(1) Legislative framework
The Income Tax Assessment Act (ITAA) 1936 was very complicated, unwieldy, without much internal integrity, due to the numerous amendments. The Tax Simplification Committee decided to slowly introduce a new Act, while at the same time leaving the old act operating.
The new ITAA came into effect in 1997 and its purpose was to make the Act simpler and easier to follow, in plain English, rather than to change the law.
The Commonwealth does not have the exclusive power to impose taxes. The states have the concurrent power to tax, subject to the constraints of provisions such as s90 and 109 of the Constitution.
The Commonwealth’s power is contained in s51(ii), which provides that the Parliament shall have power to make laws with respect to (ii) Taxation; but not so as to discriminate between States or parts of States.
Structure of the ITAA 1997 and relationship to the ITAA 1936• Section 2-1 is the design. It is a guide. It is only used for limited purposes.
• S2-5, general to particular – pyramid shape.
• Division 4 starts the core provisions. They are operative provisions. 4-1 says who pays income tax It is payable by each individual and company and some other entities.
S4-10 pay tax on 30 June.
S4-10(3) how to calculate tax which is:
Taxable income x rates – tax offsets = income tax
S4-15 how to calculate taxable income which is:
Taxable income (net profit) = assessable income (sales) – deductions (expenses)
This is variable for a variety of reasons such as depreciation, research and development expenses and the like.
• Div 6-1 assessable income is calculated:
Assessable income = ordinary income (s6-5) and statutory income (s6-10)
S6-15 If it’s not ordinary income and not statutory income (specifically listed in s10-5), it is not assessable income (so you do not have to pay income tax on it).
• Deductions is the amount you can deduct
s8-1 (general deductions)
s8-5 (specific deductions)
e.g.: ‘you’ – a company that manufactures goods and sells them to public – what type of things would be assessable income of the company? Sale proceeds, interest on excess cash etc.
Deductions: wages, costs of materials, rates, electricity, and depreciation. If you buy a capital item, you get depreciation because in earning your assessable income you have bought a machine for say $100,000, which might have a useful life of 10 years. The value of the equipment might drop by $10,000 each year and this is your depreciation.
The whole process is comparable to working out profit. A company has a profit and loss statement – Revenue less operating expenses, gives your net profit. Tax act works the same principle. It is designed to work out how much better off you are at the end of the year, at least in a realized sense, and the government taking a share of it.
Direct versus indirect tax
Direct tax – Where the economic burden of the tax is borne by the person who pays the tax.
Indirect tax – Where the person who pays the tax is able to pass on the economic burden of the tax to third parties.
E.g. The cost of income tax is borne by the person who earns the income and it is, therefore, described as direct tax. In contrast, the cost of GST, while generally paid by the supplier of goods or services, is ultimately borne by the consumer through the increase price charged for those goods or services by the supplier. Ultimately, however, the cost of all tax is passed on in one way or another.
(2) Concept of income
ITAA 1997, Div 6 & ITAA 1936 ss 6, 21, 21A, 26(e)
Section 6-5 deals with ordinary income. No definition of income in the Act.
Ordinary income falls into 1 of 3 categories:
1. income from personal exertion – salary, wages
2. income from property – e.g. rent
3. income from carrying on a business – sales proceeds
S6-10(1) your assessable income also includes some amounts which are not ordinary income – statutory income.
S6-10(2) Amounts which are not ordinary income but which are included in your assessable income by provisions about assessable income, are called statutory income (note refers us to 10-5).
6-25 the amount can be ordinary or statutory income but not caught twice. Specific provisions.
The concepts of capital and income are mutually exclusive. Capital is the tree or land. The income is the fruit or the crop. One can’t say that the sale of a building is capital. Look at the nature of the receipt in terms of tax payer.
Amounts that are included in assessable income but which are not “ordinary income” are referred to as “statutory income” (s6-10(2) ITAA97). A checklist of the many different statutory income provisions that are contained in the tax laws located in Div 10 ITAA97.
Some important statutory income provisions include ITAA36, s26(e), which relates to allowances in relation to employment. Prior to the introduction of the FBT, s26(3) ITAA36 was the main provision aimed at taxing employment allowances and benefits. The provision includes in the assessable income of a taxpayer, the “value to the taxpayer” of all allowances, gratuities, compensations, benefits, bonuses and premiums allowed, given or granted to the taxpayer in respect of, of for or in relation directly or indirectly to, any employment of or services rendered by the taxpayer.
