(TAX UPDATE) Common Tax Issues on Contractors

(TAX UPDATE) Common Tax Issues on Contractors

Introduction

Contractors often tell us the same thing when reviewing their tax computation at year end:

“Contract is done but payment belum masuk. Still need to pay tax?”

This question is very common among construction SMEs in Malaysia. The issue is rarely about whether the business made profit. It is about when the profit is recognised, how the project is accounted for, and whether documentation supports what is declared to LHDN.

From official guidance on construction contracts and industry observations, LHDN focuses heavily on:

  • Stage of completion and timing of income

  • Consistency in method across different years

  • Evidence to support entitlement to retention sums

  • Proper closing of final accounts with proof of work done

When these fundamentals are weak, contractors face:

  • Tax undercharged assessments

  • Disallowed deductions

  • Penalties up to 45% under the tax audit framework

For SMEs working with progressive claims and tight cashflow, these adjustments can feel like a shock.

1. Profit Must Follow Work Progress, Not Cash Received

Many contractors assume tax is triggered only when money is collected. But under construction-based tax expectations, income should be recognised progressively using the Percentage of Completion Method (POCM).

Tax follows economic activity and entitlement, not bank balance.

Every project needs its own standalone contract account. Do not lump several projects into one ledger, because each contract has different progress, cost forecast, and retention conditions.

Example

Assume:

  • Contract value: RM3,000,000

  • Total estimated cost: RM2,400,000

  • Cost incurred to date: RM1,200,000

Percentage completed = 50%
Recognised revenue = RM1,500,000

If the contractor waits until final payment to recognise revenue, LHDN may transfer part of the profit back to earlier years. This leads to:

  • Backdated tax

  • Higher tax bills

  • Audit penalties

Why This Happens

Even if cash has not come in, the contractor may already be entitled to the revenue, especially when work is certified or substantially completed.

Key takeaway

Tax follows work done and entitlement, not timing of collection.

This mismatch between progress and cashflow is one of the most common issues raised in construction audits.

2. Retention Sums : The Silent Tax Trap

Retention sums may be small in percentage terms, but they often cause tax issues because entitlement is delayed, conditional, or undocumented.

Common Mistakes

  • Recognising retention early based on expectation, not entitlement

  • No adjustment when defect liability ends or final accounts are confirmed

  • Variation orders approved verbally and never formalised

  • Contract extensions not documented, causing mismatched records

Retention relates to work already performed but withheld for contractual reasons. Recognition should follow entitlement, not estimated collection.

Practical Rule

Recognise retention when documentation confirms entitlement, not when cash finally arrives.

The issue is rarely accounting software—it is document discipline.

3. Final Accounts Often Lack Evidence

A large portion of disputes during tax reviews arise because contractors cannot produce documents to support final account amounts.

Recurring problems:

  • Final accounts completed late or without supporting details

  • Claims not tied to certified progress

  • Missing signed variation orders

  • Subcontractor claims unsupported by delivery or site proof

  • No audit trail from certification to invoicing

When evidence is missing, LHDN may:

  • Disallow expenses

  • Question revenue recognised

  • Issue deemed assessments based on best judgement

Operational gaps turn into tax exposure.

4. Documentation Culture Determines Audit Outcome

In many contractor audits, the tax logic is correct—but the records do not exist to back it up.

Common documentation weaknesses:

  • Contracts stored in WhatsApp messages but not archived properly

  • Project files held by site supervisors instead of a central repository

  • Cost updates done informally without revision history

  • Variation orders approved verbally with no paper trail

  • Records disposed before the seven-year requirement

LHDN requires records to be available for a minimum of seven years.
If documents cannot be produced, deductions may be denied even if the work was genuinely done.

In tax, no documentation means no deduction.

KTP’s View

Tax risk in the construction sector is driven by timing, entitlement, and documentation, not complicated tax structures.

  • Income must follow progress

  • Retention must follow certification

  • Final accounts must follow evidence

  • Records must be centralised and audit-ready

Contractor tax compliance is mainly an operational discipline.

Fix the process, reduce the tax risk.

Conclusion

Contractors do not get into trouble because they do not make money.

They get into trouble because:

  • Income is recognised too late

  • Retention is handled informally

  • Final accounts lack proof

  • Records cannot be produced when LHDN asks

Fix timing + documentation = fewer tax surprises.

Recommendations for Contractor SMEs

Start small. Take one contract file and review:

  • Percentage of completion calculation

  • Cost estimation and revision history

  • Retention entitlement documented and certified

  • Variation orders signed and filed

  • All documents stored centrally and kept seven years

A properly maintained project file becomes a model for all future projects.

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