In its recent judgment No. 2 Afs 296/2020-64, the Supreme Administrative Court (hereinafter referred to as the “SAC”) dealt with the method of accounting for long-term contracts in the construction industry.

The dispute related to the timing of the taxation of revenue in the case of contracts for work, namely whether it is possible under the Accounting Act to enter partial invoices in revenues, or whether the concept of unfinished production be applied, i.e. taxation would therefore only occur at the time of completion and handover of the work. 

The taxpayer treated the advance payments received as partial work performed on long-term construction contracts. This partial work was mutually agreed and the taxpayer then entered this sub-invoicing into revenues of the current period. The tax administrator considered this action to be incorrect and subsequently, together with the regional court, they took the position that since the contract for work did not contain any partial performances that could be included in the revenue as partial performances, the entity should have used the concept of unfinished production. However, the SAC ruled in favour of the taxpayer.

In its statement, the SAC recalls the specific nature of the construction industry and the complicated (especially temporal) effort to maintain a link between the revenues achieved and the costs incurred. These are long-term contracts that often extend over more than one accounting (tax) period. In the construction industry, the fact that due to the high financial complexity of the subject of the work contract, the customer is usually not charged for the entire contract together (upon completion), but in parts (e.g. according to individual objects or stages) also plays an important role. Therefore, construction should not be viewed as “common” custom production.  According to the SAC, the requirement to claim all costs incurred in the construction of the work only after the work is fully completed and handed over to the client would be unduly simplistic. 

In its judgment from 2007, the SAC already stated that “the principle of the material and temporal connection of tax-deductible expenses with taxable income must be interpreted in the context of the nature of the taxpayer’s business activity and the nature of the services it provides or receives”. If the taxpayer is in the construction business, he must be able to account for costs on an ongoing basis as they incur. The temporal and factual link should be ensured by the requirement that the relevant costs should be applied by the taxpayer at the time they become part of the taxable income through invoicing to the final customer of the work. The cost accounting treatment for unfinished production should only be applied to costs incurred that have not yet been invoiced to the customer.

In general, the SAC agreed with the taxpayer. Both methods of accounting are supported by the legal regulations and the SAC notes that “neither the administrative authorities nor the regional court, in their legal opinion, have in fact generally prohibited the possibility of accounting for income (instead of unfinished production) in this way, but have made it conditional, subject to  the individual stages of the work being expressly recognised a priori by the contractors of the relevant work contract as separate sub-performances of the contract (i.e. as individual stages, or parts, of the work), which will be progressively completed and handed over in the sense of article 2606 of the Civil Code.”

According to article 7 paragraph 1 of the Accounting Act, it is necessary to comply with the principle of keeping accounts in such a way that the financial statements give a true and fair image of the subject of the accounting and the financial position of the entity, and article 2 of the same Act clearly declares that “where an entity can choose between several options of a given accounting method and the chosen option would obscure the actual situation, the entity is obliged to choose another option that corresponds to the actual situation”. For accounting purposes, therefore, the actual state of affairs is of primary importance and it is not a legal requirement for this actual state of affairs to be identical to the legal state. 

The taxpayer also pointed out in the proceedings that the works invoiced and paid for already at the moment of their performance represented an undeniable economic value for the client, as they enabled the further progress of the works on the construction contracts and the tax entity could hardly “take back” the performed work and use it for the performance of another contract. The SAC therefore emphasises that the contractual arrangement for the handover of the work as a whole is relevant from a civil law point of view, but it is by no means precluded “from reflecting the fact that the work was performed, controlled, approved, invoices and paid for in instalments under the Accounting Act and the Accounting Decree. This procedure was, moreover, fully in accordance with the respective contractual arrangements; if the only argument for the incorrectness of the method of accounting chosen by the complainant should be the absence of an explicit designation of the agreed procedure for the implementation of the construction contract as “progressive implementation” and “partial handover” of the work under article 2606 of the Civil Code, the Supreme Administrative Court considers such argumentation to be unduly formalistic.”

Therefore, the SAC agreed with the taxpayer that he correctly accounted for the issued invoices as income of the taxable (accounting) period, in which the advance payments for the partial works were received.

Author: Jakub Štefáček, Renata Písecká