Hawaii Administrative Rules
Title 18 - DEPARTMENT OF TAXATION
Chapter 235 - INCOME TAX LAW
Subchapter 2 - DIVISION OF INCOME FOR TAX PURPOSES
Section 18-235-38-06.03 - Construction contractors
Current through January, 2025
(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).
(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 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.
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 percent completed at the end of the first income year and (because of change orders given during the second income year) 80 percent 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 percent 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 percent 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 percent of the estimated total contract costs have been incurred), then with respect to each contract to which the election is effective:
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 Year | 2nd Year | ||
| Beginning | Ending | Beginning | Ending |
| Construction Costs | $1,000,000 | ||
| Progress Billings | 600,000 | ||
| Balance 12/31 - (1/1) | $400,000 | $400,000 | |
| Consturction 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.
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 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.
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.
| Gross Receipts | 1st Year | 2nd Year | 3rd Year |
| $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.
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 percent 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 percent of $9,000,000), regardless of whether the taxpayer uses the accrual method or the cash method of accounting for receipts and disbursements.
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.
(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:
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 Constrctuion 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:
| 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 subjec to tax in Hawaii for 1992 is computed as follows:
| Business Income | $500,000 |
| Apportion 40% to Hawaii | 200,000 |
| Add: Income from Contrac M (Note 1) | 108,000 |
| Total business income derived fromsources 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 percent 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 Contact 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 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 Constrauction 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 percent 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 |
| Less: Total expenditures to date | $ 300,000 |
| Apportionable income | $ 50,000 |
