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.