Principles of taxation law 2020 [(2020 Edition)] 9780455243115, 0455243115
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Copyright © 2019. Thomson Reuters. All rights reserved.
PRINCIPLES OF TAXATION LAW 2020
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Thomson Reuters (Professional) Australia Limited 19 Harris Street Pyrmont NSW 2009 Tel: (02) 8587 7000 [email protected] http://legal.thomsonreuters.com.au/ For all customer inquiries please ring 1300 304 195 (for calls within Australia only)
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NORTH AMERICA Thomson Reuters Eagan United States of America
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Principles of Taxation Law 2020 Kerrie Sadiq
Richard Krever
Professor Queensland University of Technology, QUT Business School
Professor University of Western Australia Law School
Celeste Black
Wes Obst
Associate Professor The University of Sydney Law School
Taxation Consultant
Rami Hanegbi
Antony KF Ting
Senior Lecturer Deakin University, Faculty of Business and Law
Associate Professor The University of Sydney Business School
Sunita Jogarajan
Copyright © 2019. Thomson Reuters. All rights reserved.
Professor University of Melbourne, Melbourne Law School
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Lawbook Co. 2020
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Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668 19 Harris Street, Pyrmont, NSW 2009 ISBN: 9780455243115
© 2019 Thomson Reuters (Professional) Australia Limited
Copyright © 2019. Thomson Reuters. All rights reserved.
This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. All legislative material herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing. Requests should be submitted online at www.ag.gov.au/cca, faxed to (02) 6250 5989 or mailed to Commonwealth Copyright Administration, Attorney-General’s Department, Robert Garran Offices, National Circuit, Barton ACT 2600. Product Developer: Stephen Rennie Edited and typeset by Newgen Digitalworks Printed by Ligare Pty Ltd, Riverwood, NSW This book has been printed on paper certified by the Programme for the Endorsement of Forest Certification (PEFC). PEFC is committed to sustainable forest management through third party forest certification of responsibly managed forests. For more info: http://www.pefc.org
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PREFACE This is the 13th edition of a book prepared by a group of experienced tertiary tax teachers with the goal of making the Australian income tax system accessible and comprehensible to students. The book is written from the perspective of the current law and proposed changes. Tax reform continues to be debated in the public forum with issues such as international tax, taxation of the digital economy and the cash economy all featuring heavily in the media over the last 12 months. After a particularly busy time in tax reform, legislative amendments to the Australian taxation regime have slowed somewhat recently. Although there is no doubt that the law continues to evolve with both changes to the Income Tax Assessment Acts and court decisions, the most current of which have been noted in this edition of Principles of Taxation Law. In addition to these updates, each chapter contains new questions, all dealing with contemporary issues. Tax affects everyone and is paid by individuals and entities earning income from personal exertion, business or property, as well as buying goods or services subject to GST. Because the Government uses the tax legislation as a means of introducing economic policy measures, all citizens who vote have an opportunity to follow tax policy and contribute to the debate. Tax issues are regularly discussed in the daily media.
Copyright © 2019. Thomson Reuters. All rights reserved.
The Australian tax system consists of four major stakeholders: taxpayers, the Australian Taxation Office which administers the system, the Australian Government which levies taxes and makes and amends the tax laws with input from Government Departments and tax agents, many of whom are members of professional bodies, who assist taxpayers to manage their tax affairs. This book contains chapters on key areas of income tax, FBT, GST and State taxes and is divided into seven parts: an overview and structure, principles of income, deductions and offsets, timing issues, investment and business entities, tax avoidance and administration, and indirect taxes. The division of 26 chapters into seven separate parts makes it easier for students to understand the conceptual framework within which tax operates. Each chapter contains references to relevant legislation, important court decisions, rulings issued by the Australian Taxation Office and other materials. Diagrams, case studies and examples are included throughout the text. Questions at the end of each chapter provide students with the opportunity to apply their knowledge to solve practical problems. Significant contributions were made to earlier editions of this book by Cynthia Coleman, Geoffrey Hart, John McLaren and Jonathan Teoh. Cynthia, Geoffrey and John were part of the inaugural team of authors and the current team wishes to acknowledge their commitment to making the book what it is today. We wish to thank the staff at Thomson Reuters, particularly Stephen Rennie who has worked diligently to bring into being this 13th edition.
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PRINCIPLES OF TAXATION LAW 2020
People who work in tax share a passion for their discipline. The authors of this book hope that students who use it will gain knowledge, skills and also a love of the subject.
Copyright © 2019. Thomson Reuters. All rights reserved.
December 2019
CELESTE BLACK RAMI HANEGBI SUNITA JOGARAJAN RICHARD KREVER WES OBST KERRIE SADIQ ANTONY TING
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TABLE OF CONTENTS Preface................................................................................................................................ v Table of Cases................................................................................................................... ix Table of Statutes............................................................................................................. xxi Rulings Table.............................................................................................................. xxxix
Part 1: Overview and Structure..................................................................... 1 Chapter 1: Sources of taxation law................................................................. 3 Chapter 2: Study skills for taxation law........................................................ 21 Chapter 3: The taxation formula................................................................... 63 Chapter 4: Residence and source................................................................. 87 Part 2: Income............................................................................................. 115 Chapter 5: Assessable income.................................................................... 119 Chapter 6: Income from personal services and employment................... 137 Chapter 7: Fringe benefits tax..................................................................... 187 Chapter 8: Income from business............................................................... 235 Chapter 9: Income from property............................................................... 285 Chapter 10: Principles of compensation..................................................... 309 Chapter 11: Capital gains tax....................................................................... 333
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Part 3: Deductions and Offsets.................................................................. 383 Chapter 12: General deductions................................................................. 385 Chapter 13: Specific deductions................................................................. 475 Chapter 14: Capital allowances................................................................... 503 Chapter 15: Offsets...................................................................................... 541 Part 4: Timing Issues................................................................................... 557 Chapter 16: Tax accounting........................................................................ 559 Chapter 17: Trading stock........................................................................... 585 Part 5: Investment and Business Entities................................................. 613 Chapter 18: Taxation of superannuation.................................................... 617 Chapter 19: Partners and partnerships....................................................... 649 Chapter 20: Trusts and beneficiaries.......................................................... 667 Chapter 21: Companies and shareholders................................................. 689 Chapter 22: International taxation............................................................... 731 Part 6: Avoidance and Administration...................................................... 767 Chapter 23: Tax avoidance.......................................................................... 769 Chapter 24: Tax administration................................................................... 799
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PRINCIPLES OF TAXATION LAW 2020
Part 7: Indirect and State Taxes................................................................. 861 Chapter 25: Goods and services tax........................................................... 863 Chapter 26: State taxes............................................................................... 907 Appendix....................................................................................................................... 947
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Index.............................................................................................................................. 959
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TABLE OF CASES A
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AAT Case 4083 [2011] AATA 545 .................................................................................................. 8.90 AAT Case 5489A (1992) 23 ATR 1068 ....................................................................................... 12.310 AAT Case 7,752 (1992) 23 ATR 1057 ........................................................................................... 6.150 AAT Case 9824 (1994) 29 ATR 1246 ............................................................................................ 7.100 ABB Australia Pty Ltd v FCT (2007) 66 ATR 460 ....................................................................... 22.290 AGC (Advances) Ltd v FCT (1975) 132 CLR 175 ................................. 12.140, 16.140, 16.150, 16.240 AGC (Investments) Ltd v FCT (1992) 23 ATR 287 ......................................................................... 8.90 ARM Constructions Pty Ltd v DCT (1987) 18 ATR 407 ............................................................... 17.20 Agriwealth Capital Ltd v C of T [2019] FCA 56 .......................................................................... 24.420 All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874 ..................................................... 17.220 Allan J Heasman Pty Ltd v FCT [2015] FCAFC 119 ................................................................... 24.130 Allied Mills Industries Pty Ltd v FCT (1989) 20 ATR 457 ........................................................... 10.180 Allsop v FCT (1965) 113 CLR 341 ..................................................................... 10.250, 10.270, 10.290 Amalgamated Zinc (De Bavay's) Ltd v FCT (1935) 54 CLR 295 ........................ 12.40, 12.140, 16.140 Andriopoulos and FCT, Re (2009-2010) 78 ATR 654 ................................................................ 24.203 Anstis v FCT (2010) 76 ATR 735 .................................................................................................. 5.130 Archer Bros Pty Ltd v FCT (1953) 90 CLR 140 ........................................................................... 21.140 Arnold v FCT [2017] AATA 1318 ................................................................................................ 13.130 Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 ..................................... 16.30, 16.90, 23.50 Attorney-General (NT) v Kearney (1985) 158 CLR 500 ............................................................. 24.570 August v FCT [2013] FCAFC 85 ......................................................................................... 8.240, 8.250 Australasian Jam v FCT (1953) 88 CLR 23 .................................................................... 17.160, 17.170 Australia and New Zealand Banking Group Limited v Konza [2012] FCAFC 2012 .................. 24.550 Australian Air Express Pty Ltd v Langford [2005] NSWCA 96; (2005) 147 IR 240 ................... 26.360 Australian Crime Commission v Stewart [2012] FCA 29 .......................................................... 24.570 Australian Crime Commission v Stoddart [2011] HCA 47 ........................................................ 24.550 Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97 ...................................................... 21.340
B BHP Billiton Petroleum v FCT (2002) 51 ATR 520 ..................................................................... 16.110 BP Australia Ltd v FCT (1964) 110 CLR 387 ............................................................................... 12.190 BP Australia Ltd v FCT (1965) 112 CLR 386 .................................................................. 12.190, 12.200 Babka v FCT (1989) 20 ATR 1251 ........................................................................................ 6.110, 8.70 Bailey v FCT (1977) 136 CLR 214 ............................................................................................... 24.220 Baker v FCT [2012] AATA 168 ...................................................................................................... 4.140 Barnes v FCT (2007) 67 ATR 284 ............................................................................................... 24.570 Batagol v FCT (1963) 109 CLR 243 .................................................................................. 24.60, 24.110 Beckett v Tax Practitioners Board [2019] FCA 353 ................................................................... 24.698 Bellinz Pty Ltd v FCT (1998) 39 ATR 198 ................................................................................... 24.380 Bennett v FCT (1947) 75 CLR 480 ................................................................................................ 6.150 Binetter v DCT (No 2) [2012] FCAFC 126 ................................................................................... 24.550 Blakeley v CIR (2008) 23 NZTC 21,865 ...................................................................................... 24.600 Bohemians Club v Acting FCT (1918) 24 CLR 334 ...................................................................... 5.170 Brajkovich v FCT (1989) 20 ATR 1570 .................................................................................. 8.30, 8.70 Brandon v FCT (2010) 2010 ATC 10-143 ................................................................................... 12.420 Brent v FCT (1971) 125 CLR 418 .............................................................................. 6.40, 6.140, 16.20
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x
PRINCIPLES OF TAXATION LAW 2020 Brisbane Bears –Fitzroy Football Club Ltd v Commr of State Revenue [2017] QCA 223 .................................................................................................................. 26.320 British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 ......................................... 12.180 Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 ..................................... 1.110, 12.840, 12.850 Brookton Co-operative Society v FCT (1981) 147 CLR 441 ...................................................... 16.100 Brown v Brown (2007) 69 ATR 534 ........................................................................................... 24.170 Brown v FCT (2002) 49 ATR 301 ........................................................................................... 6.20, 6.30 Burmah Steamship Co Ltd v IR Commissioner of Inland Revenue (1931) 16 TC 67 ............... 10.210 Burrell's Case [1924] 2 KB 52 ..................................................................................................... 21.140 Bywater Investments Limited &Ors v Commissioner of Taxation [2016] HCA 45 .......... 4.190, 4.200
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C C of IR (NZ) v Europa Oil (NZ) No 1 [1971] AC 760 ..................................................................... 2.165 C of T (Victoria) v Phillips (1936) CLR 144 ................................................................................... 10.70 C of T (WA) v D & W Murray Ltd (1929) 42 CLR 332 ................................................................... 4.240 Cadbury-Fry-Pascall Pty Ltd v FCT (1944) 70 CLR 362 ............................................................. 24.120 Californian Copper Syndicate v Harris (1904) 5 TC 159 .................................................. 8.130, 8.180 Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28 ......................................... 9.140, 10.190 Calvert v Wainwright (1947) 27 TC 475 ......................................................................................... 6.80 Carey v Field (2002) 51 ATR 40 .................................................................................................. 24.420 Carlisle &Silloth Golf Club v Smith [1912] 2 KB 177 .................................................................... 5.170 Carlos Sanchez v FCT (2008) 73 ATR 650 ................................................................................. 12.620 Carter and Tax Practitioners Board, Re [2017] AATA 528 ........................................................ 24.690 Case 1/99 (1999) 41 ATR 1117 ..................................................................................................... 8.170 Case 36 (1949) 15 TBRD (OS) 287 ............................................................................................... 13.60 Case 37 (1966) 13 CTBR (NS) 235 ................................................................................................ 6.110 Case 40 (1968) 14 CTBR ............................................................................................................... 13.50 Case 44 (1963) 11 CTBR ............................................................................................................... 13.60 Case 58 (1962) 10 CTBR ............................................................................................................... 13.60 Case 64 (1944) 11 TBRD (OS) 202 ............................................................................................... 13.40 Case 7752 (1992) 23 ATR 1057 .................................................................................................... 6.230 Case 82 (1953) 3 CTBR ................................................................................................................. 13.50 Case 95 (1968) 14 CTBR (NS) 553 ................................................................................................ 19.20 Case J47 (1958) 9 TBRD 244 ........................................................................................................ 13.33 Case M28 (1980) 80 ATC 187 ..................................................................................................... 12.770 Case T75 (1968) 18 TBRD 377 ...................................................................................................... 13.50 Case U80 (1987) 87 ATC 470 ..................................................................................................... 12.750 Case Z42 (1992) 24 ATR 1183 .................................................................................................... 12.610 Casimaty v FCT (1997) 37 ATR 358 ............................................................................................. 8.180 Charles v FCT (1954) 90 CLR 598 ................................................................................................. 20.30 Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 ............................... 12.30, 12.40, 12.50, 12.90, 12.110, 12.150 Chevron Australia Holdings v FCT [2015] FCA 1092 ................................................................ 22.360 Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 .............. 22.360 Chief Commissioner of State Revenue v MetriconQld Pty Ltd [2017] NSWCA 11 .................. 26.284 Cliffs International Inc v FCT (1985) 16 ATR 601 ......................................................................... 4.250 Clowes v FCT (1954) 91 CLR 209 ................................................................................................. 8.290 Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 .................................... 12.200 Commercial Union Assurance v FCT (1977) 7 ATR 435 ........................................................... 16.240 Commissioner of State Revenue (WA) v Placer Dome Inc [2018] HCA 59 .............................. 26.170 Commr of Australian Federal Police v Propend Finance Pty Ltd (1997) 188 CLR 501 ............ 24.570 Commr of State Revenue (Vic) v Danvest Pty Ltd [2017] VSCA 382 ....................................... 26.170
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Confidential and Deputy Commissioner of Taxation (2000) 43 ATR 1273 .............................. 18.230 Consolidated Press Holdings v FCT (1995) 30 ATR 390 ........................................................... 24.620 Corrosion Control Engineering (NSW) Pty Ltd v Chief Commissioner of State Revenue [2017] NSWCATAD 20 ....................................................................................................... 26.350 Coward v FCT (1999) 41 ATR 1138 .............................................................................................. 10.80 Crommelin v FCT (1998) 39 ATR 377 ........................................................................................ 19.170 Cyclone Scaffolding Pty Ltd v FCT (1987) 19 ATR 674 ............................................................... 17.20