S6 of the ITAA36 provides a definition of income from personal exertion or income derived from personal exertion.
Common law concept of income
Assessable income = ordinary income + statutory income (s6-1 ITAA97)
An amount may be brought into assessable income either as:
• “ordinary income” (s6-5), or
• “Statutory income” (i.e. amounts specifically included in assessable income by particular provisions of ITAA36 or ITAA97).
These terms are not defined although descriptions have been provided.
“Ordinary income” is interpreted in s6-5 as “income according to ordinary concepts” For an amount to be ordinary income, it must have its source in an earning activity.
Statutory income is the label given to gains that are included in assessable income by specific sections. The most important type of capital income is capital gains. Fringe benefits are not included in statutory income.
The judicial notion of income is income according to the ordinary concepts and usages of mankind. There is no single rule in determining whether a particular receipt is income according to ordinary concepts. “Income” is a form of financial “gain”.
Need to distinguish between income and capital.
Capital – the tree or the land
Income – the fruit or the crop
The character of the receipt depends upon the nature of the receipt in the hand of the particular taxpayer.
E.g. In a business, capital tends to be the structure itself within which you generate this regular income. If you sell the factory, it tends to be a capital receipt. The proceeds of the manufactured goods are income. But it all depends on the facts – a person selling 10 factories in a year might have proceeds assessed as income – he is carrying a business of buying and selling factories.
Receipt of money or money’s worth
The benefit you receive back has to be income or something that can be converted to money.
Tennant v Smith [1892]
Facts: A bank manager was provided with rent-free accommodation by his bank. The manager was forbidden from assigning leasing or sub-letting premises, i.e. he could not convert the benefit to cash.
Held: House of Lords said, that simply saving someone from incurring expenditure does not mean that what has been provided is income. The receipt by the taxpayer must be something that the taxpayer can convert into cash or otherwise dispose for his advantage.
Principle: Valuation rule: that a benefit which cannot be turned into cash is (or is not) income with a zero value. It is not assessable, it is not ordinary income – must be able to convert it to benefit you.
FCT v Cooke and Sherden (1980)
Facts: Deals with a business context.
A husband and wife carried on a soft drink business, selling soft drinks from a truck. The cordial manufacturers provided prizes to the retailer who bought the most cordials in a month. The couple were given a free holiday to Singapore. The terms of the holiday were that I could not be cashed in or transferred to anyone else.
Held: Brennan, Deane & Toohey said that it was not ordinary income because the benefit could not be converted to cash. The Full Federal Court said that although it had all the characteristics of income, quoting Tennant v Smith, as it cold not be converted into cash, it was not income.
“If a taxpayer receives a benefit which cannot be turned to pecuniary account, he has not received income as that term is understood according to ordinary concepts and usages…[though] it is not necessary that the pecuniary alternative be available by way of direct conversion of the benefit received.”
This decision has been overcome by s21A.
Compensation for loss of earnings or other income flows will generally be characterized as ordinary income, while compensation for loss, surrender or substantial impairment of a capital asset will generally be characterized as capital.
The characteristics of periodicity, recurrence and regularity are often seen as prima facie indicators that an amount has the character of ordinary income.
(3) Residence
ITAA97, s995-1 & ITAA36, s6(1)
INCOME TAX ASSESSMENT ACT 1997 - SECT 6.5
Income according to ordinary concepts (ordinary income)
(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income .
Note: Some of the provisions about assessable income listed in section 10 5 may affect the treatment of ordinary income.
(2) If you are an Australian resident, your assessable income includes the * ordinary income you * derived directly or indirectly from all sources, whether in or out of Australia, during the income year.
(3) If you are a foreign resident, your assessable income includes:
(a) the * ordinary income you * derived directly or indirectly from all * Australian sources during the income year; and
(b) other * ordinary income that a provision includes in your assessable income for the income year on some basis other than having an * Australian source.
(4) In working out whether you have derived an amount of * ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.
Non-residents are only taxed on Australian sourced income, ordinary or statutory.
Is a person a resident or non-resident?
What is the source of income?
Derived- when is it taxed i.e. looks at “timing”.
