includes only that portion of the gross contract price which corresponds to the percentage of the entire contract which was completed during the income year. Example: A taxpayer which had elected the percentage of completion method of accounting entered into a long-term construction contract. At the end of its current income year (the second since starting the project), it estimated that the project was 30 per cent completed. The bid price for the project was $9,000,000 and it had received $2,500,000 from progress billings as of the end of its current income year. The amount of gross receipts to be included in the sales factor for the current income year is $2,700,000 (30 per cent of $9,000,000), regardless of whether the taxpayer uses the accrual method or the cash method of accounting for receipts and disbursements. (C) If the completed contract method of accounting is used, the sales factor includes the portion of the gross receipts (progress billings) received or accrued, whichever is applicable, during the income year attributable to each contract. Example 1: A taxpayer which had elected the completed contract method of accounting entered into a long-term construction contract. By the end of its current income year (the second since starting the project), it had billed, and had accrued on its books, a total of $5,000,000. Of that amount, $2,000,000 had accrued in the first year in which the contract was undertaken, and $3,000,000 had accrued in the current (second) year. The amount of gross receipts to be included in the sales factor for the current income year is $3,000,000. Example 2: Same facts as in Example 1 except that the taxpayer keeps its books on the cash basis and, as of the end of its current income year, had received only $2,500,000 of the $3,000,000 billed during the current year. The amount of gross receipts to be included in the sales factor for the current income year is $2,500,000. §18-235-38-06.03 (D) The sales factor, except as noted above in subparagraphs (B) and (C), is computed in the same manner regardless of which long-term method of accounting the taxpayer has elected, and is computed for each income year even though, under the completed contract method of accounting, business income is computed separately. (7) The total of the property, payroll, and sales percentages is divided by three to determine the apportionment percentage. The apportionment percentage then is applied to business income to establish the amount apportioned to Hawaii. (e) The completed contract method of accounting requires that the reporting of income (or loss) be deferred until the year in which the construction project is completed or accepted. Accordingly, a separate computation is made for each such contract completed during the income year, regardless of whether the project is located within or without Hawaii, in order to determine the amount of income which is attributable to sources within Hawaii. The amount of income from each contract completed during the income year apportioned to Hawaii, plus other business income apportioned to Hawaii by the regular three-factor formula (such as interest income, rents, royalties, or income from short-term contracts), plus all nonbusiness income allocated to Hawaii, is the measure of tax for the income year. The amount of income (or loss) from each contract which is derived from sources within Hawaii using the completed contract method of accounting is computed as follows: (1) In the income year in which the contract is completed, the income (or loss) from the contract is determined. (2) The income (or loss) determined at paragraph (1) is apportioned to Hawaii by the following method: (A) A fraction is determined for each year the contract was in progress. The numerator is the amount of construction costs paid or accrued in each year the contract was in progress and the denominator is the total of all construction costs for the project. (B) Each percentage determined in (A) is multiplied by the apportionment formula percentage for that particular year as determined in subsection (d)(7). (C) The percentages determined in (B) for each year during which the contract was in progress are totaled. The amount of total income (or loss) from the contract determined in paragraph (1) is multiplied by the total percentage. The resulting income (or loss) is the amount of business from such contract derived from sources within Hawaii. Example 1: A taxpayer using the completed contract method of accounting for long- term contracts is engaged in three long-term contracts: Contract L in Hawaii, Contract M in state X and Contract N in state Y . In addition, it has other business income (less expenses) during the income year 1992 from interest, rents, and short-term contracts amounting to $500,000, and nonbusiness income allocable to Hawaii of $8,000. During 1992, it completed Contract M in state X at a profit of $900,000. Contracts L and N in Hawaii and state Y , respectively, were not completed during the income year. The apportionment percentages of the taxpayer as determined in subsection (d)(7) and the percentages of contract costs as determined in this paragraph for each year during which Contract M in state X was in progress are as follows: 1990 1991 1992 Apportionment % 30% 20% 40% % of Construction costs of Contract M each year to total construction costs - (100%) 20% 50% 30% The corporation’s net income subject to tax in Hawaii for 1992 is computed as follows: Business Income $500,000 Apportion 40% to Hawaii 200,000 