Building & Construction Industry: Retention payments and how to account for them
Written by Elle Sweeney
Retention payments are very common in the building and construction industry and involve the customer retaining a portion of the contract amount until a time after completion of the project. The retention acts as a security that the job is done well and free of defects. Once the liability for defects period has passed, the retention is paid to the supplier. The reason that retentions are worthy of discussion, is that it can be many months (even years) between the completion of a job and the payment of the final retention component.
If retentions are being used in a project, they should always be disclosed on the contract in a clause that describes:
- how much will be retained,
- the criteria to be achieved for final payment, and
- when it will be paid back.
Because of the potential to span across GST periods or financial years, accounting for retentions can be confusing. It is essential that transactions are recorded correctly to avoid paying tax on income unnecessarily or at least earlier than absolutely necessary.
They key to accounting for retentions is: the retention portion of the invoice is not taxable income until paid (ie until the criteria for payment of the retention has been met).
When raising an invoice for a project in Xero with a retention, the retention component should not be attributed to ‘Sales’, instead it should be attributed as a ‘Retention Liability’ on the balance sheet. This way it’s not taxable income until such time as it moves off the balance sheet. Accounting for retentions correctly, mean that you will not be paying tax on the retention (at 26% in 2021 if trading as a company) until you absolutely have to some time in the future (often in the next year’s tax return if not later.
Sometimes retentions may never be paid. In this case, accounting for them correctly, means that you never pay income tax on this income which you never received.
The incorrect method which we often see
We often see the full amount of the contract invoiced and coded to Sales. This means the full amount is taxable income in that year.
The customer will pay the amount, less the retention. This will leave the retention showing in trade debtors as an overdue amount which can remain there for many months or years.
Often retentions are never paid, and this ‘unpaid’ amount is not cleared however it has still been picked up as taxable income.
By accounting for retentions incorrectly, businesses are paying more tax than they should.
If the business accounts for GST on an accruals basis, the business is required to account for GST on the total invoice value (including the retention) in the period which the business receives any consideration. This means the business is required to remit GST on the full value of the invoice even if part of the payment is not received until a later time.
If the business reports for GST on a cash basis, it would remit GST to the ATO when the cash is received.
Do you have retention payments in your business?
If you have retention payments in your business, reach out to your advisor at Link to ensure these are being accounted for correctly so that you are not paying more tax than is absolutely necessary.