INCOME TAX ASSESSMENT ACT 1936 - SECT 6
"resident or resident of Australia" means:
(a) a person, other than a company, who resides in Australia and includes a person:
(i) whose domicile is in Australia, unless the Commissioner is satisfied that his permanent place of abode is outside Australia;
(ii) who has actually been in Australia, continuously or intermittently, during more than one half of the year of income, unless the Commissioner is satisfied that his usual place of abode is outside Australia and that he does not intend to take up residence in Australia; or
(iii) who is:
(A) a member of the superannuation scheme established by deed under the Superannuation Act 1990 ; or
(B) an eligible employee for the purposes of the Superannuation Act 1976 ; or
(C) the spouse, or a child under 16, of a person covered by sub-subparagraph (A) or (B); and
(b) a company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.
Below cases rely in the dictionary definition of “reside” which means “to dwell permanently or for a considerable time, to have ones settled or usual abode, to live in or at a particular place”.
Individuals
Ordinary meaning of “resident”
IRC v Lysaght [1936]
Facts: A person shifted his permanent home to Ireland where he lived with his family. Once a month he would stay in England for a week at a hotel. He came for business reasons.
Issue: Was he rising in England, even though he was only there one week in four.
Held: House of Lords said that he was a resident of England.
“A man might well be compelled to reside here (England) completely against his will. The necessities of business often, in a practical sense, forbid the choice of residence and although the person may make his home elsewhere….if the periods for which and the conditions under which he stayed are such that they may be regarded as constituting residence, it is open to find that he does so reside.
Principle: Where someone resides is descriptive of their character rather then their property.
E.g. A person in gaol in Thailand for 10 years is a Thai resident, despite being an Australian citizen with property, family etc in Australia.
Gregory v DFCT (1937)
Facts: Taxpayer had a peal fishing business in WA. He had a home in WA which eh owned, and where he resided from time to time. He then commenced a business in Darwin, a fishing business, rented a house in Darwin, social life based in Darwin. He lived part of the year in each state and travelled the rest of the time. States had own tax laws. Did he reside in WA or NT – a lot of evidence each way.
Held: HC said he resided in both places. Although he had not ceased to be a resident of Darwin, NT. He still kept a strong presence in Broome.
Principal: With unusual circumstances, you can reside in more than one place.
Extended definition of “resident”
Test 1 – Where do you actually reside?
Test 2 – A person is a resident if you are domiciled in Australia, unless the Commissioner is satisfied his permanent place of abode is outside Australia.
(ITAA36 s6)
Test 3 – Whether the person has been in Australia continuously or intermittently for more than one half of the year of income.
Domicile does not mean citizenship or nationality.
Domicile test: Domicile is a legal relationship between a person and a state by which a person invokes the state’s legal system as his or her personal law. At birth, every person is attributed a domicile of origin and that domicile is retained until changed by choice. A domicile of choice is acquired where a person demonstrates an intention to fix a permanent residence in a new country.
So if you are born in Australia, in order to be treated as non-domiciled, you would have to demonstrate that your permanent place of abode is outside Australia. The courts have held that the word “permanent” is not used in the sense of everlasting but is used to mean something more than merely temporary or transitory - authority is:
FCT v Applegate (1979)
Facts: Taxpayer a solicitor. On 8/11/71 he surrendered a lease on his flat, went to Villa for an indefinite term with his wife to set up a law firm there, a branch office. He organized a house in Villa, entered into a lease for 12 months with an option to renew for 12months. He came back to Australia in December 1971 when his wife had a baby then went immediately back to Villa. He had been sent to Villa for an indefinite period, albeit not permanently. Very early in the next financial year between 30/6/72 and 30/6/73 he became ill, the family packed up and came back to Australia.
Issue: Tax is imposed on an annual basis, residency must be determined on an annual basis. Was he a resident for the financial year ending 30/6/72?
Held: Court said ‘permanently’ means less than everlasting. Permanent must be construed by reference to the particular year under consideration. In regard to 1972 year, had he established a permanent place of abode outside Australia? Court said he had; he had intended going there for a substantial period of time, he had established a home there, had taken his family there and given up his lease in Australia. For that year he was a resident outside Australia.
FCT v Jenkins (1982) - deals with third test
Facts: It was almost identical, although the person went overseas for a fixed term, not an indefinite term as in Applegate. Again, person got sick, had to return to Australia. He had originally been sent over for a fixed term of (3) years.
Held: Court regarded the period of three years as significant and held that the taxpayer had a permanent place of abode outside Australia.
Principle: The third test - s6(1)(a)(ii) states prima facie that a person who is physically present in Australia for more than one half of a year of income is a resident. 183 day rule.