D Dadwal and Tax Practitioners Board [2018] AATA 2878 .......................................................... 24.690 Daniels Corp v ACCC [2002] HCA 49 ......................................................................................... 24.570 DCT v Bluebottle UK Ltd (2007) 67 ATR 1 ................................................................................. 24.175 DCT v Broadbeach Properties (2008) 69 ATR 357 .................................................................... 24.150 DCT v Conley (1998) 40 ATR 227 ............................................................................................... 24.170 DCT v De Vonk (1995) 31 ATR 481 ............................................................................................ 24.550 DCT v Hua Wang Bank Berhad [2010] FCA 1014 ...................................................................... 24.180 DCT v Rennie Produce (Aust) Pty Ltd (in liq) [2018] FCAFC 38 ................................................ 24.550 DCT v Richard Walter Pty Ltd (1995) 29 ATR 644 ....................................................................... 24.80 DCT (WA), Re; Ex parte Briggs (1986) 17 ATR 1031 ......................................... 24.90, 24.100, 24.130 DCT (WA), Re; Ex parte Briggs (No 2) (1987) 18 ATR 570 .......................................................... 24.90 Deloitte Touche Tohmatsu v DCT (1998) 40 ATR 435 .............................................................. 24.590 Denlay v Federal Commissioner of Taxation (2011) 193 FCR 412; 83 ATR 625 ...................... 24.140 Dickenson v FCT (1958) 98 CLR 460 ............................................................................................ 9.170 Dickson v R [2016] NSWCCA 105 .............................................................................................. 24.203
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E Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474 ........................................................... 23.300, 23.320 Egerton-Warburton v DCT (1934) 51 CLR 568 ............................................................................ 9.210 Eisner v FCT (1971) 2 ATR 3 ........................................................................................................ 8.300 Eisner v Macomber 252 US 189 (1920) ............................................................................ 5.100, 5.145 Elmslie v FCT (1993) 26 ATR 611 ................................................................................................. 11.50 Ensign Shipping Co Ltd v IR Commissioner of Inland Revenue (1928) 12 TC 1169 ............... 10.210 Esquire Nominees Ltd v FCT (1973) 129 CLR 177 ...................................................................... 4.280 Essenbourne Pty Ltd v FCT (2002) 51 ATR 629 ............................................................................ 7.65 Esso Australia Resources Ltd v FCT (2000) 43 ATR 506 .............................................. 24.570, 24.575 Europa Oil (NZ) Ltd v CIR (NZ) (No 2) (1976) 5 ATR 744 .......................................................... 12.310 Evans v FCT (1989) 20 ATR 922 ............................................................................................ 8.30, 8.70
F FCT v AGC (1984) 15 ATR 982 ....................................................................................................... 9.50 FCT v Anstis (2010) 76 ATR 735 ........................................................................ 12.60, 12.240, 12.640 FCT v Applegate (1979) 9 ATR 899 .............................................................................................. 4.110 FCT v Arnold (No 2) [2015] FCA 34 ........................................................................................... 24.207 FCT v Australia and New Zealand Banking Group Ltd, Smorgan v FCT (1976) 134 CLR 475 ............................................................................................................ 24.540 FCT v ANZ; Smorgon v FCT (1979) 143 CLR 499 (Smorgon (No 2) ........................... 24.540, 24.550 FCT v Australian Guarantee Corporation Ltd (1984) 15 ATR 982 ............................................... 23.50 FCT v BHP Billiton Finance Ltd [2010] FCAFC 25 ........................................................................ 13.85 FCT v BHP Billiton Ltd [2011] HCA 17 .......................................................................................... 13.85
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xii
PRINCIPLES OF TAXATION LAW 2020 FCT v Ballesty (1977) 7 ATR 411 ................................................................................................ 12.430 FCT v Barnes Development Pty Ltd (2009) 76 ATR 570 ........................................................... 24.170 FCT v Beville (1953) 10 ATD 170 ............................................................................................... 19.100 FCT v Blake (1984) 15 ATR 1006 ................................................................................ 5.90, 6.70, 6.100 FCT v Brent (1971) 125 CLR 418 .................................................................................................. 6.150 FCT v Brixius (1988) 19 ATR 506 ............................................................................................... 24.270 FCT v Brown (1999) 43 ATR 1 ....................................................................................... 12.140, 24.210 FCT v CSR Ltd (2000) 45 ATR 559 ............................................................................................. 10.290 FCT v Citibank Ltd (1989) 20 ATR 292 ................................................ 24.530, 24.560, 24.590, 24.650 FCT v Citibank Ltd (1993) 26 ATR 423 ....................................................................................... 23.320 FCT v Citilink Melbourne Ltd (2006) 62 ATR 648 ........................................................................ 23.50 FCT v Collings (1976) 6 ATR 476 ............................................................................................... 12.390 FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281 ................................................. 12.840, 12.850 FCT v Consolidated Press Holdings Ltd (2001) 47 ATR 229 ..................................................... 23.300 FCT v Cooke and Sherden (1980) 10 ATR 696 ........................................................ 5.60, 6.130, 8.160 FCT v Cooling (1990) 21 ATR 13 ....................................................................................... 8.240, 8.250 FCT v Cooper (1991) 21 ATR 1616 ............................................................................................ 12.220 FCT v Dalco (1990) 20 ATR 1370 ............................................................................................... 24.225 FCT v Darling (2014) 285 FLR 428 .............................................................................................. 24.550 FCT v Day (2008) 70 ATR 14 ............................................. 12.40, 12.50, 12.60, 12.80, 12.150, 12.220 FCT v De Martin (2011) 82 ATR 906 .......................................................................................... 24.170 FCT v Dixon (1952) 86 CLR 540 ......................................................... 5.130, 6.70, 6.220, 10.20, 10.70 FCT v Donoghue [2015] FCAFC 183 ............................................................................... 24.90, 24.570 FCT v EA Marr and Sons (Sales) Ltd (1984) 15 ATR 879 .......................................................... 12.140 FCT v Edwards (1994) 28 ATR 87 ................................................................................. 12.760, 12.770 FCT v Efstathakis (1979) 9 ATR 867 ............................................................................................. 4.260 FCT v Everett (1980) 143 CLR 440 ............................................................................................. 19.150 FCT v Faichney (1972) 3 ATR 435 .............................................................................................. 12.720 FCT v Finn (1961) 106 CLR 60 ....................................................................................... 12.620, 12.660 FCT v Forsyth (1981) 11 ATR 657 .............................................................................................. 12.720 FCT v French (1957) 98 CLR 398 .................................................................................................. 4.260 FCT v Futuris Corporation Ltd (2008) 69 ATR 41 ........................................................... 24.90, 24.130 FCT v Gulland; Watson v FCT; Pincus v FCT (1985) 160 CLR 55 ............................................. 23.160 FCT v Hacon Pty Ltd [2017] FCAFC 181 .................................................................................... 24.460 FCT v Harris (1980) 10 ATR 869 ............................................................................................ 5.90, 6.50 FCT v Hart (2004) 217 CLR 216 .................................................................................................. 23.290 FCT v Hatchett (1971) 2 ATR 557 ..................................................................... 12.590, 12.600, 12.660 FCT v Hoffnung& Co Ltd (1928) 42 CLR 39 .................................................................................. 24.80 FCT v Holmes (1995) 31 ATR 71 .................................................................................................. 6.220 FCT v Hurley Holdings (NSW) Pty Ltd (1989) 20 ATR 1293 .......................................................... 9.40 FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218 ......................................................................... 8.150 FCT v Indooroopilly Children Services (Qld) Pty Ltd (2007) 158 FCR 325 ................................... 7.65 FCT v Inkster (1989) 20 ATR 1516 ................................................................................................ 6.230 FCT v International Indigenous Football Foundation Australia Pty Ltd [2018] FCA 528 ............ 24.207 FCT v J Walter Thompson (Australia) Pty Ltd (1944) 69 CLR 227 ................................................ 7.85 FCT v JR Walker (1985) 16 ATR 331 ..................................................................................... 8.40, 8.50 FCT v James Flood Pty Ltd (1953) 88 CLR 492 ............................................................ 16.190, 16.200 FCT v Jenkins (1982) 12 ATR 745 ................................................................................................ 4.110 FCT v Jones (2002) 49 ATR 188 .................................................................................... 12.140, 16.150 FCT v Kurts Development Ltd (1998) 39 ATR 493 .................................................................... 17.150 FCT v La Rosa (2003) 53 ATR 1 ....................................................................................... 12.90, 12.240 FCT v Lenzo (2008) 71 ATR 511 ................................................................................................. 23.290 FCT v Ludekens [2013] FCAFC 100 ............................................................................................ 24.207 FCT v Ludekens (No 2) [2016] FCA 755 ..................................................................................... 24.207
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TaBle of Cases xiii FCT v Luxottica Retail Australia Pty Ltd [2011] FCAFC 20 ........................................................ 25.175 FCT v MBI Properties Pty Ltd [2014] HCA 49 ............................................................................ 25.100 FCT v Macquarie Bank Ltd [2013] FCAFC 13 ............................................................................. 21.410 FCT v Maddalena (1971) 2 ATR 541 ............................................................................. 12.340, 12.350 FCT v McDonald (1987) 18 ATR 957 ............................................................................................ 19.30 FCT v McGrouther [2015] FCAFC 34 ......................................................................................... 24.230 FCT v McPhail (1968) 117 CLR 111 ............................................................................................ 13.130 FCT v Merv Brown Pty Ltd (1985) 16 ATR 218 ................................................................. 8.140, 8.150 FCT v Metals Manufactures Ltd (2001) 46 ATR 497 .................................................................. 23.320 FCT v Mitchum (1965) 113 CLR 401 ............................................................................................ 4.260 FCT v Munro (1926) 38 CLR 153 ................................................................................................ 12.810 FCT v Murry (1998) 193 CLR 605 ................................................................................................. 26.70 FCT v Myer Emporium Ltd (1987) 163 CLR 199 ............................... 5.80, 8.130, 8.150, 8.170, 8.210, 8.220, 8.250, 8.260, 10.150, 10.280 FCT v National Commercial Banking Corp of Australia Ltd (1983) 15 ATR 21 .......................... 13.85 FCT v Osborne (1990) 21 ATR 888 .............................................................................................. 8.110 FCT v Payne (2001) 202 CLR 93 ............................................................ 12.60, 12.150, 12.440, 13.110 FCT v Peabody (1994) 181 CLR 359 .............................................................................. 23.290, 23.310 FCT v Pilnara Pty Ltd (2000) 43 ATR 581 ................................................................................... 24.610 FCT v Prestige Motors Pty Ltd (1994) 28 ATR 336 .................................................................... 24.120 FCT v Qantas Airways Ltd [2012] HCA 41 ................................................................................. 25.100 FCT v Radnor Pty Ltd (1991) 22 ATR 344 ...................................................................................... 8.90 FCT v Regent Pacific Group Ltd [2013] FCA 36 ......................................................................... 24.180 FCT v Reliance Carpet Co Pty Ltd (2008) 68 ATR 158 .................................................. 25.100, 25.115 FCT v Resource Capital Fund IV LP [2013] FCAFC 118 ............................................................. 24.175 FCT v Roberts and Smith (1992) 23 ATR 957 ............................................................................ 19.100 FCT v Rowe (1997) 187 CLR 266 ................................................................................................ 10.260 FCT v Ryan (2000) 43 ATR 694 ......................................................................................... 24.50, 24.60 FCT v SNF (Australia) Pty Ltd (2011) 193 FCR 149 .................................................................... 22.350 FCT v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 44 ATR 370 ....................... 11.50 FCT v Seven Network Ltd [2016] FCAFC 70 .............................................................................. 22.310 FCT v Slade Bloodstock Pty Ltd (2007) 68 ATR 911 ..................................................................... 7.75 FCT v Slater Holdings Ltd (1984) 156 CLR 447 ........................................................................... 1.100 FCT v Snowden &Willson Pty Ltd (1958) 99 CLR 431 ......................................... 12.80, 12.90, 12.850 FCT v South Australian Battery Makers Pty Ltd (1978) 14 CLR 645 ......................................... 12.310 FCT v Spotless Services Ltd (1996) 34 ATR 183 ....................................................................... 23.300 FCT v St Hubert's Island Pty Ltd (1978) 8 ATR 452 .................................. 8.100, 17.20, 17.30, 17.210 FCT v Star City Pty Ltd (2009) 72 ATR 431 ................................................................................ 12.200 FCT v Stokes (1996) 34 ATR 478 ................................................................................................. 24.80 FCT v Studdert (1991) 22 ATR 762 .................................................................. 12.590, 12.600, 12.640 FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277 ............................... 17.220 FCT v Vogt (1975) 5 ATR 274 ..................................................................................................... 12.420 FCT v Wade (1951) 84 CLR 105 ...................................................................................... 10.220, 17.20 FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 .................................... 13.50, 13.60, 13.70 FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 ................................... 8.170, 8.180, 8.190, 8.200, 8.260, 8.280, 8.290, 10.150 FCT v Whitfords Beach Pty Ltd (1982) 14 ATR 247 ..................................................................... 25.60 FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 ................................................................... 12.30 FCT v Wiener (1978) 8 ATR 335 ................................................................................................. 12.410 FCT v Wilkinson (1983) 14 ATR 218 ............................................................................................ 12.50 FCT v Woite (1982) 13 ATR 579 ........................................................................................ 6.160, 6.170 FJ Bloemen Pty Ltd v FCT (1981) 147 CLR 360 ......................................................................... 24.130 Fairway Estates Pty Ltd v FCT (1970) 1 ATR 726 ........................................................................ 13.85 Farnsworth v FCT (1949) 78 CLR 504 ........................................................................................ 17.220
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xiv PRINCIPLES OF TAXATION LAW 2020 Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519 ............................................................ 5.155, 5.160 Federal Wharf Co Ltd v DCT (1930) 44 CLR 24 .................................................................... 9.80, 9.90 Ferguson v FCT (1979) 9 ATR 873 ............................................................................... 8.20, 8.40, 8.50 Finance (Canada), Minister of v Smith [1927] AC 193 ................................................................ 5.150 Fletcher v FCT (1991) 173 CLR 1 ..................................................................................... 12.310, 23.10 Fletcher v FCT (1992) 92 ATC 4611 ........................................................................................... 12.310 Foley v Fletcher [1843–1860] All ER Rep 953 ................................................................................ 5.90 Ford v FCT (2014) AATA 361 ..................................................................................................... 12.420 Freeman v FCT (1983) 14 ATR 457 .............................................................................................. 6.300 Fullerton v FCT (1991) 22 ATR 757 ............................................................................................ 12.360
G GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR 1 ..................................................... 8.140 Gashi v FCT [2013] FCAFC 30 ......................................................................................... 24.90, 24.100 Gasparin v FCT (1994) 28 ATR 130 ............................................................................................ 17.230 George v FCT (1952) 86 CLR 183 ................................................................................................. 24.90 Gill v The Australian Wheat Board [1980] 2 NSWLR 795 ......................................................... 10.220 Glenboig Union Fireclay Co Ltd v IR Commissioner of Inland Revenue [1922] SLT 182 ........... 10.210 Glencore International AG v C of T [2019] HCA 26 ................................................................... 24.570 Goodman Fielder Wattie Ltd v FCT (1991) 22 ATR 26 ................................................................ 8.110 Granby Pty Ltd v FCT (1995) 30 ATR 400 .................................................................................... 17.70 Grealy v FCT (1989) 20 ATR 403 .................................................................................................. 6.310 Greig v FCT [2018] FCA 1084 .............................................................................................. 8.90, 8.230 Guinea Airways v FCT (1950) 83 CLR 584 ................................................................................... 17.30 Gulland v FCT (1984) 15 ATR 892 .............................................................................................. 24.220
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H HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 .................................................. 10.270, 10.280 Hallstroms Pty Ltd v FCT (1946) 72 CLR 634 ............................................................................. 12.840 Harding v FCT [2019] FCAFC 29 .................................................................................................. 4.125 Handley v FCT (1981) 11 ATR 644 ............................................................................................. 12.720 Haritos v FCT [2015] FCAFC 92 .................................................................................................. 24.270 Hart v FCT (2004) 217 CLR 216 .................................................................................................. 23.310 Hayes v FCT (1956) 96 CLR 47 ............................................................... 6.20, 6.40, 6.90, 6.100, 6.220 Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512 ................................................................... 10.170 Henderson v FCT (1970) 119 CLR 612 ........................................................ 16.30, 16.60, 16.70, 17.30 Henry Jones (IXL) Ltd v FCT (1991) 22 ATR 328 ......................................................................... 8.260 Hepples v FCT (1991) 22 ATR 465 ............................................................................................... 6.170 Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 .................................... 12.80, 12.90, 12.240 Higgs v Olivier [1952] Ch 311 ........................................................................................... 6.160, 6.170 Hii v FCT [2015] FCA 375 ........................................................................................................... 24.130 Hill v FCT (2016) AATA 514 ........................................................................................................ 12.410 Hill and Tax Practitioners Board [2019] AATA 756 ................................................................... 24.698 Hochstrasser v Mayes [1960] AC 376 ................................................................................... 5.70, 6.40 Hogan v Australian Crime Commission (2010) 75 ATR 794 ..................................................... 24.590 Hogan v Australian Crime Commission (No 4) (2008) 72 ATR 107 .......................................... 24.590 Hollis v Vabu Pty Ltd [2001] HCA 44 ......................................................................................... 26.360 Howland-Rose v FCT (2002) 49 ATR 206 .................................................................................. 23.330 Hua Wang Bank Berhad v FCT (No 19) [2015] FCA 454 ........................................................... 17.130 Hunter Valley Developments Pty Ltd v Cohen (1984) 3 FCR 344 ............................................. 24.210 Hutchins v DCT (1996) ATR 620 ................................................................................................ 24.650