Add: Income from Contract M (Note 1) 252,000 Total business income derived from sources within Hawaii 452,000 Add: Nonbusiness income allocated to Hawaii 8,000 Net income subject to tax $460,000 Note 1 - Income from Contract M apportioned to Hawaii: §18-235-38-06.03 1990 1991 1992 Total Apportionment % 30% 20% 40% % of Construction Costs 20% 50% 30% 100% Product 6% 10% 12% 28% 28% of $900,000 = $252,000 Example 2: Same facts as in Example 1 except that Contact L was started in 1992 in Hawaii, the first year in which the taxpayer was subject to tax in Hawaii. Contract L in Hawaii and Contract N in state Y are incomplete in 1992. The corporation’s net income subject to tax in Hawaii for 1992 is computed as follows: Business Income $500,000 Apportion 40% to Hawaii 200,000 Add: Income from Contract M (Note 1) 108,000 Total business income derived from sources within Hawaii 308,000 Add: Nonbusiness income allocated to Hawaii 8,000 Net Income subject to tax $316,000 Note 1 - Income from Contract M apportioned to Hawaii: 1990 1991 1992 Total Apportionment % -0- -0- 40% Costs 20% 50% 30% 100% Product -0- -0- 12% 12% 12% of $900,000 = $108,000 Here, only 12 per cent is used to determine the income derived from sources within Hawaii since the corporation was not subject to tax in Hawaii prior to 1992. Example 3: Same facts as in Example 1 except that the figures relate to Contract L in Hawaii and 1992 is the first year the corporation was taxable in another state (see sections 235-22 and 235-23, HRS, and the rules that interpret those provisions). Contracts M and N in states X and Y were started in 1992 and are incomplete. The corporation’s net income subject to tax in Hawaii for 1992 is computed as follows: Business Income $500,000 Apportion 40% to Hawaii 200,000 Add: Income from Contract L (Note 1) 738,000 Total business income derived from sources within Hawaii 938,000 Add: Nonbusiness income allocated to Hawaii 8,000 Net income subject to tax $946,000 Note 1 - Income from Contract L apportioned to Hawaii: 1990 1991 1992 Total Apportionment % 100% 100% 40% % of Construction Costs 20% 50% 30% 100% Product 20% 50% 12% 82% 82% of $900,000 = $738,000 (f) Use of the completed contract method of accounting for long-term contracts requires that income derived from sources within Hawaii from incomplete contracts in progress outside Hawaii on the date of withdrawal, dissolution, or cessation of business in Hawaii be included in the measure of tax for the taxable year during which the corporation withdraws, dissolves, or ceases doing business in Hawaii. The amount of income (or loss) from each contract to be apportioned to Hawaii by the apportionment method set forth in subsection (e)(2) shall be determined as if the percentage of completion method of accounting §18-235-38-06.03 were used for all contracts on the date of withdrawal, dissolution, or cessation of business. The amount of business income (or loss) for each contract shall be the amount by which the gross contract price from each contract which corresponds to the percentage of the entire contract which has been completed from the commencement of the contract to the date of withdrawal, dissolution, or cessation of business exceeds all expenditures made during that period in connection with each contract. In so doing, account must be taken of the material and supplies on hand at the beginning and end of the income year for use in each contract. Example: A construction contractor qualified to do business in Hawaii had elected the completed contract method of accounting for long-term contracts. It was engaged in two long- term contracts. Contract L in Hawaii was started in 1991 and completed at a profit of $900,000 on December 16, 1993. The taxpayer withdrew on December 31, 1993. Contract M in state X was started in 1992 and was incomplete on December 31, 1993. The apportionment percentages of the taxpayer, as determined in subsection (d), and percentages of construction costs, as determined in subsection (e)(2), for each year for each contract are as follows: 1991 1992 1993 Total Apportionment % 30% 20% 40% % of Construction Costs: Contract L, Hawaii 20% 50% 30% 100% Contract M, state X -0- 10% 25% 35% The corporation had other business income (net of expenses) of $500,000 during 1992 and $300,000 during 1993. The gross contract price of Contract M (state X) was $1,000,000, and it was estimated to be 35 per cent completed on December 31, 1993. Total expenditures to date for Contract M (state X) were $300,000 for the period ended December 31, 1993. The measure of tax for the taxable year ended December 31, 1993 is computed as follows: Taxable Year 1993 Income Year 1992 Income Year 1993 Business Income $500,000 $300,000 Apportionment % to Hawaii 20% 40% Amount apportioned to Hawaii 100,000 120,000 Add: Income from contracts: L (Hawaii) (Note 1) 252,000 M (state X) (Note 2) 6,000 Total business income derived from sources within Hawaii $100,000 $378,000 Note 1 - Income from Contract L apportioned to Hawaii: 1991 1992 1993 Total Apportionment % 30% 20% 40% % of Construction Costs 20% 50% 30% 100% Product 6% 10% 12% 28% 28% of $900,000 = $252,000 Note 2 - Income from Contract M apportioned to Hawaii: 1991 1992 1993 Total Apportionment % -0- 20% 40% % of Construction Costs -0- 10% 25% 35% Product -0- 2% 10% 12% 12% of 50,000 (Note 3) = $6,000 Note 3 - Computation of apportionable income from Contract M based on percentage of completion method: Total Contract Price $1,000,000 Estimated to be 35% completed 350,000