So if a person is physically in Australia for more than 6 months of the year of income may be treated as resident unless the person satisfies the Commissioner that the persons usual place of abode is outside Australia and that the person does not intend to take up residence in Australia.
e.g. Say on 30/6/99 you go to UK, get a unit for a few months, work as a bartender, go to France picking grapes, travel across Europe, Asia, arrive back in Australia 1/7/00. Are you a resident in the year ended 30/6/00?
Test 1 – no
Test 3 – no
Test 2 – Yes, presumably your domicile is Australia, and you would not be able to satisfy the Commissioner that you had established a permanent abode outside Australia, as you were always on the move. Different if you say you worked as a solicitor, with a 12-month lease.
Section 6-5, 6-10 places jurisdictional limitations on entities, and talk about whether you are a resident or not.
Residents are taxable on income from all sources while non-residents are taxable on income from Australian sources.
Companies
(ITAA36 s6(1)(b))
Test 1 – Is incorporated in Australia;
Test 2 – Carries on business in Australia and has its central management and control in Australia;
Test 3 – Carries on business in Australia and has its voting power controlled by Australian residents both must be satisfied.
If any of the above tests are not satisfied, the company is a non-resident.
Koitaki Para Rubber Estates v FCT (1940)
Facts: The directors of a company resided and met in Sydney. The seal book and register of members and records were kept in the registered office, which was in Sydney. The main assets were plantations in PNG. The company employed a manager in PNG, Manager had a power of attorney from company, which authorised him to manage and carry on the company’s affairs there. On a weekly basis the manager would send weekly reports to the Board of Directors in Australia regarding labourers and the large workforce.
Issue: Where was the central management and control?
Held: HC held that the company’s central management and control was in Sydney. They said the place of central management and control is where the superior or directing authority is located. (In effect, where the ultimate power rests, where the major decisions is made. The manager in PNG had day to day control, but the big decisions, the ultimate directing power lay with the Board of Directors.
Principle: Central management and control is where the directors make their decisions. If there is more than one place of management, then the central management and control of the company will be where the “superior or directing authority” of the company is located as opposed to the place of management of the company’s day-to-day operations.
Unit Construction Co v Bullock [1960]
Facts: A UK parent company had set up a subsidiary company in Kenya. They appointed a Board, all residents of Kenya, company incorporated in Kenya. The Board (Kenya Co) was specifically prohibited under the articles from meeting in UK. The purpose was to ensure that it was non-resident.
Under UK law, if a subsidiary incurred tax losses, its parent could use those tax losses, but it was limited to transfer of losses from UK subsidiaries. Company originally set up as a company not resident in UK, now they wanted it resident in UK to obtain tax losses. UK parent claimed the losses.
Issue: Where was the Kenyan company resident? Court had to determine where central management and control was for the company.
Held: The Board of the subsidiary never met, nor took or made any decisions. The decisions were all made in UK by Board of Directors of parent company. Held Central management and control was in UK. All central management or control is determined by the facts. The articles may prescribe what ought to be done but cannot create an actual state of control of management which does not exist in fact. All a question of fact.
Malayan Shipping Co v FCT (1946) - Third test
Facts: A Mr Sleigh in Melb established a company in Singapore, which was incorporated in Singapore. He was one of three directors. The other two were residents in Singapore. The two Singaporean company directors could not act without the say so of Mr Sleigh i.e. they rubber stamped what he did. Mr Sleigh lived in Melb. He was not a direct shareholder. It was a boat chartering company, which would charter and sub-charter boats. Mr Sleigh used to deal with people in England, and when it came to executing the agreement and doing the formalities of the deal, the document would be sent to Singapore , executed in Singapore, Board meetings there, charter finalized there. The profit between the two companies remained with Singapore, a tax haven.
Issue: Is the company a company of Australia?
Held: HC said it would take the view that the chartering and sub-chartering was solely carried out in Singapore. But, even with that being the case, it found that central management and control was in Australia, as Mr Sleigh was the ultimate power, making the decisions. But was the company carrying on a business here? By having the central management and control in Australia then ipso facto you are carrying on a business i.e. you only have to establish central management and control, then you are carrying on business in Australia. This is what was happening in Australia, therefore the company is also carrying on business in Australia.
Principle: Wherever central management and control is, there will also be the carrying on of business. The effect of Malaysian Shipping is that if you can satisfy that central management and control is in Australia, then you have also satisfied that the company is carrying on business here.
e.g. If you have a company incorporated in US, it has a lot of shareholders in Australia, e.g. wholly owned by Australians, and only business carried out in US.