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xv
I IR, Commissioner of v Philips Gleilampenfabrieken [1955] NZLR 868 ...................................... 4.270 IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482 ........................................................ 12.190 IRC v Lysaght [1928] AC 234 ................................................................................................. 4.70, 4.80 Industrial Equity Ltd v DCT (1990) 170 CLR 649 ....................................................................... 24.530 Investment & Merchant Finance v FCT (1971) 2 ATR 361 .......................................................... 17.30
J J & G Knowles, Re (2000) 45 ATR 1101 ......................................................................................... 7.70 J & G Knowles & Associates Pty Ltd v FCT (2000) 44 ATR 22 ...................................................... 7.70 JJ Kerrison&Banich Management Pty Ltd v FCT (1986) 17 ATR 338 ....................................... 24.550 JMA Accounting Pty Ltd and Entrepreneur Services Pty Ltd v Carmody (2004) 57 ATR 365 .............................................................................................................. 24.570 Jarrold v Boustead (1963) 41 TC 701 .......................................................................................... 6.180 Joachim v FCT (2002) 50 ATR 1072 .............................................................................................. 4.70 John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 ................................................ 12.840, 12.850 John Holland Group Pty Ltd v FCT (2015) FCAFC 82 ............................................................... 12.390 Jupiters Ltd v DCT (2002) 50 ATR 236 ...................................................................................... 12.200
K Kajewski v FCT (2003) 52 ATR 455 ............................................................................................ 24.140 Kameel Pty Ltd v Commissioner of State Revenue (Vic) [2016] VSCA 83 ............................... 26.220 Keily v FCT (1983) 83 SASR 494 .................................................................................................. 5.130 Kelly v FCT (1985) 16 ATR 478 ........................................................................ 6.40, 6.110, 6.120, 8.80 Koustrup v FCT, Re [2015] AATA 126 ......................................................................................... 4.130 Kosciusko Thredbo Pty Ltd v FCT (1983) 15 ATR 165 ................................................................ 9.170 Krok v FCT [2015] FCA 51 .......................................................................................................... 24.570
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L L'Estrange v FCT (1978) 9 ATR 410 ............................................................................................ 24.100 LHRC v DCT (No 3) [2015] FCAFC 184 ...................................................................................... 24.570 LHRC v FCT [2015] FCAFC 184 .................................................................................................. 24.570 Laidler v Perry [1965] 2 All ER 121 ....................................................................................... 6.50, 6.70 Lance, Re; Ex parte Nilant (1996) 34 ATR 573 ............................................................................ 19.20 Lansell House Pty Ltd v FCT (2011) 79 ATR 22 ......................................................................... 25.142 Law Shipping Co Ltd v Inland Revenue Commissioners (1923) 12 TC 621 ............................... 13.40 Le Grand v FCT (2002) 51 ATR 139 ............................................................................................. 6.290 Leonard v FCT (1919) 26 CLR 175 ............................................................................................. 19.100 Leppington Pastoral Co Pty Ltd v Chief Commissioner of State Revenue [2017] NSWSC 9 ................................................................................................................. 26.284 Levene v IRC [1928] AC 217 .................................................................................................. 4.70, 4.80 Lighthouse Philatelics Pty Ltd v FCT (1991) 22 ATR 707 .......................................................... 24.210 Lindsay v FCT (1960) 106 CLR 377 .............................................................................................. 13.60 Lindsay v IR Commrs (1932) 18 TC 43 ........................................................................................ 5.150 Living & Leisure Aus Ltd v Commissioner of State Revenue (Vic) [2018] VSCA 237 .............. 26.220 Lodge v FCT (1972) 3 ATR 254 .................................................................................................. 12.370 Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671 ........................................................ 9.20, 9.30, 9.40 London Australia Investment Co Ltd v FCT (1977) 7 ATR 757 ..................................................... 8.90
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xvi PRINCIPLES OF TAXATION LAW 2020 Lui v FCT (2009) 76 ATR 633 ...................................................................................................... 24.190 Lunney v FCT; Hayley v FCT (1958) 100 CLR 478 ............................................. 12.60, 12.390, 23.180 Lurcott v Wakely and Wheeler [1911] 1 KB 905 .......................................................................... 13.33
M MLC Ltd v DCT (2002) 51 ATR 283 ............................................................................................ 14.170 MacCormick v FCT (1984) 15 ATR 437 .......................................................................................... 3.20 Maddalena v FCT (1971) 2 ATR 541 .............................................................................................. 8.80 Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276 ............... 12.90, 12.150, 12.270, 12.300 Mansfield v FCT (1995) 31 ATR 367 ............................................................................. 12.780, 12.790 MarevaCompaniaNaviera SA v International Bulkcarriers SA, “The Mareva” [1980] 1 All ER 213 ............................................................................................................. 24.180 Marijancevic v Mann (2008) 73 ATR 709 ........................................................................ 24.90, 24.170 Martin v FCT (1953) 90 CLR 470 .................................................................................................... 8.70 Martin v FCT (1984) 15 ATR 808 ................................................................................................ 12.370 Matthews v Chicory Marketing Board (1938) 60 CLR 263 ............................................................ 3.20 McCauley v FCT (1944) 69 CLR 235 ............................................................................................. 9.190 McCurry v FCT (1998) 39 ATR 121 .............................................................................................. 8.250 McDonald v FCT (1998) 38 ATR 563 ............................................................................................ 11.50 McIntosh v FCT (1979) 20 ATR 13 .................................................................................... 6.290, 6.300 McLaurin v FCT (1961) 104 CLR 381 .......................................................................................... 10.250 Memorex Pty Ltd v FCT (1987) 19 ATR 553 ..................................................................... 8.140, 8.150 Meridien Marinas Horizon Shores Pty Ltd v FCT (2009) 74 ATR 787 ....................................... 25.165 Midford v DFCT (2005) 60 ATR 1009 ......................................................................................... 25.148 Miller v FCT (1946) 73 CLR 93 ........................................................................................................ 4.70 Mills v FCT [2012] HCA 51 ......................................................................................................... 23.310 Moorhouse v Dooland [1955] 1 All ER 93 ..................................................................................... 6.20 Morris v FCT (2002) 50 ATR 104 ................................................................................... 12.780, 12.790 Mt Pritchard & District Community Club Ltd v FCT [2011] FCAFC 129 .................................... 24.380 Murdoch v Commr of Pay-roll Tax (Vic) (1980) 143 CLR 629 ....................................................... 7.85
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N Nathan v FCT (1918) 25 CLR 183 ................................................................................................. 4.230 National Australia Bank v FCT (1993) 26 ATR 503 ...................................................................... 7.390 National Australia Bank Ltd v FCT (1997) 37 ATR 378 .............................................................. 12.200 Necovski and FCT, Re (2009) 75 ATR 152 .................................................................... 24.203, 24.205 Nilsen Development Laboratories Pty Ltd v FCT (1981) 11 ATR 505 .......................... 16.190, 16.200
P Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 1017 ............................................................... 17.180 Pastoral & Development Pty Ltd v FCT (1971) 2 ATR 401 ........................................................ 17.110 Patcorp Investments Ltd v FCT (1976) 6 ATR 420 ................................................ 4.210, 17.30, 21.50 Pay-Roll Tax (Vic), Commissioner of v Mary Kay Cosmetics (1982) 13 ATR 360 .............................................................................................................. 26.360 Payne v FCT (1996) 32 ATR 516 .......................................................... 5.60, 6.130, 6.210, 6.220, 7.58 Penn v Spiers& Pond Ltd [1908] 1 KB 766 ..................................................................................... 6.80 Peter Lenten v FCT (2008) 71 ATR 862 ...................................................................................... 12.620 Philip Morris Ltd v FCT (1979) 10 ATR 44 ................................................................................. 17.150 Pickford v FCT (1998) 40 ATR 1078 ............................................................................................. 6.180
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TaBle of Cases xvii Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 ....................... 12.140, 16.140, 16.150 Point v FCT (1970) 119 CLR 453 ................................................................................................... 13.80 Pratt Holdings Pty Ltd v FCT (2004) 56 ATR 128 ....................................................................... 24.570 Premier Automatic Ticket Issuers v FCT (1933) 50 CLR 268 ........................................................ 5.90 Prince v FCT (1959) 7 AITR 505 ..................................................................................................... 8.60
Q Quality Publications Australia Pty Ltd v FC of T [2012] FCA 256 ............................................. 11.470
R
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R v DCT; Ex parte Hooper (1926) 37 CLR 368 ............................................................................. 24.50 R v Issakidis [2018] NSWSC 378 ................................................................................................ 24.203 RACV v FCT (1973) 4 ATR 567 ..................................................................................................... 5.170 RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610 ...................................................... 16.230, 16.240 Rafferty v FCT [1976] 2 All ER 801 ............................................................................................. 10.180 Raja's Commercial College v Gian Singh & Co Ltd [2017] AATA 636 ...................................... 12.420 Rawson Finances Pty Ltd v DCT [2011] FCA 1231 .................................................................... 24.150 Reany v FCT (2016) AATA 672 ................................................................................................... 12.420 Reseck v FCT (1975) 5 ATR 538 ........................................................................................ 6.290, 6.310 Reuter v FCT (1993) 27 ATR 256 .................................................................................................. 6.170 Rhodesia Metal Ltd (Liquidator) v Taxes Commr [1940] 3 All ER 422 ....................................... 4.250 Riches v Westminster Bank Ltd [1947] AC 390; 1 All ER 469 .......................................... 9.20, 12.810 Rigoli v FCT [2014] FCAFC 29 ...................................................................................................... 24.90 Rigoli v FCT [2015] FCA 803 ........................................................................................................ 24.90 Rigoli v FCT, Re [2015] AATA 169 ............................................................................................... 24.90 Rigoli v FCT [2016] FCAFC 38 ...................................................................................................... 24.90 Rio Tinto Services Pty Ltd v FCT [2015] FCAFC 117 ................................................................. 25.214 Roads & Traffic Authority of NSW v FCT (1993) 26 ATR 76 .............................................. 7.280, 7.85 Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 ................... 12.40, 12.50, 12.270, 12.280, 12.300
S SNF (Australia) Pty Ltd v FC of T (2011) 193 FCR 149 .............................................................. 22.360 St George Bank Ltd v FCT (2009) 73 ATR 148 .......................................................................... 12.830 Saitta Pty Ltd v FCT (2002) 50 ATR 565 ..................................................................................... 24.170 Samuel Jones & Co (Devondale) Ltd v IRC (1951) 32 TC 513 .................................................... 13.60 Sanctuary Lakes v FCT [2013] FCAFC 50 .................................................................................. 24.201 Satyam Computer Services Ltd v FCT[2018] FCAFC 172 ........................................................... 4.290 Scott v C of T (NSW) (1935) 3 ATD 142 ....................................................................................... 3.150 Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 ....................................................... 5.20 Scott v FCT (1966) 117 CLR 514 ..................................................................... 6.20, 6.90, 6.100, 6.220 Scott v FCT, Re (2002) 50 ATR 1235 ............................................................................................ 19.90 Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188 ........................................... 8.140, 8.180 Skase v FCT (1991) 32 FCR 206; 22 ATR 889 ............................................................................ 24.190 Slade Bloodstock Pty Ltd v FCT (2007) 68 ATR 911 ............................................................ 7.30, 7.70 Smith v FCT (1987) 19 ATR 274 ........................................................................................ 6.190, 6.220 Smith and Commissioner of Taxation [2010] AATA 576 .............................................................. 8.90 Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101 ................................................... 8.110, 8.120 Sommer v FCT (2002) 51 ATR 102 .............................................................................................. 10.80 South Steyne Hotel Pty Ltd v FCT (2009) 71 ATR 228 .............................................................. 25.165
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xviii PRINCIPLES OF TAXATION LAW 2020 South Steyne Hotel Pty Ltd v FCT (2009) 74 ATR 41 ................................................................ 25.165 South Western Indemnities Ltd v Bank of New South Wales (1973) 129 CLR 512 ............................................................................................................ 24.530 Spencer v Commonwealth (1907) 5 CLR 418 ................................................................ 11.470, 17.70 Spotless Services v FCT (1993) 25 ATR 344 ............................................................................... 4.270 Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148 ......................................... 8.20, 8.80, 12.350, 25.60 Squatting Investment Co Ltd v FCT (1953) 86 CLR 570 ................................................................ 6.90 Stanton v FCT (1955) 92 CLR 630 ................................................................................................ 9.200 Starrim Pty Ltd v FCT (2000) 44 ATR 487 ...................................................................................... 7.70 Statham v FCT (1988) 20 ATR 228 ............................................................................................... 8.180 Steele v DCT (1999) 41 ATR 139 ...................................................................... 12.130, 12.810, 16.170 Steinberg v FCT (1975) 5 ATR 565 .............................................................................................. 8.290 Stergis v Boucher (1989) 20 ATR 591 ........................................................................................ 24.550 Stevenson v FCT (1991) 22 ATR 56 ............................................................................................. 8.180 Stone v FCT (2005) 59 ATR 50 .............................................................................................. 8.40, 8.80 Strick v Regent Oil Co Ltd [1966] AC 295 ..................................................................... 12.190, 12.200 Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 ................................................................................... 12.180, 12.210, 12.830, 12.840, 13.37 Sunchen Pty Ltd v FCT (2010) 78 ATR 197 ............................................................................... 25.165 Swan v Scanlan (DCT Qld) (1982) 13 ATR 420 ......................................................................... 24.550 Swinford v FCT (1984) 15 ATR 1154 .......................................................................................... 12.710 Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 73 ATR 28 ........................................ 10.210
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T T v FCT (1986) 18 ATR 1 ............................................................................................................ 24.190 Taxation, Commissioners of v Kirk [1900] AC 588 ..................................................................... 4.240 Taxes (South Australia), Commissioner of v Executor, Trustee and Agency Company of South Australia Limited (Carden's Case) (1938) 63 CLR 108 .......................................... 16.70 Tennant v Smith [1892] AC 150 .......................................................................................... 5.60, 6.130 Thiel v FCT (1990) 171 CLR 338 ................................................................................................. 22.460 Thomas v FCT (1972) 3 ATR 165 ................................................................................................... 8.50 Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834 ................................................................ 4.250 Tooheys Ltd v Commissioner of Taxation for NSW (1922) 22 SR (NSW) 432 ........................ 12.300 Toyama Pty Ltd v Landmark Building Developments Pty Ltd (2006) 62 ATR 73 ..................... 25.165 Trautwein v FCT (1936) 56 CLR 196 .............................................................................................. 8.60 Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123 .............. 17.70 Tweedle v FCT (1942) 7 ATD 186 .............................................................................................. 12.300
U Uber BV v Commissioner of Taxation [2017] FCA 110 ............................................................... 25.70 Undershaft (No 1) Ltd v FCT (2009) 74 ATR 888 ....................................................................... 22.480 Ure v FCT (1981) 11 ATR 484 ..................................................................................................... 12.310
V Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 ............................................................ 12.180 Vidler v FCT (2009) 74 ATR 520 ................................................................................................. 25.165 Vidler v FCT (2010) 75 ATR 825 ................................................................................................. 25.165 Virgin Holdings SA v FCT (2008) 70 ATR 478 ........................................................................... 22.480
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W
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W Nevill& Co Ltd v FCT (1937) 56 CLR 290 ..................................................... 12.100, 12.150, 16.160 W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58 ................................................ 13.40, 13.50, 13.60 WR Carpenter Holdings Pty Ltd v FCT (2008) 69 ATR 29 ......................................................... 22.350 WTPG v FCT, Re [2016] AATA 971 ............................................................................................ 12.240 Walstern Pty Ltd v FCT (2003) 138 FCR 1; 54 ATR 423 ............................................................ 24.201 Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171 .......................................... 10.270, 10.280 Westcott v FCT (1997) 37 ATR 1017 ............................................................................. 12.750, 12.770 Westfield Ltd v FCT (1991) 21 ATR 1398 .................................................... 8.150, 8.170, 8.220, 8.250 Westpac Banking Corporation v FCT (1996) 34 ATR 143 .................................................. 7.40, 7.280 Whitaker v FCT (1998) 38 ATR 219 .......................................................................... 9.80, 9.100, 9.110
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Copyright © 2019. Thomson Reuters. All rights reserved.
