Tricky issue of retention payments

By and - , Build 137

Inland Revenue (IRD) recently provided some clarity for retention payments on construction projects in a draft Questions we’ve been asked. We review this advice and contractors’ rights when projects go bad.

INLAND REVENUE (IRD) states that, where retention money is withheld from a contractor payment to rectify repairs or omissions, the retention money becomes the contractor’s income when the repair or omission is rectified or signed off by a third party.

The same principle applies if the main contractor withholds money from a subcontractor.

Balancing income and expenditure

For the person making the payment, expenditure relating to the retention money is incurred in the income year the repair is complete or the omission rectified. IRD regards the timing of the resulting income and expenditure as symmetrical.

As a general example, a lead contractor receives a contract payment of $100,000 and also pays a subcontractor $100,000. Retention money of $10,000 has been held from both payments to rectify faulty work on the project.

When the first payment is made, the contractor has taxable income of $90,000 and deductible expenditure of $90,000. When the remedial work is complete or certified by a third party, the remaining $10,000 is taxable and deductible to the contractor.

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Some contractors out of sync

The draft document refreshes and confirms an approach that Inland Revenue notified back in 1980.

However, because of the age of the original interpretation, some contractors have moved away from that approach to one that was not symmetrical – taking deductions prior to retention work being completed and not returning income until the money subject to retention was released.

In the above example, when the initial payment was received, the contractor might return $90,000 as income and deduct expenditure of $100,000. The balance of $10,000 income might be returned in a later period, creating a timing advantage.

What remains unclear is how the IRD’s reissued policy will apply to existing situations where they have signed off on the non-symmetrical treatment. IRD policy statements are not law, but they do provide a good indication of how IRD views specific transactions.

It should be stressed that the example cited is general and should not be relied upon, as individual circumstances and specific contract wording may change the treatment.

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Rights when things go bad

When a contracting business fails – Mainzeal being a recent high profile case (see Build 136, pages 92–93) – what are the rights of a contractor who is owed retentions?

This depends on the nature of the relationship, whether the contractor is dealing with the customer or subcontracting, their trade and contract terms, and security instruments if any.

The Minister of Building and Construction Maurice Williamson indicated in Parliament that he would not see blanket provisions applying to protect subcontractor retentions, as these could be currently covered by contract. Having said that, the Minister is ‘listening to the sector … and will consider changes’.

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Review your contracts

We suggest businesses review their trade and contract terms and ensure they include the right to register a purchase money security interest (PMSI) on the Personal Property Securities Register (PPSR).

Where the goods will ultimately be located in fixed property and the business is contracting with the property owner, it should also include the ability to take an equitable mortgage.

We are currently dealing with a number of cases involving the non-payment of retentions under PMSI arrangements. These are expected to go before the courts, which will clarify the rights of contractors. Contractors in this position should seek advice, as it a tricky area with no generic answer.

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