Often people say in exams, as no business in Australia, does not come under third test. But as all its voting power here, people go on to say, central management and control is here, and therefore Malayan Shipping says it also carries on business here.
But just because voting power is here, it does not mean central management and control is here – Look at BHP – the shareholders of BHP do not control and manage the company, it is the Board of Directors who control and manage the company. Shareholders turn up at AGM’s and special meetings to vote on resolutions, but they do not actually control the company.
We do not look at where trusts are residents – too complicated.
(4) Source
ITAA97, s995-1 & ITAA36, ss 6C, 25(2)
Ordinary and statutory income have an Australian source if, and only if, derived from a source in Australia for the purposes of ITAA36 (s995-1(1) ITAA97, definition of “Australian Source”). It is expressly provided, therefore, that the existing law on the source of income will apply for the purposes of taxing an entity that is not an Australian resident.
How do you determine the source of income? Basically, it is a question of fact – Nathan’s case (HCA). The HC in Nathan’s case said that the legislature in using the word “source” meant, not a legal concept but something a practical man would regards as a hard matter of fact to be the real source of income.
It basically involves a two-step process:
1. Identifying the property or event that gives rise to or generates the income.
2. What is the geographical status of that property or event.
Once you have determined this, you have determined the source of income.
e.g. a building that generates rent. Source of rent in the building. One could argue that the source of income is the tenant, or the lease which could have been executed overseas – but courts seem to focus on the immovables e.g. where the building is actually situated, as source of the income.
Sale of goods
What is the activity that generates the income? It is where the item is sold, at least as to part of the source of that income. But if raw materials mined in one country with materials then taken to another country for processing then goods imported into Australia for sale, income really needs to be apportioned between several jurisdictions, as the activities which generate the income are in several jurisdictions.
The source of income from the sale of trading stock depends on the nature of the taxpayer’s activities.
- Where the essence of the taxpayer’s business is contracting (i.e. buying and selling goods), income from sales is sourced at the place where the contract of sale was entered into (i.e. where the goods are sold).
-Where the essence of the taxpayer’s business involves a range of activities, such as extraction, manufacture/processing and sale, the source of income is apportioned between the places at which the various activities are carried out.
Provision of services
What gave rise to it? Source should attach to:
(i) place of entering into the contract of service,
(ii) place of performance;
(iii) place of payment.
From a practical viewpoint, it is where the service is performed.
FCT v French (1957)
Facts: Taxpayer was a resident in Australia and went to NZ for a few months. He was sent by his company, and Australian company, to do some engineering work in NZ. He was employed in Australia, his money was paid into a bank account in Australia. He was actually employed in Australia. He actually went to NZ and worked for 3 months.
Held: The HC said the source of income was in NZ for those three months i.e. where the work was performed.
Principle: If the services are performed in more than one country, then the source of income is usually apportioned between two countries subject to a de minimus rule. The income in NZ was sourced in NZ.
FCT v Mitchum (1965)
Facts: The taxpayer, an American resident, had entered into an agreement with a Swiss Company, and he was employed by the Swiss Company to advise and act in the two motion pictures as and when directed by the company. He was to be paid a certain amount for that, whether or not he was actually called upon to perform those services. His services were eventually contracted out by the Swiss Company to Warner Bros.
The movie was produced partly in Australia, partly in UK, and for about 11 weeks the film “The Sundowners” was produced in Australia. The Commissioner assessed Mitchum for those 11 weeks on the basis that it was Australian source income.
Held: The HC was asked to rule on a particular point, a question of law. The question was, does French say that income from personal services is always sourced from where it is performed. The HC said no, it depends on the facts.
Principle: This case is a proposition that the source is where the contract is entered into.
Interest
Income from property. The general rule seems to be that the source is where the property is located, not where the claim is made or where the contract is entered into. This is so, particularly when the property is immovable. But what happens if the property is movable property.
Eg interest income – is the source where loan is entered into, or where interest is paid? The better view seems to be that it is where the contract for the loan is made is where the interest is sourced.
Dividends
Esquire Nominees v FCT (1973) - Dividend income.
Facts: This case involved a flow of dividends through a chain of companies. The bottom company in the chain, Manolas Pharmacy Pty Ltd, carried on an active business in Australia. The dividend was then passed through two companies resident in Norfolk Island, before eventually being paid to the taxpayer, who was also a company resident in Norfolk Island. The High court held that the activity giving rise to the profits derived by Mitchell Credits Ltd was the holding of the shares in Pharmaceutical Investments Ltd. This activity took place in Norfolk Island, and therefore the profits derived by Mitchell Credits Ltd were not sourced in Australia.