TABLE OF STATUTES
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Commonwealth A New Tax System (Goods and Services Tax) Act 1999: 1.190, 3.20, 25.10, 25.235, 25.255 s 9-5: 25.90, 25.130, 25.150, 25.170 s 9-10: 25.100 s 9-10(4): 25.100 s 9-15: 25.110 s 9-15(2): 25.110 s 9-20: 25.60 s 9-20(1)(d) to (h): 25.60 s 9-20(2): 25.60 s 9-25: 25.120 s 9-25(5)(d): 25.297 s 9-25(7): 25.295 s 9-30(3): 25.160 s 9-40: 25.130 s 9-70: 25.130, 25.230 s 9-75: 25.130, 25.230 s 9-75(1): 25.130 s 9-75(3): 7.450 s 9-80: 25.175 s 11-5: 25.190, 25.220, 25.230 s 11-10: 25.200 s 11-15: 25.210 s 11-15(2)(a): 25.214 s 11-15(2)(b): 25.210 s 11-15(4): 25.217 s 11-20: 25.230 s 11-25: 25.230 s 11-30: 25.230 s 13-1: 25.270 s 13-5: 25.260 s 13-5(4): 25.260 s 13-10(b): 25.260 s 13-15: 25.270 s 13-20(1): 25.270 s 13-20(2): 25.270 s 15-1: 25.290 s 15-5: 25.280 s 15-15: 25.290 s 15-20: 25.290 s 17-5: 25.310 s 17-5(1): 25.300 s 17-5(2): 25.310 s 19-10: 25.310 s 23-5: 25.70 s 23-10: 25.50
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s 23-15: 25.70 s 27-5: 25.300 s 29-5: 25.300, 25.304 s 29-10: 25.304 s 29-10(2): 25.304 s 29-10(3): 25.304, 25.306 s 29-10(4): 25.306 s 29-15(1): 25.304 s 29-20(1): 25.310 s 29-20(2): 25.310 s 29-20(3): 25.310 s 29-40: 25.304, 25.306 s 29-70: 25.306 s 29-75: 25.310 s 29-80(1): 25.306 s 29-80(2): 25.310 s 31-5: 25.300 s 31-8: 25.300 s 33-15(1)(a): 25.304 s 38-1: 25.150 s 38-2: 25.142 s 38-4: 25.142 s 38-6: 25.142 s 38-7: 25.144 s 38-7(2): 25.144 s 38-7(3): 25.144 s 38-10: 25.144 s 38-15: 25.144 s 38-20: 25.144 s 38-25: 25.144 s 38-30: 25.144 s 38-35: 25.144 s 38-40: 25.144 s 38-45: 25.144 s 38-50: 25.144 s 38-55: 25.144 s 38-85: 25.146 s 38-90: 25.146 s 38-95: 25.146 s 38-97: 25.146 s 38-105: 25.146 s 38-110: 25.146 s 38-185(1): 25.148 s 38-185(2): 25.148 s 38-190: 25.297 s 38-190(1): 25.148 s 38-325(1): 25.148 s 38-325(2): 25.148 s 38-540: 25.148
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xxii PRINCIPLES OF TAXATION LAW 2020
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A New Tax System (Goods and Services Tax) Act 1999 — cont s 40-1: 25.170 s 40-65(1): 25.167 s 40-65(2): 25.167 s 40-70(1): 25.167 s 40-70(2): 25.167 s 40-75: 25.167 s 40-75(2): 25.167 s 42-5: 25.260 s 42-10: 25.260 s 69-5: 25.240, 25.280 s 69-5(3A): 25.240 s 69-10: 25.240 s 70-5: 25.217 s 84-55: 25.297 s 84-75: 25.299 s 84-77: 25.299 s 84-79(3): 25.299 s 84-81: 25.299 s 84-100: 25.297 s 87-15: 25.165 s 87-25: 25.165 s 93-5: 25.304 s 99-10: 25.100 s 111-5: 7.450, 25.330 s 144-5: 25.70 s 188-15: 25.70 s 188-15(3): 25.297, 25.299 s 188-20(3): 25.297, 25.299 s 189-5: 25.217 s 189-10: 25.217 s 195-1: 25.120, 25.144, 25.146, 25.165, 25.167, 25.255 reg 29-80.01: 25.306 Div 13: 25.250 Div 19: 25.310 Div 21: 25.310 Div 38: 25.140 Div 40: 25.160, 25.165 Div 48: 25.315 Div 60: 25.235 Div 69: 25.235 Div 72: 25.180 Div 75: 25.180 Div 78: 25.180 Div 84: 25.180, 25.255 Div 87: 25.165 Div 100: 25.180 Div 105: 25.180 Div 129: 25.310 Div 130: 25.310
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Div 136: 25.310 Div 137: 25.235 Div 153: 25.180, 25.235 Div 165: 25.300 Div 188: 25.70 Sch 1: 25.142, 25.260 Sch 2: 25.142 Sch 3: 25.144 subdiv 38-A: 25.140, 25.150 subdiv 38-B: 25.140, 25.144 subdiv 38-C: 25.140 subdiv 38-D: 25.140, 25.148 subdiv 38-E: 25.140, 25.148 subdiv 38-F: 25.140 subdiv 38-G: 25.140 subdiv 38-H: 25.140 subdiv 38-I: 25.140 subdiv 38-J: 25.140, 25.148 subdiv 38-K: 25.140 subdiv 38-L: 25.140 subdiv 38-M: 25.140 subdiv 38-N: 25.140 subdiv 38-O: 25.140 subdiv 38-P: 25.140 subdiv 38-Q: 25.140 subdiv 38-R: 25.140 subdiv 38-S: 25.140 subdiv 38-T: 25.140 subdiv 40-A: 25.160 subdiv 40-B: 25.160 subdiv 40-C: 25.160 subdiv 40-D: 25.160 subdiv 40-E: 25.160 subdiv 40-F: 25.160 subdiv 40-G: 25.160 subdiv 84-A: 25.295 A New Tax System (Goods and Services Tax Administration) Act 1999 : 25.10 A New Tax System (Goods and Services Tax) Bill 1998 : 25.20 A New Tax System (Goods and Services Tax Imposition –Customs) Act 1999 : 25.10 A New Tax System (Goods and Services Tax Imposition –Excise) Act 1999 : 25.10 A New Tax System (Goods and Services Tax Imposition –General) Act 1999: 3.20, 25.10
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TABLE OF STATUTES xxiii A New Tax System (Goods and Services Tax) Regulations 1999 reg 23-15.01: 25.70 reg 23-15.02: 25.70 reg 29.80.02: 25.310 reg 40.5.09: 25.163 reg 40.5.11: 25.163 reg 40.5.12: 25.163 reg 40.5.13: 25.163 reg 70-5.02: 25.217 reg 70-5.02A: 25.217 reg 70-5.03: 25.217 Sch 7: 25.163 Acts Interpretation Act 1901 s 29: 24.110 Administrative Appeals Tribunal Act 1975 s 29(7): 24.240 s 33(1)(c): 24.260 s 35: 24.260 s 41: 24.698 s 43(1): 24.270 s 43(2A): 24.270 s 44: 24.250
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Administrative Decisions (Judicial Review) Act 1977: 24.00, 24.630, 24.650 s 5(1): 24.650 s 5(2): 24.650 s 13: 24.650 s 16: 24.650 Sch 1: 24.650 Australian Crime Commission Act 2002: 24.570 Australian Participants in British Nuclear Tests and British Commonwealth Occupation Force (Treatment) Act 2006 : 3.70 Banking Act 1959: 22.410 Commonwealth of Australia Constitution 1901 : 3.20 s 51(ii): 3.00, 3.20 s 55: 3.20 s 90: 3.20 s 114: 3.20 Corporations Act 2001: 4.180, 20.30, 21.100, 21.390, 22.410 s 9: 24.420 s 46: 26.250 s 50: 26.350 s 254T: 21.100
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Corporations Amendment (Crowd-sourced Funding for Proprietary Companies) Act 2018 8.107 Crimes Act 1914 s 3E: 24.510 s 3F: 24.510 s 4AA: 24.200 Crimes (Taxation Offences) Act 1980: 24.203 Criminal Code Act 1995: 24.203 Sch 1, s 135.1: 24.203 Sch 1, s 135.2: 24.203 Sch 1, s 135.4: 24.203 Domicile Act 1982 : 4.100 s 10: 4.100 Electronic Transactions Act 1999 s 14A: 24.110 Evidence Act 1995: 24.600 s 118: 24.600 s 119: 24.600 s 120: 24.600 Family Law Act 1975: 11.540 Federal Court of Australia Act 1976 s 24: 24.270 s 25: 24.270 s 33(3): 24.270 Financial Sector (Collection of Data) Act 2001: 22.410 Freedom of Information Act 1982: 24.00, 24.630 s 11: 24.640 s 11A: 24.640 s 33: 24.640 s 34: 24.640 s 47: 24.640 s 47C: 24.640 s 47E: 24.640 s 47F: 24.640 s 47G: 24.640 Fringe Benefits Tax Assessment Act 1986: 1.190, 1.240, 3.20, 7.10 s 5B: 7.410 s 5B(1A): 7.420 s 5C(3): 7.400
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xxiv PRINCIPLES OF TAXATION LAW 2020
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Fringe Benefits Tax Assessment Act 1986 — cont s 5C(4): 7.400 s 6: 7.30 s 7(1): 7.100 s 7(2): 7.100, 7.130 s 7(2A): 7.100 s 7(3): 7.100 s 7(4): 7.100 s 8(2): 7.110 s 8(2)(a): 7.110 s 8(3): 7.110 s 9: 7.120, 7.130 s 10: 7.120, 7.140 s 10(1): 7.120 s 10(3)(a)(v): 7.140 s 10(5): 7.120 s 10A: 7.140 s 10B: 7.140 s 11: 7.140 s 14: 7.150 s 15: 7.160 s 16: 7.170 s 17(1): 7.180 s 17(2): 7.180 s 17(3): 7.180 s 17(4): 7.180 s 18: 7.190 s 19(1)(i): 7.390 s 19(5): 7.390 s 20: 7.200 s 20A: 7.210 s 21: 7.210 s 22: 7.210 s 22A: 7.220 s 22A(4): 7.380 s 23: 7.220, 7.380 s 24: 7.220 s 37B: 7.240 s 37AA: 7.230 s 37AF: 7.230 s 37BA: 7.240, 7.320 s 37CA: 7.240 s 37CB: 7.240 s 37CC: 7.240 s 37CD: 7.240 s 37CD(2): 7.240 s 37CD(3): 7.240 s 40: 7.250 s 41: 7.260 s 42: 7.270 s 43: 7.270 s 45: 7.280
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s 47: 7.290 s 47(2): 7.290 s 47(3): 7.290 s 47(4): 7.290 s 48: 7.300 s 49: 7.300 s 50: 7.300 s 51: 7.300 s 53: 7.110, 7.130 s 58(4): 7.330 s 58A: 7.310 s 58B: 7.310 s 58C: 7.310 s 58D: 7.310 s 58E: 7.310 s 58F: 7.310 s 58H: 7.310 s 58K: 7.310 s 58L: 7.310 s 58M: 7.310 s 58P(f): 7.320 s 58X: 14.20 s 58X(2): 7.330 s 58X(3): 7.330 s 58AA: 7.310 s 62: 7.370, 7.380 s 66: 7.420 s 66(1): 7.10 s 68 24.20 s 136(1): 7.10, 7.20, 7.30, 7.40, 7.50, 7.58, 7.60, 7.70, 7.80, 7.85, 7.100, 7.140, 7.220, 7.250, 7.270, 7.320 s 137: 7.50 s 138(3): 7.390 s 148(1): 7.75 s 148(2): 7.65 s 148(3): 7.40 s 148(4): 7.40, 7.58 s 149A: 7.400 s 159: 7.55 Div 4: 7.280 Div 6: 7.90 Div 7: 7.90 Div 8: 7.90 Div 9: 7.90 Div 9A: 7.230, 7.240, 12.250 Div 10: 7.90 Div 10A: 7.90 Div 13: 7.310 Health Insurance Act 1973: 3.40, 3.70 s 3(1): 3.40 s 10: 3.40 s 21: 3.40
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TABLE OF STATUTES xxv Higher Education Support Act 2003: 12.240, 12.680 Income Tax Act 1986: 1.245, 3.20
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Income Tax Assessment Act 1922 s 116-55: 11.470 Income Tax Assessment Act 1936: 1.130, 1.190, 1.200, 3.20, 10.00, 11.310, 12.240, 15.10, 24.130, 24.530 s 6: 3.70, 21.50 s 6(1): 4.40, 4.50, 4.170, 4.200, 9.150, 19.30, 21.60, 21.90, 21.140, 22.310, 24.50 s 6(1)(a)(i): 24.00 s 6(4): 21.70 s 6C: 4.290 s 6CA: 23.40 s 8: 24.510 s 16: 24.620 s 18: 3.120 s 21A: 5.60, 8.160 s 21A(1): 8.160 s 21A(2): 8.160 s 21A(2)(a): 8.160 s 21A(4): 8.160 s 21A(5): 8.160 s 23(q): 4.260 s 23L(1A): 7.440 s 23L(1): 3.170, 6.20, 6.240, 7.440 s 23L(2): 8.160 s 23AB(7): 15.190 s 23AF: 22.80 s 23AG: 12.230, 12.280, 22.80 s 23AH: 22.100 s 25(1): 5.10 s 25(1A): 8.300 s 25A: 8.300 s 26(e): 3.160, 6.100, 6.130, 6.190, 6.210, 6.220, 6.230, 7.10, 7.65 s 26(j): 10.290 s 26BB: 9.00, 9.60, 9.70 s 27H: 6.50, 9.210, 10.140 s 43B(1)(b): 21.50 s 44: 1.220, 3.160, 9.00, 9.150, 21.40, 21.50, 21.60, 21.70, 21.100, 21.200 s 44(1): 16.100, 21.100, 22.290 s 44(1A): 21.100 s 44(1B): 21.70 s 47: 21.140 s 47(1): 21.140 s 50: 6.10 s 51(1): 12.20, 16.170, 19.100
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s 51AH: 12.260 s 51AK: 25.240 s 51AEA: 7.430, 12.250, 25.240 s 63: 1.220 s 70B: 9.00, 9.60, 9.70 s 73BA: 11.150, 14.70, 14.140 s 78A: 12.240, 13.140, 13.160 s 78A(2)(a): 13.140 s 78A(2)(b): 13.140 s 78A(2)(c): 13.140, 13.160 s 78A(2)(d): 13.140 s 78A(3): 13.140 s 79A: 15.180 s 79B: 15.190 s 82A: 12.680 s 82A(2): 12.680 s 82KZL(1): 16.182 ss 82KZL to 82KZMG: 16.00, 16.180 s 82KZM: 16.185 s 90: 19.60, 19.70 s 91: 19.40 s 92: 19.60 s 92(2): 19.70 s 92(3): 19.70 s 94: 19.140 s 95(1): 20.80 s 95A(2): 20.120 s 97: 20.70, 20.90, 20.140, 20.150 s 98: 20.140, 20.150, 21.210 s 98(2A): 20.170 s 98(3): 20.170 s 99: 20.150 s 99A: 20.150, 21.210 s 100(2): 20.140 s 101: 20.120 s 102: 20.40, 20.160 s 102B: 23.130 s 102CA: 23.130 s 103A(1): 21.120 s 103A(2): 21.120 s 103A(3): 21.120 s 108: 21.130 s 109(1): 21.130 s 109C: 21.130 s 109D: 21.130 s 109E: 21.130 s 109F(1): 21.130 s 109F(6): 21.130 s 109G: 21.130 s 109J: 21.130 s 109K: 21.130 s 109M: 21.130 s 109N: 21.130 s 109Y: 21.130