Held: HC held that the activity giving rise to the profits derived by Mitchell Credits Ltd was the holding of the shares in Pharmaceutical Investments Ltd. This activity took place in Norfolk Island, and therefore the profits derived by Mitchell Credits Ltd were not sourced in Australia. The source is where the profit of the company is located out of which the divided was made.
Principle: The source of dividend income is generally the place where the profits of the company that pays the dividends are made. Dividends paid by non-resident companies that are resident in countries with which Australia has International Tax agreements are deemed to be sourced in the relevant foreign country (ITAA s18(1)) subject to the terms of the relevant agreement (ITAAs18(2)).
Royalties
If you are looking at immovable property, like a mine, it would be where the mine is located, not where the agreement is entered into. It is a bit more difficult when you are dealing with moveable property, intellectual property.
The principle seems to be with regard to moveable property, in the sense of intellectual property, that again it is where the property is located, and in respect to intellectual property, it is where it is registered. If you have a trademark registered in Australia, that obviously gives you a proprietary right, and that property is here. If you then licence it to someone to use, then what you are doing is allowing someone to use your property which is located in Australia as it is registered in Australia. The source of that royalty income is in Australia.
Four types of royalties are envisaged for tax purposes:
(1) royalties within the ordinary meaning of “royalty” that are assessable as ordinary income under s6-5ITAA97
(2) amounts that fall outside the ordinary meaning of “royalty” but are defined to be royalties under s6(1) and are assessable as ordinary income under s6-5
(3) royalties that fall within the ordinary meaning of “royalty” but do not constitute ordinary income and are assessable as statutory income under s15-20ITAA97, and
amounts that fall outside the ordinary meaning of “royalty” but are defined to be royalties under s6(1) and do not constitute ordinary income assessed under s6-5.
Royalties credited to non-residents that are outgoings of an Australian business are deemed to have an Australian source (ITAA36, s6C).
FCT v United Aircraft Corporation (1943)
Facts: a US company supplied know-how in the US to an Australian company under an agreement made in the US. Paid for in the US and the account was held in the US. The issue was the source of the income derived by the US company from the supply of know-how.
Held: that the income did not have an Australian source because the information was supplied in the US under agreements entered into in that country.
Section 6C was then introduced which deems in Australia, the entity incurs expenditure then deemed source in Australia.
(5) Derivation
ITAA97, ss6-5 (see above), 6-10
INCOME TAX ASSESSMENT ACT 1997 - SECT 6.10
Other assessable income (statutory income)
(1) Your assessable income also includes some amounts that are not * ordinary income.
Note: These are included by provisions about assessable income.
For a summary list of these provisions, see section 10 5.
(2) Amounts that are not * ordinary income, but are included in your assessable income by provisions about assessable income, are called statutory income .
Note 1: Although an amount is statutory income because it has been included in assessable income under a provision of this Act, it may be made exempt income or non assessable non exempt income under another provision: see sections 6 20 and 6 23.
Note 2: Many provisions in the summary list in section 10 5 contain rules about ordinary income. These rules do not change its character as ordinary income.
(3) If an amount would be * statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct.
(4) If you are an Australian resident, your assessable income includes your * statutory income from all sources, whether in or out of Australia.
(5) If you are a foreign resident, your assessable income includes:
(a) your * statutory income from all * Australian sources; and
(b) other * statutory income that a provision includes in your assessable income on some basis other than having an * Australian source.
Ordinary income is included in assessable income when it is “derived” by a taxpayer (s6-5(2)(3)). The time at which statutory income is included in assessable income is set out by the section that includes the amount in statutory income.
Derivation goes to the timing of income, not source or whether it should be included in income. When do you return something as assessable income?
The meaning of ‘derived’ is based on judicial principles that draw upon but do not fully accord with generally accepted accounting principles.
Appropriate method of recognition of income: cash/accruals
In terms of “ordinary business and commercial principles” there are two alternative methods of accounting relevant to the recognition of income in a particular period:
(1) The cash (or receipts) basis: under this method income is recognized only when cash, or something capable of being turned into cash is received;
(2) The accruals (or earnings) basis: under this method income is recognized as it is earned and not as money is received. This normally occurs when the performance of the obligation which gives rise to the income is complete, eg:
a. When goods sold are delivered;
b. When services have been performed; and
c. When rent or interest is due.
C of T (SA) v Executor Trustee (Carden’s case) (1938)
Facts: Dr Carden was a medical practitioner, a sole practitioner, he used a cash basis. Then he died, and his estate filed a return in his name of income received till date of death. The executor began calculating the outstanding debts owed for his services. All the executor did was collect the debts, it did not provide any services it was not carrying on a business. The character of the money received by his estate after his death was held to be of a capital nature.
Commissioner wanted to tax those amounts, and as law stood at that time the amounts were not assessable to the deceased estate. So, the C of T went back and assessed deceased person in his individual capacity, on an accruals basis, so that amounts owing would be treated as income in taxpayers hand as from date of debt.
But, it is a matter of law as to which method you apply. The statute does not say the Commissioner has discretion. You make the decision if Commissioner disagrees he will assess you in a different way and at the end of day it is for the court to decide what method you should be using, as a matter of law.
Held: High Court disallowed what Commissioner had done, and said the taxpayer had been appropriately using the receipts method.
Dixon J said:
“Where there is nothing analogous to a stock of vendible articles to be acquired or produced and carried by the taxpayer.
Where outstandings on the expenditure side does not correspond to, and are not naturally connected with, the outstandings on the earning side.
Where there is no fund of circulating capital from which income or capital must be detached for actual enjoyment.
But, where on the contrary the receipt represents, in substance a reward for professional skill and personal work to which the expenditure on the other side of the account contributes only in a subsidiary or minor degree, then I think according to ordinary conceptions, the receipts basis forms a fair and appropriate foundation for estimating professional income.
NB – Dixons test is a question of fact, and as such raises enormous difficulties of administration
Principle: The enquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayers true income.
The High Court says that you choose the method which gives a better reflection based on the taxpayers true income, based on ordinary business and commercial principles. Income there used in the very broad sense.
What factors should the taxpayer take into account when determining which method should be used?
• It is a question of whether you have trading stock.
• Level of overheads eg employees and premises.
• The volume of bad debts.
• The general size of the enterprise.
• If you had a business which has a very high level of bad debts, so that eg, bad debts constitute 50% of all your sales, in that case you might have an argument to bring the money into account when it is actually received as it gives a truer reflection of the actual income I have actually derived.
It is a matter for the taxpayer to make the decision which basis you should be on. If you get it wrong, the Commissioner will re-assess you or you would have to fight his decision.
On a cash basis you are assessed on receipt. It is a “constructive receipt”, if someone deals with the money that is in effect your money on your behalf, as you direct, then it is treated as being received. This is a common law concept, but the act has a section that in effect repeats the common law position. S6-5(4).
NB this is only really relevant to cash taxpayers, not to anyone else. If you are taken to have received it (cash taxpayer) you are also taken to have derived it.
This looks not at whether something is assessable or not but at the timing of when something become assessable income. It is only really relevant to ordinary income provision 6-5. The statutory provisions under s6-10 have their own timing rules.
Salary and wages
Where there are few employees and the level of profit attributable to the employees is low relative to the level of profit attributable to the principal, the Commissioner will lean towards cash-basis accounting.
Trading income
If the sale of trading stock is only incidental to the provision of services, cash-basis accounting will be accepted; if it is an important part of the business, accruals-basis accounting will be required.
In accordance with general principles, the proceeds from the sale of trading stock constitutes ordinary income which is assessable under s6-5 ITAA97 and expenditure incurred in purchasing trading stock is a revenue outgoing which is deductible under the general deduction provision in s8-1 ITAA97.
Income from professional practice
Henderson v FCT (1971)
Facts: An accountant in a practice. Over time the accounting practice got quite large. It was on a cash basis, and then they took on more partners, employees, bigger premises etc. At the end of 1963, he decided to change, due to size of business growth, from a cash basis to accruals basis. Where the work was done and bill sent in period to 30 June 1963, but received after that date it was not taxable in 1963 on a cash basis as the money had not been received by year end, and would not be assessed in 1964 on an accruals basis. The Commissioner sought to assess this income for 1963 on accruals basis.
Held: The High Court said no. It is a matter of law. The taxpayer was quite justified in 1963 in using the cash basis, and in 1964 in using accruals basis. The taxpayer was quite justified in 1963 in using the cash basis and in 1964 using the accruals basis. Bad luck to Commissioner.
The down side of an accrual basis is that you pay tax on income you have not actually received as yet, but, if you went from accrual basis to cash basis, you would pay tax twice.