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xxvi PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1936 — cont s 109Z: 21.130 s 109ZC: 21.130 s 128B: 22.290 s 128D: 21.40, 21.260, 22.290 s 136(1): 7.55 s 159N: 15.170 s 159P: 15.200 s 160AAAA: 15.50 s 160APHO: 21.290 s 160APHD: 21.290, 21.300 s 160APHM: 21.290 s 160APHJ: 21.290 s 160APHT: 21.290 s 160APHN: 21.300 s 160APHO(3): 21.290 s 161: 24.20 s 161A(1): 24.20 s 161AA: 24.30: s 162: 24.20 s 163: 24.20 s 166: 24.50, 24.90 s 166A: 24.40, 24.70 s 167: 24.00, 24.90, 24.100, 24.225 s 170: 24.60, 24.140, 24.520 s 170(1): 24.140 s 170BB: 24.380 s 174: 24.110, 24.120 s 175: 24.00, 24.120, 24.130 s 175A: 24.130 s 177: 24.130, 24.150, 24.190 s 177(1): 24.130 s 177A: 23.270 s 177A(1): 23.280 s 177A(3): 23.280 s 177C: 23.270, 23.290 s 177C(1)(ba): 23.340 s 177D: 23.270, 23.300 s 177D(1): 23.270 s 177D(2): 23.270 s 177D(a): 23.280 s 177D(b): 23.00 s 177F: 23.270 s 177F(3): 24.130 s 177CA: 23.290 s 177CB(3): 23.270 s 177CB(4): 23.270 s 177EA: 21.280 s 207-145: 21.290 s 218: 21.170 s 251S(1)(a): 3.50 s 251T: 3.70 s 251U: 3.70
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s 252: 21.30 s 255: 24.175 s 255(1)(b): 24.175 s 255(1)(c): 24.175 s 255(1)(d): 24.175 s 260: 23.260 s 262A: 24.520 s 263: 24.200, 24.550, 24.560, 24.570 s 263(1): 24.530 s 264: 24.200, 24.540, 24.550, 24.560, 24.570, 24.590 s 264(2): 24.540 s 264A: 24.610 ss 316 to 468: 22.170 s 318: 7.55, 14.70, 14.90 Pt IIIAA, Div 1A: 21.290 Pt III, Div 3, subdiv H: 23.50 Pt III, Div 6B: 20.30 Pt III, Div 6C: 20.30 Pt III, Div 7A: 21.160 Pt III, Div 10B: 14.20 Pt III, Div 10BA: 14.20 Pt III, Div 11A: 22.280 Pt III, Div 16F: 22.380 Pt IVA: 1.130, 12.300, 12.310, 16.80, 20.40, 22.517, 23.00, 23.10, 23.20, 23.160, 23.260, 23.270, 23.280, 23.300, 23.310, 23.330, 23.350, 24.207,25.300 Pt VIIB: 3.40 Div 5: 19.10 Div 5A: 19.190 Div 6: 20.10 Div 6A: 23.130 Div 6B: 20.30 Div 6C: 20.30 Div 6AA: 20.160 Div 7A: 21.130, 21.460, 23.20, 23.140 Div 13: 22.350 Div 16E: 9.60 Income Tax Assessment Act 1997: 1.190, 1.210, 3.20, 3.110, 9.70, 9.80, 10.00, 10.20, 10.150, 10.290, 11.00, 11.310, 12.240, 14.90, 22.350 s 3-5: 3.00, 3.110 s 4-1: 21.10 s 4-5: 3.110 s 4-10: 3.110, 3.120, 12.10, 16.10 s 4-10(1): 3.120 s 4-10(3): 3.00 s 4-15: 3.00, 3.130, 12.10 s 4-15(1): 2.430, 24.50 s 5-5: 24.150
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TABLE OF STATUTES xxvii
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Income Tax Assessment Act 1997 — cont s 5-5(2)-(3): 24.30 s 5-5(4): 24.30, 24.150 s 5-5(5): 24.30, 24.150 s 5-5(5): 24.30 s 6-1: 5.170 s 6-1(1): 3.140 ss 6-1(2) to (4): 3.140 s 6-5: 1.220, 2.30, 2.380, 4.230, 5.00, 5.10, 6.10, 6.20, 6.40, 6.100, 6.130, 6.200, 8.10, 8.20, 8.80, 8.105, 8.107, 8.120, 8.130, 8.150, 8.160, 8.265, 8.270, 8.310, 9.10, 9.20, 9.150, 9.200, 10.20, 10.40, 10.60, 10.90, 10.220, 10.230, 10.240, 11.310, 12.820, 16.40, 17.90, 17.210, 17.260 s 6-5(1): 3.150, 5.10, 6.170 s 6-5(2): 3.150, 6.60, 9.50 s 6-5(3): 3.150 s 6-5(4): 3.150, 5.160, 16.30, 16.40 s 6-10: 4.230, 6.10, 8.265, 16.40 s 6-10(2): 3.160 s 6-10(3): 3.160, 5.160, 16.30 s 6-25: 8.265, 9.10, 9.130, 9.150 s 6-25(1): 3.160 s 6-25(2): 3.160 s 8-1: 1.220, 2.30, 2.90, 2.430, 2.450, 3.180, 6.200, 7.430, 8.80, 8.107, 8.110, 12.00, 12.10, 12.20, 12.30, 12.40, 12.50, 12.60, 12.70, 12.80, 12.100, 12.110, 12.130, 12.140, 12.160, 12.170, 12.210, 12.220, 12.230, 12.240, 12.250, 12.270, 12.280, 12.290, 12.300, 12.310, 12.330, 12.340, 12.360, 12.370, 12.390, 12.400, 12.410, 12.420, 12.430, 12.440, 12.450, 12.570, 12.580, 12.600, 12.610, 12.620, 12.630, 12.650, 12.660, 12.680, 12.690, 12.700, 12.710, 12.730, 12.750, 12.760, 12.770, 12.780, 12.790, 12.800, 12.810, 12.820, 12.840, 13.00, 13.10, 13.20, 13.30, 13.33, 13.37, 13.100, 13.110, 13.140, 13.160, 13.210, 14.10, 14.160, 14.180, 14.210, 16.120, 16.150, 16.160, 16.170, 16.190, 17.60, 17.210, 17.250, 17.260, 19.100 s 8-1(1): 2.400, 2.410, 12.20, 12.40, 16.230 s 8-1(1)(b): 2.430, 8.230 s 8-1(2): 2.410, 12.20, 12.160 s 8-1(2)(a): 12.170 s 8-1(2)(b): 12.220
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s 8-1(2)(c): 12.230 s 8-1(3): 12.20 s 8-5: 3.180, 12.10 s 8-10: 3.180, 12.10, 13.10, 13.30, 13.210 s 9-1: 3.110 s 11-5: 3.170 s 11-15: 3.170 s 11-55: 3.170 s 12-5: 13.10 s 13-1: 3.220, 15.10, 15.140 s 15-2: 2.380, 3.160, 6.00, 6.100, 6.130, 6.190, 6.200, 6.210, 6.220, 6.230, 6.240, 7.10, 7.65, 7.440 s 15-2(3)(b): 2.380 s 15-2(3)(d): 3.160, 6.190, 6.200, 6.230 s 15-3: 6.00, 6.250 s 15-10: 8.280 s 15-10(b): 8.280 s 15-15: 8.290, 13.210 s 15-15(2)(a): 8.290 s 15-15(2)(b): 8.290 s 15-20: 8.265, 9.00, 9.10, 9.200 s 15-20(2): 9.10 s 15-25: 9.180 s 15-30: 2.430, 10.00, 10.90, 10.230 s 15-35: 9.130 s 15-50: 19.170 s 17-5: 3.170, 25.320 s 20-20: 10.290 s 20-20(2): 10.290 s 20-20(3): 10.290 s 20-30: 10.290 s 25-5: 7.390, 13.20, 24.220 s 25-5(2): 13.20 s 25-5(2)(e): 13.20 s 25-5(3): 13.20 s 25-5(4): 13.20 s 25-5(1)(c): 24.140 s 25-5(5): 13.20 s 25-10: 13.30, 13.33, 13.35, 13.37, 13.40, 13.50, 13.60, 13.70, 14.10, 14.90 s 25-10(1): 13.30 s 25-10(2): 13.35 s 25-10(3): 13.37 s 25-15: 9.180 s 25-20: 13.210 s 25-25: 13.210 s 25-35: 13.80, 13.83, 16.00, 16.220 s 25-35(1)(a): 13.80 s 25-35(1)(b): 13.80 s 25-40: 13.210 s 25-45: 13.210 s 25-47: 13.210 s 25-50: 13.210
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xxviiiPRINCIPLES OF TAXATION LAW 2020
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Income Tax Assessment Act 1997 — cont s 25-50(3): 13.210 s 25-55: 13.100 s 25-95: 19.170 s 25-100: 12.440, 13.110 s 26-5: 11.480, 12.240, 25.240 s 26-5(a): 12.240 s 26-5(b): 12.240 s 26-10: 16.00, 16.200, 16.210 s 26-19: 12.240, 12.640, 12.680 s 26-20: 12.240, 12.680 s 26-20(2): 7.430, 12.240, 12.680 s 26-22: 12.240 s 26-30: 12.240, 25.240 s 26-30(2): 12.240 s 26-30(3): 7.430, 12.240 s 26-31: 12.240 s 26-35: 12.240, 12.300, 23.120 s 26-35(2): 12.240 s 26-35(4): 12.240 s 26-40: 25.240 s 26-45: 12.240, 25.240 s 26-45(2): 12.240 s 26-45(3): 7.430, 12.240 s 26-50: 25.240 s 26-50(8): 7.430 s 26-52: 12.240 s 26-53: 12.240 s 26-54: 11.480, 12.90, 12.240 s 26-55: 12.240, 13.140, 13.160, 18.70 s 26-55(1): 13.140 s 26-105: 12.240 s 27-5: 25.240, 25.320 s 27-80: 14.90 s 28-10: 12.450 s 28-13: 12.550 s 28-20(1): 12.450 s 28-20(2): 12.450 s 28-20(3): 12.450 s 28-25: 12.460 s 28-25(2): 12.480 s 28-25(4): 12.460 s 28-35: 12.470 s 28-90: 12.550 s 28-90(4): 12.550 s 28-90(5): 12.550 s 28-90(6): 12.550 s 30-15: 13.130, 17.110 s 30-242: 12.240, 13.150 s 30-243: 12.240, 13.150 s 32-5: 7.430, 12.250 s 32-10: 12.250 s 32-10(1): 12.250
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s 32-10(2): 12.250 s 32-20: 7.430, 12.250, 25.240 s 32-30: 7.430, 12.250 s 32-35: 12.250 s 32-40: 12.250 s 32-45: 12.250 s 34: 25.240 s 34-10: 12.790 s 34-10(3): 12.790 s 34-15: 12.790 s 34-20(1): 12.790 s 34-20(2): 12.790 s 36-10: 3.170, 13.180, 21.310 s 36-15: 13.180, 13.190 s 36-15(5): 13.180 s 36-17: 13.180, 13.190, 21.230 s 36-17(7): 13.180 s 36-55: 21.240 s 40--45: 14.165 s 40-25: 14.40, 14.50 s 40-25(1): 14.40 s 40-25(2): 14.40, 14.100 s 40-25(7): 14.100 s 40-27: 14.20 s 40-30(1): 14.30 s 40-30(1)(b): 17.290 s 40-30(2): 14.30 s 40-30(4): 14.35 s 40-35: 14.60 s 40-40: 14.50, 14.60 s 40-45(1): 14.20 s 40-45(2): 14.20, 14.30 s 40-45(5): 14.20 s 40-50: 14.20 s 40-55: 14.20, 14.125 s 40-60: 14.70 s 40-65: 14.70 s 40-65(2): 14.70, 14.90 s 40-65(3): 14.70 s 40-65(5): 14.70 s 40-65(6): 14.70 s 40-70: 14.80 s 40-70(1): 14.90 s 40-70(2): 14.70, 14.90 s 40-70(3): 14.90 s 40-72: 14.80, 14.90, 14.125 s 40-72(2): 14.70, 14.90 s 40-72(3): 14.90 s 40-75: 14.80, 14.90, 14.125 s 40-75(2): 14.90 s 40-75(3): 14.90 s 40-75(5): 14.90 s 40-80(1): 14.40 s 40-80(2): 14.40, 14.140
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TABLE OF STATUTES xxix
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1997 — cont s 40-80(2)(c): 14.40 s 40-80(2)(d): 14.40 s 40-85: 14.90, 14.110 s 40-95(1): 14.90 s 40-95(3): 14.90 s 40-95(4): 14.90 s 40-95(5): 14.90 s 40-95(5)(c): 14.90 s 40-95(5)(d): 14.90 s 40-95(6): 14.90 s 40-95(7): 14.90 s 40-102: 14.90 s 40-105: 14.90 s 40-105(2): 14.90 s 40-110: 14.90 s 40-110(1): 14.90 s 40-110(2): 14.90 s 40-110(3): 14.90 s 40-130: 14.70 s 40-180: 14.90 s 40-180(2): 14.90 s 40-185: 14.90 s 40-190: 14.90 s 40-215: 14.90 s 40-230: 14.90, 14.125 s 40-230(2): 14.125 s 40-285: 14.110, 14.115 s 40-285(1): 14.110 s 40-285(2): 14.110, 14.125 s 40-290: 14.110, 14.115 s 40-295: 14.110 s 40-295(2): 14.120 s 40-295(3): 14.110 s 40-300: 14.110 s 40-325: 14.125 s 40-340: 19.180 s 40-340(1): 14.120 s 40-340(3): 14.120 s 40-345: 14.120 s 40-365(1): 14.120 s 40-365(2): 14.120 s 40-370: 14.125 s 40-425: 14.140 s 40-425(2): 14.140 s 40-425(4): 14.140 s 40-425(5): 14.140 s 40-425(7): 14.140 s 40-425(8): 14.140 s 40-430(1): 14.140 s 40-435: 14.145 s 40-440(1): 14.150 s 40-440(2): 14.150
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s 40-445(1): 14.155 s 40-445(2): 14.155 s 40-450: 14.160 s 40-450(1): 14.160 s 40-450(2): 14.160 s 40-450(3): 14.160 s 40-450(4): 14.160 s 40-455: 14.160 s 40-460: 14.160 s 40-830: 14.190 s 40-840: 14.190 s 40-840(2)(d): 14.190 s 40-860: 14.190 s 40-865: 14.190 s 40-880: 1.110, 2.410, 8.107, 14.00, 14.200, 14.210, 14.215 s 40-880(2): 14.200 s 40-880(2A): 14.215 s 40-880(5): 14.200 ss 40-880(5)(h) to (j): 14.200 s 40-880(7): 14.210 s 43: 14.170 s 43-10: 14.170 s 43-15: 14.170 s 43-20: 14.170 s 43-25: 14.170 s 43-30: 14.170 s 43-70: 14.170 s 43-250: 14.170 s 50-50(1)(c): 12.230, 12.280 s 51-57: 9.100, 9.110, 10.100 s 58P: 7.430 s 61-105: 15.170 s 61-110: 15.170 s 61-205: 15.40, 15.160 s 61-610: 15.200 s 63-10: 15.210 s 67-23: 15.40 s 67-25: 15.80, 21.210 s 70: 10.220 s 70-5(2)(b): 17.90, 17.210 s 70-10: 17.20, 17.210, 17.290 s 70-15: 17.60, 17.210, 17.260 s 70-20: 17.70, 17.100, 17.150, 23.120 s 70-25: 17.60 s 70-30: 17.250 s 70-30(3): 17.250 s 70-30(4): 17.250 s 70-35: 17.120, 17.210 s 70-40: 17.130 s 70-45: 17.140, 17.170, 17.190, 17.250 s 70-45(1A): 17.140 s 70-50: 17.190 s 70-55: 17.200
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xxx PRINCIPLES OF TAXATION LAW 2020
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Income Tax Assessment Act 1997 — cont s 70-90: 17.110 s 70-90(2): 17.110 s 70-95: 17.110 s 70-100: 19.180 s 70-105: 17.110 s 70-110: 17.260 s 70-115: 10.220, 17.270 s 80-10: 6.310 s 82-10: 6.370 s 82-10(1): 6.370 s 82-10(2): 6.370 s 82-10(4): 6.370 s 82-10(6): 6.370 s 82-10(7): 6.370 s 82-65: 6.380 s 82-65(1): 6.370 s 82-70: 6.380 s 82-70(1): 6.370 s 82-130: 6.280 s 82-135: 6.280 s 82-140: 6.370 s 82-145: 6.370 s 82-150: 6.370 s 82-150(2): 6.370 s 82-155: 6.370 s 83-10: 6.390 s 83-10(7): 6.370 s 83-15: 6.390 s 83-85: 15.130 s 83-170: 6.320, 6.360 s 83-175: 6.330, 6.350, 6.370 s 83-180: 6.340, 6.350 s 84-5: 23.170 s 85-10: 23.180 s 85-15: 23.180 s 85-20: 23.180 s 86-10: 23.160 s 86-15: 23.160 s 87-15(3): 23.190 s 87-18: 23.200 s 87-20: 23.210 s 87-25: 23.220 s 87-30: 23.230 s 87-60: 23.240 s 87-60(4): 23.240 s 90: 19.70 s 100-10(3): 11.20 s 102-5: 3.160 s 102-5(1): 11.10 s 102-10(2): 11.570 s 102-15: 11.530 s 102-15(1): 11.570
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s 102-20: 11.40 s 102-25(1): 11.40 s 104-5: 11.40, 11.440 s 104-10: 11.50 s 104-10(1): 11.50 s 104-10(2): 11.50 s 104-10(3): 11.50 s 104-10(4): 11.50, 11.450 s 104-15(1): 11.60 s 104-15(2): 11.60 s 104-20(1): 11.70 s 104-20(2): 11.70 s 104-25: 21.140 s 104-25(1): 11.70 s 104-25(2): 11.70 s 104-30(1): 11.70 s 104-30(2): 11.70 s 104-35: 11.80 s 104-35(1): 11.80 s 104-40(1): 11.80 s 104-45(1): 11.80 s 104-47(1): 11.80 s 104-125: 11.100 s 104-130: 11.100 s 104-135: 21.60, 21.140 s 104-135(1): 11.110 s 104-145(1): 11.110 s 104-150(1): 11.120 s 104-155: 11.120 s 104-155(1): 11.120 s 104-160(1): 11.130 s 104-170(1): 11.130 s 104-220: 17.250 s 106-5(4): 19.130 s 108-5: 11.170 s 108-5(1): 11.170 s 108-5(1)(a): 11.170 s 108-5(1)(b): 11.170 s 108-10: 11.180 s 108-10(1): 11.240 s 108-10(2): 11.180 s 108-15: 11.180 s 108-20(1): 11.240 s 108-20(2): 11.190 s 108-20(3): 11.190 s 108-55(1): 11.200 s 108-55(2): 11.200 s 108-60: 11.200 s 108-65: 11.200 s 108-70: 11.200 s 109-5(1): 11.210 s 109-5(2): 11.210 s 109-10: 11.210 s 110-25(2): 11.480
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TABLE OF STATUTES xxxi
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1997 — cont s 110-25(4): 11.480 s 110-25(5): 11.480 s 110-25(6): 2.450, 11.480 s 110-35: 11.480 s 110-38(1): 11.480 s 110-38(2): 11.480 s 110-38(3): 11.480 s 110-38(4): 11.480 ss 110-40(2) to 110-45(1B): 11.480 s 110-40(3): 11.480 s 110-45(3): 11.480 s 112-20: 23.120 s 112-20(1): 11.490 s 112-20(2): 11.490 s 112-25: 11.490 s 112-30: 11.490 s 112-35: 11.490 s 112-37: 11.490 s 112-115: 11.430 s 112-150: 11.430 s 114-1: 11.495 s 115-5: 11.15 s 115-10: 20.130 s 115-20(2): 11.540 s 116-20: 11.470 s 116-20(5): 11.470 s 116-30: 11.470, 23.120 s 116-40: 11.470 s 116-45: 11.470 s 116-50: 11.470 s 116-60: 11.470 s 118-5: 11.230 s 118-10: 11.180 s 118-10(1): 11.240 s 118-10(3): 11.240 s 118-12(1): 11.250 s 118-13: 11.260 s 118-20: 11.310, 21.140 s 118-20(1): 11.310 s 118-22: 11.310 s 118-24: 14.30, 14.118 s 118-24(1): 11.270 s 118-25: 11.275, 17.250, 17.290 s 118-30: 11.310 s 118-35: 11.310 s 118-37: 9.120, 10.100, 10.110 s 118-37(1): 10.120 s 118-37(1)(a): 10.100, 11.290 s 118-37(1)(a)(i): 10.100 s 118-37(1)(a)(ii): 10.100 s 118-37(1)(b): 10.100, 11.290 s 118-37(1)(c): 11.300
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s 118-37(1)(ba): 10.100 s 118-105: 11.380 s 118-110(1): 11.390 s 118-115(1): 11.390 s 118-120: 11.390 s 118-135: 11.400 s 118-140(1): 11.400 s 118-140(2): 11.400 s 118-145: 11.420 s 118-145(2): 11.400 s 118-145(3): 11.400 s 118-150(2): 11.400 s 118-150(4): 11.400 s 118-160: 11.400 s 118-165: 11.410 s 118-170(1): 11.410 s 118-170(3): 11.410 s 118-170(4): 11.410 s 118-175: 11.410 s 118-178: 11.410 s 118-185: 11.420 s 118-190: 11.420 s 118-192: 11.420 s 128-10: 11.425 s 128-15(4): 11.425 s 136(1): 7.430 s 152-5: 11.330 s 165-10: 21.320 s 165-12: 21.330 s 165-12(1): 21.330 s 165-12(7): 21.330 s 165-13: 21.330, 21.340 s 165-15: 21.330 s 165-115A: 21.350 s 165-115A(1B): 21.350 s 165-115A(1): 21.350 s 165-115B: 21.350 s 165-115E: 21.350 s 165-115L: 21.360 s 165-115M: 21.360 s 165-115R: 21.360 s 165-115U: 21.360 s 165-115X(1): 21.360 s 165-115X(5): 21.360 s 165-115Y: 21.360 s 165-115Z: 21.360 s 165-115ZA: 21.360 s 165-115ZB: 21.360 s 165-165: 21.330 s 165-210: 21.330, 21.340 s 165-210(3): 21.340 s 165-211: 21.330, 21.340 s 165-211(2): 21.340 s 165-C: 21.320
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xxxiiPRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1997 — cont s 165-CA: 21.320 s 165-CB: 21.320 s 166-5: 21.330 s 166-175: 21.330 s 166-225: 21.330 s 195-1: 25.70 s 197-45: 21.70 s 197-50: 21.70 s 202-5: 21.160, 21.170 s 202-15: 21.160 s 202-20: 21.160 s 202-40: 21.160 s 202-45: 21.160 s 202-45(e): 21.70 s 202-45(g): 21.110 s 202-60(2): 21.170 s 202-75: 21.170 s 202-80: 21.170 s 203-15: 21.270 s 203-25: 21.270 s 203-30: 21.270 s 203-40: 21.270 s 203-45: 21.270 s 203-50(1)(a): 21.270 s 203-50(1)(b): 21.270 s 203-55: 21.270 s 204-30: 21.280 s 204-75: 21.270 s 204-80: 21.270 s 205-10: 21.180 s 205-15: 21.180, 21.190, 21.220 s 205-30: 21.180 s 205-45(1): 21.190 s 205-45(2): 21.190 s 205-70(1): 21.190 s 205-70(2): 21.190 s 207-20: 15.80, 21.200 s 207-35: 19.120, 21.250 s 207-45: 21.250 s 207-55: 21.250 s 207-70: 21.260 s 207-95: 21.260 s 207-145(1)(a): 21.290 s 290-60: 18.60, 18.70 s 290-80: 18.70 s 290-150: 18.60, 18.70 ss 290-150: 18.70, 19.70 s 290-160: 18.70 s 290-165: 18.70 s 290-170: 18.70, 18.90 s 291-20(3)–(7): 18.80 s 291-25: 18.70
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s 292-20: 18.80 s 292-25: 18.70 s 292-85: 18.100 s 292-85(b): 18.140 s 292-85(2)(b): 18.100 s 292-85(3): 18.100 s 292-85(5): 18.100 s 292-90: 18.90 s 294-35: 18.100, 18.140 s 295-160: 18.70 s 295-190: 18.70 s 301-10: 18.210 s 301-15: 18.210 s 301-20: 15.90 s 301-25: 18.210 s 301-30: 18.210 s 301-100: 18.210 s 301-110: 18.210 s 301-115: 15.90 s 301-120: 18.210 s 302-60: 18.230 s 302-145: 18.230 s 302-195: 6.380, 18.230 s 302-200: 18.230 s 307-70: 18.200 s 328-180: 14.280 s 328-175(1): 14.165 s 328-175(2)-(10): 14.165 s 328-180: 14.165 s 328-180(1): 14.165 s 328-185: 14.165 s 328-190: 14.165 s 328-195: 14.165 s 328-200: 14.165 s 328-205: 14.165 s 328-210: 14.165 s 328-210(1): 14.165 s 328-215: 14.165 s 328-215(2): 14.165 s 328-215(4): 14.165 s 328-220(1): 14.165 s 328-220(2): 14.165 s 328-225: 14.165 s 328-285: 17.280 s 328-285(2): 19.200, 20.190 s 328-295: 17.280 s 355-15: 24.620 s 385-130: 10.230 s 700-10: 21.380 s 701-1: 21.410 s 701-5: 21.420 s 701-10: 21.450 s 701-15: 21.450 s 701-40: 21.420
06-Dec-19 14:01:15
TABLE OF STATUTES xxxiii
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1997 — cont s 703-10: 21.390 s 703-15(1): 21.390 s 703-15(2): 21.390 s 703-30: 21.390 s 703-35: 21.390 s 703-50: 21.390 s 707-120: 21.440 s 707-305(3): 21.440 s 707-310: 21.440 s 707-320: 21.440 s 707-410: 21.440 s 713-130: 21.390 s 719-5: 21.400 s 721-10(1): 21.430 s 721-15: 21.430 s 721-25: 21.430 s 768-5: 22.90 s 770-10: 15.100 s 770-10(1): 22.130 s 770-15(1): 22.130 s 900-35: 12.320 s 900-40: 12.320 s 900-50: 12.320 s 900-55: 12.320 s 900-60: 12.320 s 900-115: 12.320 s 900-165: 12.320 s 960-115: 21.20, 21.160 s 960-120(1): 21.160 s 960-130: 21.390 s 960-275: 11.495 s 960-555: 24.201 s 974-10(1): 21.50 s 974-115: 21.80 s 974-120: 21.80 s 974-120(2): 21.80 s 975-300: 21.70 s 975-300(3)(d): 21.70 s 975-300(3)(ba): 21.70 s 995-1: 3.120, 4.40, 7.55, 7.100, 11.230, 12.240, 13.20, 14.90, 14.125, 14.160, 17.20, 17.70, 19.30, 21.20, 21.80, 24.00, 24.50 s 995-1(1): 8.20, 17.20 s 1675-211(3): 21.340 Ch 3, Pt 3-1: 11.10 Ch 3, Pt 3-3: 11.10 Pt 2: 12.10 Pt 3-1, subdiv 118-100: 11.380 Pt 3-6: 21.150 Pt 3-30: 18.10 Div 6: 3.130, 4.20
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Div 8: 3.130, 12.10, 13.10 Div 8-5: 13.10 Div 10: 3.160 Div 13: 22.360 Div 20: 10.290 Div 25: 13.00, 13.10, 13.210 Div 26: 12.240 Div 28: 12.380, 12.450, 12.860 Div 30: 13.00, 13.130, 13.140, 13.160 Div 32: 12.250, 25.240 Div 35: 13.200, 23.150, 23.190, 23.200 Div 36: 13.00, 13.180 Div 40: 10.200, 10.300, 12.800, 14.00, 14.20, 14.35, 14.160, 14.165, 14.170, 17.250, 17.260 Div 43: 14.00, 14.20, 14.30, 14.35, 14.170 Div 50: 8.107 Div 54: 10.00, 10.140 Div 61-A: 15.150 Div 70: 11.275, 17.00, 17.10 Div 82: 6.00 Div 83: 6.00 Div 85: 6.60 Div 87: 23.190 Div 100: 11.20 Div 104: 11.10, 11.40, 11.220 Div 108: 11.10, 11.170 Div 109: 11.210 Div 110: 11.10 Div 115: 11.540, 18.140, 18.150 Div 116: 11.10 Div 118: 11.10, 11.220 Div 128: 11.425 Div 152: 11.320 Div 166: 21.330 Div 197: 21.70 Div 207: 21.210 Div 220: 21.160 Div 230: 9.00, 9.70, 17.20, 17.290 Div 293: 18.140 Div 294: 18.150 Div 295: 18.150 Div 328: 14.160, 17.10 Div 355: 15.40 Div 768: 4.150 Div 770: 22.130 Div 820: 22.380, 22.390 Div 815: 12.300 Div 900: 12.320 Div 961: 15.150 Div 974: 9.00, 9.150 Divs 84 to 87: 23.160 Subdiv 61-K: 15.200 Subdiv 328-F: 15.130
06-Dec-19 14:01:15
xxxivPRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Income Tax Assessment Act 1997 — cont Subdiv 360-A: 11.265 subdiv 20-A: 13.210 subdiv 28-G: 12.570 subdiv 32-B: 12.250 subdiv 40-C: 14.90 subdiv 40-D: 14.110 subdiv 40-E: 14.20, 14.70, 14.130 subdiv 40-F: 14.20 subdiv 40-G: 14.20 subdiv 40-I: 14.180, 14.200 subdiv 40-J: 14.20 subdiv 87-B: 23.240 subdiv 104-A: 11.40 subdiv 104-B: 11.40 subdiv 104-C: 11.40 subdiv 104-D: 11.40 subdiv 104-E: 11.40, 11.90 subdiv 104-F: 11.40, 11.100 subdiv 104-G: 11.40, 11.110 subdiv 104-H: 11.40, 11.120 subdiv 104-I: 11.40, 11.130 subdiv 104-J: 11.40, 11.140 subdiv 104-K: 11.40, 11.150 subdiv 104-L: 11.40, 11.160 subdiv 108-D: 11.200 subdiv 110-A: 11.480 subdiv 112-C: 11.430 subdiv 112-D: 11.430 subdiv 115-C: 20.100 subdiv 118-A: 11.280 subdiv 118-B: 11.380 subdiv 124-N: 11.140 subdiv 152-A: 11.330 subdiv 152-E: 11.140 subdiv 165-B: 21.320 subdiv 165-D: 21.330 subdiv 165-CC: 21.350, 21.360 subdiv 165-CD: 21.360 subdiv 207-B: 20.100, 21.250 subdiv 207-F: 21.280 subdiv 328-D: 14.20, 14.140, 14.165 subdiv 768-R: 4.150 subdiv 815: 22.350 subdiv 815-B: 22.350, 22.360 subdiv 815-C: 22.350 subdiv 815-D: 22.350, 22.360 subdiv 815-E: 22.350, 22.375 subdiv 900-C: 12.570 subdiv 960-M: 11.495 Income Tax Assessment Regulations 1997 reg 995-1.01: 18.200
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Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974: 22.280 Income Tax Rates Act 1986: 1.245, 3.20, 3.190 Inspector-General of Taxation Act 2003: 24.00, 24.630, 24.670 International Tax Agreements Act 1953 : 1.245 s 4(1): 22.440 Judiciary Act 1903 s 35A: 24.270 s 39B: 24.130, 24.210, 24.380, 24.650 Medicare Levy Act 1986 : 3.40 Migration Act 1958 : 4.150 Military Rehabilitation and Compensation Act 2004 : 3.70 Public Service Act 1922: 12.80, 12.90 Retirement Savings Accounts Act 1997 s 40-880: 8.110 Sex Discrimination Act 1984: 10.120 Social Security Act 1991 : 4.150 Superannuation Act 1976 : 4.50 Superannuation Act 1990 : 4.50 Superannuation Industry (Supervision) Act 1993 s 10: 18.225, 18.230 s 10A: 18.225 s 59(1A): 18.225 Superannuation Industry (Supervision) Regulations 1994 reg 1.06(1): 18.200 reg 1.06(9A): 18.200 reg 6.17A: 18.125, 18.225 reg 6.22: 18.225 subreg 7.01(3): 18.125 reg 7.04: 18.125 Tax Administration Act 1953 : 1.245 s 353-10: 24.560 s 353-15: 24.560
06-Dec-19 14:01:15
TABLE OF STATUTES xxxv Taxation Administration Act Regulations 2017 s 70: 24.330 Tax Agents Services Act 2009: 24.690 s 20-5: 24.690 s 20-15: 24.690 s 20-20: 24.690 s 20-25: 24.690 s 30-5: 24.695 s 30-10: 24.695 s 30-15: 24.695 s 60-95: 24.698 s 60-100: 24.698 s 60-105: 24.698 s 70-10: 24.690, 24.698 Tax Agent Services Regulations 2009 Sch 2: 24.690 Tax Laws Amendment (2006 Measures No 1) Act 2006: 14.200, 14.210 Tax Laws Amendment (2008 Measures No 5) Act 2008 : 7.390 Sch 4: 7.390 Tax Laws Amendment (2009 Budget Measures No 1) Act 2009 : 22.80 Tax Laws Amendment (Combating Tax Avoidance) Act 2015: 22.375
Copyright © 2019. Thomson Reuters. All rights reserved.