FCT v Firstenberg (1976)
Facts: The taxpayer, a solicitor and a sole practitioner, had for many years adopted a cash (or receipts) basis in calculating the assessable income derived by him from his profession. For the year ended 30 June 1970 the Commissioner calculated the assessable income of the taxpayer from his profession on an earnings (or accruals) basis. The Commissioner of Taxation appealed to the Supreme Court of Victoria from the decision of a Board of Review that calculation of the assessable income of the taxpayer from his profession upon a receipts basis was, in the circumstances, appropriate.
Held: Appeal was dismissed.
(i) In the case of a sole professional practitioner the essential feature of income "derived" is receipt. - Carden’s case applied. Henderson’s case distinguished.
(ii) It is a question of fact in each case whether receipts basis or accruals basis constitutes the correct method of ascertaining assessable income. The accruals basis is an artificial, unreal and unreasonably burdensome method of arriving at income "derived" in the case of a professional practice of the kind conducted by the taxpayer.
Prepaid income
Under the general law, payments that are made in advance for goods and services are usually fully deductible in the year that the payments are made. This principle allowed taxpayers to enter into pre-payment schemes under which they obtained up-front deductions for expenditure on things which were to be provided over a number of years.
To combat these schemes, special pre-payment rules were introduced and the rules are contained in s82KZL-82KZO ITAA36. Essentially, they require taxpayers to spread expenditure incurred under certain agreements over the “eligible service period”.
Arthur Murray (NSW) v FCT (1965)
Facts: the taxpayer was in the business of providing dancing lessons. Payments were often made in advance for a course of lessons. There was no right to a refund although a refund was sometimes given. In its internal accounting set-up, the company when it received the pre-payment credited it to an account called “Unearned deposits Lessons a/c” like a suspense account. This account sat there. The account at the end of the year did not regard this as income. But as the lessons were given these amounts were transferred over into another internal account called the “Taught Lessons a/c”. At that point it was recognized for their internal purposes as revenue, i.e., only when it was transferred across. The Commissioner sought to tax the money that had been received up-front. The company said income was derived only after lessons had been given and transferred across.
Issue: It went to the High Court as to when the income was derived.
Held: The High Court said the test is whether what has taken place is enough to satisfy the general understanding among practical business people of what constitutes derivation of income. On the facts here, the accounting treatment indicated that income was derived and treated as revenue, not in the suspense account, but in the “Taught Lessons a/c”. this was held to be relevant but not decisive. The High Court said as a matter of business prudence the taxpayer should not treat the income as being derived in the suspense a/c because of the contingency that it would have to be paid back if the lessons were not given. The fact that there was no right to a refund did not matter, as in many cases refunds were in fact given. The High Court said that if the company did not give the lessons they would be sued. The accounting records were a fair indication of how a practical businessman would treat that receipt.
Another benefit of not treating the income as being derived at that point of time is that the expenses would also occur later at the time the expenses occur – you would be matching the expenses with the revenue, it would be a better matching of costs with income (this was not in case, but would be applicable). Arthur Murray worked on an accrued basis. Later cases have agreed with this because of the matching principle i.e. better match of expenditure with income.
(6) Exempt income
ITAA97 Div 11, 50, 51
INCOME TAX ASSESSMENT ACT 1997 - SECT 11.1
Overview
Ordinary income or statutory income which is exempt from income tax can be divided into 3 main classes:
(a) ordinary or statutory income of entities that are exempt, no matter what kind of ordinary or statutory income they have (see table in section 11 5);
(b) ordinary or statutory income which is exempt, no matter whose it is (see table in section 11 10);
(c) ordinary or statutory income which is exempt only if it is * derived by certain entities (see table in section 11 15).
- The “first class” exempts charities (s50-5); trade unions (s50-15) and public hospitals (s50-30).
- The “second class” exempts dividends paid by PDF’s (s124ZM ITAA36) and government superannuation co-contributions (s51-65).
- The “third class” exempts Foreign source income of non-residents (s23(r) ITAA36), overseas employment income from continuous service of not less than 91 days of residents (s23AG ITAA36) and allowances received by members of the defence force (s51-5).
INCOME TAX ASSESSMENT ACT 1997 - SECT 50.1
Entities whose ordinary income and statutory income is exempt - refer to act.
INCOME TAX ASSESSMENT ACT 1997 - SECT 51.1
Amounts of ordinary income and statutory income that are exempt - refer to act.