Tax Laws Amendment (Simplified Superannuation) Act 2007 : 18.10 Taxation Administration Act 1953: 24.150, 24.200 s 3A: 24.510 ss 8A–13C: 24.203 s 8C: 24.20,24.203, 24.550 s 8D: 24.203 s 8K: 24.203 s 8L: 24.203, 24.520 s 8N: 24.203 s 8Q: 24.203 s 8T: 24.203 s 8U: 24.203 s 8ZE: 24.203 s 8AAB: 24.140, 24.150 s 8AAC: 24.150 s 8AAG: 24.140, 24.150 s 14E: 24.250 s 14R: 24.190 s 14S: 24.190
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s 14T: 24.190 s 14U: 24.190 s 14U(1)(b): 24.190 s 14V: 24.190 s 14Y: 24.190 s 14ZQ: 24.250 s 14ZU: 24.210 s 14ZV: 24.210 s 14ZW(1): 24.210 s 14ZW(1)(aa): 24.210 s 14ZW(1)(c): 24.206 s 14ZW(1B): 24.210 s 14ZW(1BA): 24.210 s 14ZW(1BB): 24.206 s 14ZX: 24.210 s 14ZY: 24.230 s 14ZZ: 24.240, 24.260 s 14ZYA: 24.230 s 14ZYB: 24.230 s 14ZZC: 24.240 s 14ZZE: 24.260 s 14ZZK: 24.210 s 14ZZK(b): 24.225 s 14ZZL: 24.270 s 14ZZM: 24.150 s 14ZZN: 24.240 s 14ZZO(b): 24.225 s 14ZZR: 24.150 s 18-15: 24.150 s 45-15: 24.150 s 45-30: 24.150 s 284-75(1): 24.201, 24.203 s 284-75(1)(a): 24.203 s 284-75(2): 24.201, 24.203 s 284-75(4): 24.201, 24.203 s 284-75(6): 24.201, 24.690 s 284-145: 24.201 s 284-160: 24.201 s 284-220: 24.201 s 284-224: 24.201 s 286-75: 24.201 s 288-25: 24.201 s 298-30: 24.201 s 350-10: 24.90, 24.130, 24.201, 24.540 s 353-15: 24.201 s 353-15(2): 24.530 s 353-15(3): 24.530 s 353-25: 24.610 s 353-30: 24.610 s 357-75: 24.390 Pt IVA: 24.130, 24.140 Pt IVC: 24.150, 24.210, 24.230, 24.250, 24.380, 24.470, 24.700 Pt 4-25, Sch 1: 24.200, 24.201
06-Dec-19 14:01:15
xxxviPRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Taxation Administration Act 1953 — cont Div 2 Pt III: 24.200 Div 284: 24.201, 24.205 Div 286: 24.201 Div 288: 24.201 Div 290, Sch 1: 24.200 Div 357: 24.390 Div 358: 24.390 Div 359: 24.390 Div 360: 24.390 Sch 1: 7.80, 7.85, 12.240, 24.90, 24.150, 24.203, 24.370, 24.610 Sch 1, Div 269: 24.202 Sch 1, Div 280: 24.140 Sch 1, Div 286: 24.20 Sch 1, Div 290: 24.207 Sch 1, Div 355: 24.620 Sch 1, Div 357: 24.370, 24.380 Sch 1, Div 358: 24.370, 24.410 Sch 1, Div 359: 24.370, 24.450 Sch 1, Div 360: 24.370, 24.490 Sch 1, Div 361: 24.370 Sch 1, Div 370: 24.305 Sch 1, Div 393: 24.330 Sch 1, Div 400: 24.330 Sch 1, s 10-5: 24.160 Sch 1, s 12-35: 7.80 Sch 1, s 12-140: 24.330 Sch 1, s 12-190: 24.340 Sch 1, s 18-100: 24.520 Sch 1, s 255-5: 24.150 Sch 1, s 255-5(1): 24.150 Sch 1, s 255-10: 24.150 Sch 1, s 255-15: 24.150 Sch 1, s 260-5: 24.170 Sch 1, s 260-5(3)(b): 24.170 Sch 1, s 260-15: 24.170 Sch 1, s 269-20: 24.202 Sch 1, s 269-30: 24.202 Sch 1, s 280-160: 24.140 Sch 1, s 284-75(5): 24.201, 24.205 Sch 1, s 284-75(6): 24.205 Sch 1, s 286-75(1A): 24.205 Sch 1, s 288-25: 24.520 Sch 1, s 290-50(3): 24.207 Sch 1, s 290-60(2): 24.207 Sch 1, s 290-65: 24.207 Sch 1, s 290-125: 24.207 Sch 1, s 290-200: 24.207 Sch 1, s 298-10: 24.201 Sch 1, s 298-20: 24.201, 24.206 Sch 1, s 298-20(3): 24.201, 24.206 Sch 1, s 298-30(1): 24.201
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Sch 1, s 298-30(2): 24.201, 24.206 Sch 1, s 340-5: 24.150 Sch 1, s 350-10(1): 24.150 Sch 1, s 353-15(1)(b): 24.530 Sch 1, s 355-30: 24.620 Sch 1, s 357-55: 24.380 Sch 1, s 357-60: 24.380 Sch 1, s 357-70: 24.380 Sch 1, s 357-75(1): 24.390 Sch 1, s 357-75(2): 24.390 Sch 1, s 357-80: 24.390 Sch 1, s 357-85: 24.390 Sch 1, s 357-90: 24.390 Sch 1, s 357-105(2): 24.400, 24.460 Sch 1, s 357-110(2): 24.400 Sch 1, s 357-120: 24.400 Sch 1, s 357-125: 24.400 Sch 1, s 358-20: 24.410 Sch 1, s 359-30: 24.460 Sch 1, s 359-35: 24.460 Sch 1, s 359-35(4): 24.400, 24.460 Sch 1, s 359-50(1): 24.470 Sch 1, s 359-50(3): 24.470 Sch 1, s 360-5(3): 24.490 Sch 1, s 388-55: 24.20 Sch 1, Pt 2-10: 24.160 Sch 1, Pt 4-25: 24.200 Taxation (Interest on Overpayments and Early Payments) Act 1983 : 9.130 Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019: 24.202 Treasury Laws Amendment (Medicare Levy and Medicare Levy Surcharge) Act 2018 : 15.00 Treasury Laws Amendment (Personal Income Tax Plan) Act 2018 : 15.00 Treasury Laws Amendment (Junior Minerals Exploration Incentive) Act 2018 : 15.00 Treasury Laws Amendment (Tax Integrity and Other Measures No 2) Act 2018 : 15.00 Veterans' Entitlements Act 1986 : 3.70
Australian Capital Territory Duties Act 1999 : 26.20 Land Tax Act 2004: 26.210 s 9: 26.280 Payroll Tax Act 2011: 26.300
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TABLE OF STATUTES xxxvii
New South Wales
Tasmania
Duties Act 1997 : 26.20 s 11(1)(i): 26.170 s 25: 26.120 s 32A: 26.130 s 104ZJA: 26.135
Duties Act 2001 : 26.20
Land Tax Act 1956: 26.210
Payroll Tax Act 2008: 26.300
Land Tax Management Act 1956: 26.210 s 7: 26.290 s 9: 26.230 s 9AA: 26.230 s 10AA: 26.284 Payroll Tax Act 2007: 26.300
Northern Territory Payroll Tax Act 2009: 26.300
Land Tax Rating Act 2000: 26.210
Victoria Alpine Resorts Act 1983: 26.220 Duties Act 2000 : 26.20 s 3H: 26.170 Land Tax Act 2005: 26.210 s 10: 26.220 s 19: 26.230 Pt 3, Div 2A: 26.270
Stamp Duty Act 1978 : 26.20
Partnership Act 1958 : 19.20 s 5: 19.20
Queensland
Payroll Tax Act 2007: 26.300 s 32: 26.370
Duties Act 2001 : 26.20 s 10(1)(d): 26.80 s 26: 26.80 s 27: 26.80 s 35(1)(f): 26.80 s 167: 26.170 Copyright © 2019. Thomson Reuters. All rights reserved.
Land Tax Act 2000: 26.210
Western Australia Duties Act 2008 : 26.20 Land Tax Act 2002: 26.210
Land Tax Act 2010: 26.210 s 1: 26.290
Land Tax Assessment Act 2002: 26.210
Payroll Tax Act 1971: 26.300
Metropolitan Region Improvement Tax Act 1959: 26.210
South Australia Land Tax Act 1936: 26.210 s 5: 26.282 Payroll Tax Act 2009: 26.300 Stamp Duties Act 1923 : 26.20 Div 6: 26.70
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Pay-roll Tax Act 2002: 26.300 Pay-roll Tax Assessment Act 2002: 26.300
New Zealand Taxation Administration Act 1994 s 20B: 24.600
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Copyright © 2019. Thomson Reuters. All rights reserved.
RULINGS TABLE Rulings
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Law Companion Ruling LCR 2018/7 [12.240] Tax Rulings TR 92/3 [8.170], [8.230] TR 92/4 [12.30] TR 92/15 [7.85] TR 92/18 [13.83] TR 93/20 [17.30] TR 93/23 [17.190] TR 93/25 [5.150] TR 93/30 [12.710], [12.730] TR 93/32 [19.30] TR 94/8 [19.20], [19.30] TR 94/11 [14.35] TR 94/22 [12.770] TR 95/7 [17.230] TR 95/24 [7.430] TR 95/25 [19.100] TR 95/33 [12.310] TR 95/34 [12.410] TR 95/35 [10.190], [10.250], [11.290] TR 97/2 [15.190] TR 97/7 [16.130] TR 97/12 [12.740], [12.790] TR 97/15 [17.230] TR 97/17 [7.230] TR 97/20 [22.360] TR 97/23 [13.33], [13.35], [13.40], [13.50], [13.60], [13.70] TR 97/25 [14.170] TR 98/1 [6.60], [16.40] TR 98/7 [17.40] TR 98/8 [17.20], [17.40] TR 98/9 [12.220], [12.590], [12.610], [12.630], [12.680], [12.690] TR 98/17 [4.60], [4.90], [4.130] TR 1999/6 [7.58] TR 1999/9 [21.340] TR 1999/10 [13.160] TR 1999/17 [6.180] TR 2000/4 [7.290] TR 2001/2 [7.450] TR 2001/7 [23.160], [23.170] TR 2001/8 [23.190], [23.240] TR 2001/10 [6.60] TR 2001/12 [22.480] TR 2003/1 [22.420]
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TR 2003/16 [12.780], [12.790] TR 2004/4 [12.810] TR 2004/6 [12.320] TR 2004/11 [21.410] TR 2004/15 [14.200] TR 2004/16 [14.35] TR 2005/4 [14.190] TR 2005/7 [19.90] TR 2005/13 [13.130], [13.160] TR 2006/10 [24.410] TR 2006/11 [24.450] TR 2006/13 [23.320] TR 2007/8 [23.330] TR 2007/9 [14.35] TR 2007/12 [7.320] TR 2008/1 [23.340] TR 2008/2 [17.20] TR 2011/6 [14.210] TR 2013/1 [22.490] TR 2017/2 [14.90] TR 2017/D1 [4.35] TR 2017/D6 [12.390], [12.460] TR 2018/2 [24.520] TR 2018/5 [4.200] TR 2019/1 [17.280] TR 2019/2 [12.810] TR 2019/5 [14.90] Income Tax Rulings IT 167 [6.110] IT 180 [13.35] IT 333 [17.30] IT 2197 [14.90] IT 2218 [19.90] IT 2289 [17.160] IT 2424 [10.120] IT 2615 [3.40] IT 2650 [4.120] IT 2655 [8.60] IT 2670 [17.220] Class Rulings CR 2001/1 [24.430]
Determinations Tax Determinations TD 92/198 [17.180] TD 93/58 [10.70], [10.240]
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PRINCIPLES OF TAXATION LAW 2020 TD 93/97 [12.680] TD 93/125 [17.120] TD 93/195 [12.690] TD 94/16 [7.100] TD 94/42 [7.430] TD 95/48 [17.230] TD 1999/40 [11.180] TD 2003/28 [20.180] TD 2006/40 [14.125] TD 2007/5 [14.70] TD 2008/26 [17.20] TD 2013/19 [11.200] TD 2014/19 [12.320] TD 2016/12 [11.200] TD 2016/14 [13.160] TD 2017/8 [13.20] TD 2017/13 [11.400] TD 2017/16 [11.200] TD 2018/2 [7.190] TD 2018/6 [25.240] TD 2018/8 [11.200] TD 2018/10 [17.260] TD 2018/11 [12.320]
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Commonwealth Indirect Taxes GST Rulings GSTR 2000/2 [25.310] GSTR 2000/13 [25.304] GSTR 2000/19 [25.310] GSTR 2000/29 [25.304] GSTR 2001/3 [25.210], [25.330] GSTR 2001/4 [10.150] GSTR 2001/7 [25.70] GSTR 2001/8 [25.175] GSTR 2002/2 [25.163] GSTR 2002/5 [25.148] GSTR 2002/6 [25.148] GSTR 2003/3 [25.167] GSTR 2003/9 [25.217]
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GSTR 2004/1 [25.217] GSTR 2006/3 [25.220] GSTR 2006/4 [25.220], [25.310] GSTR 2006/9 [25.100] GSTR 2008/1 [25.210] GSTR 2012/5 [25.165] GSTR 2012/6 [25.165] GSTR 2012/7 [25.165] GSTR 2013/1 [25.306] GSTR 2013/2 [25.310] GSTR 2017/1 [25.295] GSTR 2018/1 [25.120] GSTR 2018/2 [25.120] GST Determinations GSTD 2012/4 [25.144] Miscellaneous Tax Rulings MT 2008/1 [24.201] MT 2016 [7.60], [7.75] MT 2019 [7.75] MT 2027 [7.100] ATO Interpretative Decisions ATO ID 2004/940 [14.145] ATO ID 2005/26 [12.240] ATO ID 2008/127 [7.330] ATO ID 2008/133 [7.330] ATO ID 2009/25 [17.20] ATO Law Administrations Practice Statements PS LA 2003/7 [24.210] PS LA 2004/14 [24.595] PS LA 2007/21 [3.120] PS LA 2007/24 [24.90] PS LA 2008/4 [24.480] PS LA 2008/6 [24.140] PS LA 2011/13 [24.170] PS LA 2011/18 [24.170], [24.190] PS LA 2012/5 [24.203]
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Part 1 Overview and Structure
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The purpose of this book is to guide business and law students through the laws of Australian taxation. To aid in this process, the book is divided into seven parts, each with its own introduction explaining how each part fits into the taxation process, as well as how the chapters contained within those parts contribute to the overall regime. Part 1 provides an overview and structure of the Australian tax regime and serves as a platform from which students can embark on their studies. The four chapters contained in this part should be revisited throughout the process. Chapter 1 provides students with an introduction to taxation law. The role of both legislation and cases is explained, along with the five major differences between taxation law and accounting. Also discussed is the use of the doctrine of precedent in tax law, a process not used in interpretation of financial accounting standards. Students are then introduced to the main tax legislation, consisting of two Income Tax Assessment Acts, a Fringe Benefits Tax Act and a Goods and Services Tax Act. Chapter 2 focuses on study skills for taxation law. This chapter assists students in gaining the most they can from their tax studies. Included in this chapter is advice on how to approach the course generally, as well as information on assignment writing for tax law, exam preparation and examination techniques. It is recommended that students continue to consult this chapter throughout their tax studies. Once students understand how to approach questions of taxation law and a taxation law course, it is possible to consider the overall structure of the Australian tax regime. Chapter 3, “The Taxation Formula”, explains the key concepts to be investigated and considers the relationships between
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PRINCIPLES OF TAXATION LAW 2020
them. Most importantly, it explains that to determine income tax payable for the financial year, the following formula must be used: Income tax = (Taxable income × Rate) − Tax offsets Where: Taxable income = Assessable income −Deductions
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While Chapter 3 discusses the key concepts to determine taxable income, Chapter 4 discusses the basis upon which income tax is levied on taxpayers under Australian domestic law, that is, residence and source. Prior to determining what is “assessable income” and “deductions”, it is necessary to understand that an Australian resident pays tax on income from all sources, while a foreign resident pays tax on income sourced in Australia. Therefore, it is necessary to understand the concepts of residency and source in order to determine the income to be taxed and the related deductions allowed. Chapter 4 explains the tests of residency for both individuals and companies and discusses the source rules applicable to different categories of income.
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1
Copyright © 2019. Thomson Reuters. All rights reserved.
Sources of taxation law Key points...................................................................................................... [1.00] Introduction.................................................................................................. [1.10] Understanding tax law and the doctrine of precedent............................. [1.30] Technical differences between tax law and accounting........................... [1.70] Not all receipts are recognised for tax purposes.................................. [1.80] Income tax law distinguishes between capital and revenue expenses.................................................................. [1.110] Income tax law excludes some income and expenses for policy reasons......................................................................... [1.120] Income tax law ignores some transactions on the basis of anti-avoidance provisions............................................................ [1.130] Timing rules differ in income tax law and accounting principles.................................................................... [1.140] Origins of judicial tax law concepts.......................................................... [1.150] Sources of tax law...................................................................................... [1.180] Legislation............................................................................................ [1.190]
Income tax legislation.............................................................................. [1.200] FBT legislation.......................................................................................... [1.240] Rates Act, Administration Act, and International Agreements Act................................................................................... [1.245] GST legislation......................................................................................... [1.250] Case law............................................................................................... [1.270] Rulings.................................................................................................. [1.280] Private rulings.......................................................................................... [1.290] Public rulings............................................................................................ [1.300] Using this chapter...................................................................................... [1.310]
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[1.00] PRINCIPLES OF TAXATION LAW 2020
Key points [1.00] • The main tax legislation consists of two Income Tax Assessment Acts, Fringe Benefits Tax Act and Goods and Services Tax Act. • Tax legislation is interpreted using the doctrine of precedent, a process not used in interpretation of financial accounting standards. • There are five key differences between tax concepts and accounting principles. • Tax law exam problems usually involve facts that might attract two alternative characterisations of a receipt or expense, and a good answer will canvass both possibilities. • The main sources of tax law are statutes and case precedents used to interpret the provisions in tax law, but taxpayers can rely on Tax Office rulings to avoid penalties when interpreting the law.
Introduction
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[1.10] Time and again, surveys show many commerce and business students view taxation law as one of the most difficult subjects they encounter in their studies. This need not be so provided, it is understood that the skills necessary for the successful study of taxation law are fundamentally different from other commerce subjects. If you understand the differences and learn the essential techniques of how to study taxation law, you should have no difficulty successfully completing the subject. [1.20] This chapter gives valuable guidance on the skills that you need to develop to get the most out of your study of tax law and explains how tax law differs from other commerce subjects. The key points covered are as follows: • The importance of the doctrine of precedent in interpreting tax law and its absence from the interpretation of financial accounting standards: see [1.30]. • Five technical differences between financial accounting and tax law: see [1.70]. • Detail on how the doctrine of precedent led to different definitions of “income” for financial accounting and tax law purposes: see [1.160]. • How to use the principal pieces of tax legislation in Australia and how the main Acts work together: see [1.190]. • The importance of case law in the interpretation of the legislation: see [1.270]. How you can most effectively access the hints set out in this chapter to maximise higher grades in this subject is described at [1.310].
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1: SoUrces of taxation law [1.40]
5
Understanding tax law and the doctrine of precedent [1.30] Interpretation of the financial reporting standards is based on accounting principles. The words in the standards are interpreted with a single aim: to ensure amounts are recognised on a prudent and conservative basis that reflects actual increases or decreases in a firm’s economic position. The process of interpreting words in the tax legislation is fundamentally different from the principle-based interpretation of financial reporting standards. Terms in tax legislation are interpreted not by reference to any commercial or economic principles, but instead on the basis of a system of legal analysis known as the “doctrine of precedent”. The doctrine of precedent is the foundation of the common law legal system used in English-speaking countries. The doctrine of precedent requires judges (and, as a result, tax officials) to interpret words in laws in a manner that is consistent with the interpretation of those words in earlier judgments. If the facts of a later case are the same as those in a previously decided case, a similar result should follow in the later case. If the facts in the later case are slightly different from the earlier case, the precedent may be distinguished and another result might follow.
Copyright © 2019. Thomson Reuters. All rights reserved.
[1.40] The first step in solving a tax law problem is to find the relevant rules in the tax legislation. Rarely, however, will only one rule be relevant. More likely, two or more provisions might potentially apply to the transaction described in the problem, with the borderline between competing rules unclear. To determine on which side of the borderline a given transaction will fall, the tax accountant must proceed to the second step in solving a tax law problem, which is to interpret the words in the different rules. This, as mentioned at [1.30], is completed by looking at the judicial precedents in earlier tax cases. The process is perhaps best explained with an illustration. Example 1.1: Using precedents A tax accountant is asked to advise a client who makes pottery whether there is any tax liability when she gives a piece of pottery to a friend. First, the accountant will turn to the tax legislation to find the relevant tax rules. They are very clear. If the client’s activities amount to a business, the item of pottery is trading stock and a tax liability is triggered when a taxpayer disposes of trading stock outside the ordinary course of business. If the client’s activities are merely a hobby, the pottery is a personal asset,
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[1.50] PRINCIPLES OF TAXATION LAW 2020
not trading stock, and there is no tax liability when a personal asset is given away. The law is obvious –there is one legal consequence if the client’s activities amount to a hobby and another if they amount to a business. The tax legislation is silent, however, as to when activities cross the threshold from being a hobby to becoming a business. To answer the crucial question as to whether the client’s activities constitute a hobby or a business, the accountant will look outside the legislation to the precedents of previously decided court cases and try to find a case that closely resembles the client’s situation. The outcomes in those precedents will provide a good indication as to whether the client’s activities will amount to carrying on a business as a matter of tax law.
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To the extent that the client’s situation is similar to the situations of taxpayers described in the precedents, the same characterisation is likely to apply to the client’s activities. To the extent that the client’s situation differs from the situations of taxpayers described in the precedents, a different characterisation may apply. The tax accountant must decide whether the precedents will apply to the client and yield the same characterisation of the client’s activities or whether the facts in the precedents are sufficiently different for them to be distinguished with a different characterisation applying to the client. [1.50] An important difference between tax law advice and accounting advice is the relative level of certainty. The accountant providing accounting advice can state with confidence that an outcome does or does not conform to accounting standards. In fact, on audit, an accountant must be completely certain before signing off on the audit. In contrast, the accountant dispensing tax law advice may only state a probability, based on the accountant’s interpretation of the precedents and indications in public rulings issued by the Australian Taxation Office (ATO) of how the Commissioner of Taxation (Commissioner) interprets those precedents (the roles of the ATO and Commissioner are explained at [1.280]). This advice will be expressed as a view of how the law is likely to apply to the client but will caution that, as with any advice on legislation, another interpretation is always possible. The fact that there are two alternative arguments does not mean that there is no “answer” to a tax question. When the facts of a particular case are considered in light of the precedents, a probable answer will emerge and, while there is no guarantee that a court will not prefer the alternative argument, advice should set out the likely outcome with a summary of the alternative answer that could prevail if the expected outcome does not occur.
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1: SoUrces of taxation law [1.80]
7
[1.60] Example 1.1 illustrates two aspects of tax law that commerce students sometimes find troubling. The first is learning how to use the doctrine of precedent –relying on decisions in previous cases to advise on how the law will apply to a new set of facts. The second is coming to grips with the inherent uncertainty of any advice based on precedents. By definition, there is always a correct answer to an accounting problem. Accounting students are trained to discover the answer by way of coherent facts and unambiguous rules. But in tax law, students can only offer opinions of how precedents are likely to apply. To provide an opinion that first explains one possible outcome and then canvasses other possible competing views or interpretations of precedent is contrary to everything that an accounting student has previously been taught. No wonder then that commerce students find tax law difficult until they master the new skills required to succeed in the subject.
Technical differences between tax law and accounting [1.70] The commerce subject that at first glance seems most similar to taxation law is financial accounting. Both accounting and tax law scrutinise receipts and expenditures and measure net gains over an annual accounting period. However, these apparent similarities mask five key differences between the two subjects:
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• Not all receipts are recognised for tax purposes: see [1.80]. • Accounting principles recognise all outgoings but may record an offsetting asset if an expenditure gives rise to an ongoing benefit or property. Income tax law distinguishes between capital and revenue expenses and recognises expenditures depending on their classification: see [1.110]. • Income tax law excludes some income and expenses for policy reasons: see [1.120]. • Income tax law ignores some transactions on the basis of anti-avoidance provisions: see [1.130]. • Timing rules differ in income tax law and accounting principles: see [1.140].
Not all receipts are recognised for tax purposes [1.80] To begin with, accounting rules and tax law take substantially different approaches to recognising receipts.
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[1.90] PRINCIPLES OF TAXATION LAW 2020
The objects of accounting are to measure net gains or losses over a period and to measure net assets and liabilities at the end of the period. To do this accurately, accounting must recognise all receipts, whatever their character. When preparing a set of accounts, an accountant starts with gross income, meaning all amounts received by a business; profits from business activities, returns on investments, an unexpected windfall and even a gift will be included in the income account. If a receipt is genuinely unexpected or unusual, the accountant will note that it is an unanticipated or one-off receipt so readers of the accounts are alerted to the fact that the receipt should not be regarded as typical and likely to be repeated each year. But the receipt itself will be fully recognised for accounting purposes to the same extent as repeated receipts such as ordinary and regularly received business income. [1.90] In contrast, some receipts are not recognised at all for tax law purposes while others are recognised but partially excluded from tax accounts. Many one- off or unusual receipts in particular are excluded or only partially recognised for tax purposes.
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Receipts that are recognised for tax purposes are known as “assessable income”. Early Commonwealth income tax Acts defined assessable income using language almost identical to that used in financial accounting. Indeed, the early income tax laws looked very similar on paper to accounting principles. However, drawing on concepts from other areas of the law, courts concluded that gross income for tax purposes comprised only a subset of gross accounting income. See [1.160] for more detail on how the courts developed this narrow concept of income, now known as “ordinary income”. As a result of the restricted judicial interpretation of “income” for tax purposes, when income tax was first imposed in Australia, only a slice of accounting gross income was transferred to the income side of a tax return: see [1.150]–[1.170]. [1.100] Soon after income tax was first adopted by the Commonwealth Government in 1915, the legislature began to broaden the tax base beyond “ordinary income”. Over the years, many sections were added to the income tax Acts to bring into assessable income various types of receipts, which had been excluded from the judicial concept of “ordinary income”. Since 1997, the receipts that have been brought into assessable income by specific inclusion provisions have been known as “statutory income”. As a result of these developments, the accountant’s gross income for accounting purposes must be categorised into three boxes for tax purposes: ordinary income, statutory income (now included in assessable income, but often subject to concessional treatment or partial exclusion), and other receipts. The third category of receipts –amounts that are neither ordinary income nor statutory income –still falls completely outside the scope of income tax law, though of course they are recognised for financial accounting purposes.
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1: SoUrces of taxation law [1.110]
9
Case study 1.1: Gifts In FCT v Slater Holdings Ltd (1984) 156 CLR 447, the father of shareholders in a company gifted money to the company. As gifts are not characterised as ordinary income under the judicial concept of income and there is no statutory income measure that includes gifts, the amounts had not been included in the assessable income of the company. However, the Full High Court agreed that the payments were nevertheless “profits” of the company within the accounting sense of that word.
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Income tax law distinguishes between capital and revenue expenses [1.110] A second significant difference between financial accounting and tax law is the treatment of expenses in the two systems. Accounting principles recognise outgoings as expenses in the profit and loss statement unless the expenditure yields an asset. In that case, it appears on the balance sheet as an asset (with a corresponding debit to cash if internal funds are used or an increase to debt if borrowed funds are used to purchase the asset). The cost of the asset is then recognised as deductions on the profit and loss statement as it is used or depreciates in value. In contrast, tax law distinguishes between two broad categories of expenditures: “revenue” expenses and “capital” expenses. Revenue expenses are deducted when they are incurred. Capital expenses are deducted over a period under a “capital allowance” or a “capital works” system. The distinction between capital and revenue expenses is based on judicial doctrines derived from case law. Whether an asset is acquired with the expenditure is not one of the factors considered directly in the judicial doctrines that distinguish between revenue and capital expenses, although how long a benefit acquired as the result of an expense will last is one factor used in the judicial doctrines. Others such as the frequency of similar expenses and the relationship between the expense and a business’ income earning “process” and income earning “structure” are more important factors in the judicial tests. As a result, income tax law permits immediate deductions for some expenses that would be depreciated over a period of years for accounting purposes while it requires deductions over many years for some expenses that would be expensed immediately on a profit and loss statement in accounting practice. Case study 1.2: Expenses to protect position In Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, the taxpayer incurred legal expenses opposing a licence application by a potential competitor. Licence applications were heard annually, and, as a result of the expenditure, the taxpayer was protected from competition for at least
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10 [1.120] PRINCIPLES OF TAXATION LAW 2020
12 months. The taxpayer argued that the expense should be deductible as a revenue expense as it did not alter or add to any asset of the taxpayer. However, the Full High Court viewed the expense as one related to the structure of the taxpayer’s business, namely its ability to continue to operate without a competitor. Therefore, although the expense would be immediately deductible for accounting purposes, the court characterised the outgoing as a capital expense for tax purposes and denied the taxpayer an immediate deduction. The expense would now fall into one of the statutory provisions that allow taxpayers to deduct capital expenses over a period. Under s 40-880 of the Income Tax Assessment Act 1997 (Cth), a taxpayer would be able to deduct a capital expense of this type in equal instalments over five years.
Income tax law excludes some income and expenses for policy reasons
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[1.120] A third major difference between financial accounting and tax law emanates from the inclusion of many “policy” provisions in the income tax laws. In terms of the profit and loss account, accountants pursue a single objective of measuring net gains in the accounting period. The tax law, in contrast, is used by politicians to achieve a wide variety of social and economic objectives. Thus, for example, while an accountant records all income and receipts for financial accounting purposes, the tax law explicitly exempts some types of otherwise assessable receipts for policy reasons. On the expenditure side, the financial accountant does not distinguish between different types of expenses for policy reasons: if an expense was incurred in a business, it is recognised for accounting purposes. The tax law, however, explicitly denies taxpayers deductions for some types of payments. For example, to discourage taxpayers from engaging in prohibited activity when carrying on a business, the tax law denies deductions for expenses such as fines, bribes, and some expenses incurred in illegal businesses.
Income tax law ignores some transactions on the basis of anti-avoidance provisions [1.130] A fourth important difference between accounting and tax law derives from the effect of numerous anti-avoidance provisions in the tax law. Financial accounting measures net profits on an entity-by-entity basis. If one entity pays an excessive amount to another related entity, accounting will ignore the relationship between the two entities and record an expenditure by the first entity and a receipt by the second. Tax law may ignore the transfer, however, if it falls afoul of an anti-avoidance rule that seeks to prevent taxpayers shifting
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1: SoUrces of taxation law [1.150]
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profits from one entity subject to high tax rates to a related entity (a relative or another entity owned by the same person) subject to low tax rates. In addition to a large number of specific anti-avoidance provisions in the tax legislation, there is a general anti-avoidance rule in the income tax law made up of several sections that operate together and which are collectively referred to as Pt IVA (pronounced “four A”, as the IV is the roman numeral for the number four) after the location of the rule in the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). Like the specific anti-avoidance measures, the general anti- avoidance provisions can lead to divergences between financial accounting and tax law. Another general anti-avoidance rule is included in the goods and services tax law, and a further general anti-avoidance rule is included in the fringe benefits tax law.
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Timing rules differ in income tax law and accounting principles [1.140] Finally, a fifth major difference between accounting and tax law arises as a result of the different timing rules for when income receipts and expense payments are recognised. Financial accounting principles roughly align with a business’ economic position. Receipts are recorded on an accrual basis and offset by provisions if the receipts relate to future obligations. Outgoings are similarly recorded on an accrual basis and offset by assets if assets are acquired as a result of the expenditures. These receipts and expenditures are not reflected immediately in the profit or loss accounts; receipts encumbered by future obligations are brought into profit or loss accounts only as the offsetting obligations are satisfied and expenditures for assets lasting beyond the end of the year are brought into profit or loss account only as the offsetting assets are consumed. In contrast, income tax law measures receipts when they are “derived” and evaluates expenses when they are “incurred”. As a result of judicial interpretation, the terms “derived” and “incurred” have unique judicial meanings. Only sometimes do the tax rules relating to when income is derived and when expenses are incurred coincide with accounting principles that determine when receipts and outgoings enter profit and loss accounts.
Origins of judicial tax law concepts [1.150] We have seen that there are five main areas of difference between accounting and tax law concepts: see [1.80]–[1.140]. Only two of these differences are the result of specific rules in the tax legislation: the adoption of special rules to achieve policy objectives other than the measurement of net gains and the adoption of specific anti-avoidance provisions and one general
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12 [1.160] PRINCIPLES OF TAXATION LAW 2020 anti- avoidance rule. The remaining areas of divergence between financial accounts and tax accounts result from judicial concepts: the judicial distinction between ordinary income and other receipts, the judicial distinction between revenue expenses and capital expenses, and the judicial concepts of when amounts are derived and when expenses are incurred. Understanding the origins of those concepts is crucial to learning how to study tax law and write tax law exams. [1.160] Income tax is imposed on a taxpayer’s “taxable income”, which is defined as a person’s assessable income minus deductions. Assessable income was defined in the original income tax laws as gross income while deductions were allowed for expenses other than capital expenses.
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Australian courts were not encountering these terms –“income” and “capital expenses” –for the first time when they appeared in the original income tax laws. Both terms had been used much earlier in trust law. Trust law distinguished between two types of trust beneficiaries: income beneficiaries and capital beneficiaries. All receipts derived by the trustee had to be classified as either income gains or capital gains to determine which class of beneficiaries would be entitled to the receipts. All expenses incurred by the trustee had to be classified as either revenue expenses or capital expenses to determine which class of beneficiaries would be charged for the outgoings. When income taxation was first adopted in Australia, the courts concluded that the term “income” was intended to have the same meaning for tax law as it did for trust law. As a result, only receipts meeting the trust law concept of income were presumed to be income for tax purposes. Similarly, expenses labelled capital outgoings under trust law doctrines were treated as capital expenses for tax law purposes. As is pointed out at [5.20], while the original trust law notions of income may be much narrower than those used in accounting, they are probably similar to the understanding of income held by an “ordinary” person on the street. It is for this reason that gains fitting in the original judicial concept of income for tax purposes are usually labelled “ordinary income”. [1.170] Later chapters in this book explore in detail the nature of ordinary income and the tests used by the courts to determine whether a receipt will constitute ordinary income. As will be seen, one of the main features of ordinary income is its identification with a source that generates the income. If a receipt can be seen to be a product of labour or business activity or the use or exploitation of property, it will acquire an income character under the judicial tests. Thus, for example, salaries are considered ordinary income from employment, proceeds from the sale of trading stock are considered ordinary income from business, and royalties or interest payments are considered ordinary income from property.
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1: SoUrces of taxation law [1.190]
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The basic tests used by the courts to identify when a receipt might constitute ordinary income from labour, business, or the use of property are bolstered by two supplementary judicial tests. The first supplementary test treats a receipt as income if it has certain income-like characteristics, namely that it is periodic in nature, expected by the recipient and applied to the same uses as other types of income might be applied. The second test treats a receipt as income if it is received as compensation for lost income or in substitution for what would have been income receipts.
Sources of tax law [1.180] While tax law ultimately derives from the statutes that impose the tax, as we have noted, the coverage of the inclusion sections, exemption provisions, and deduction measures is based on interpretation of the law based on judicial precedents. Thus, court cases have become a second source of law in Australia. A third source for tax rules in practice, if not strictly as a matter of law, is the interpretations issued by the Commissioner in the form of “rulings”. These three sources are explained at [1.190]–[1.300].
Legislation
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[1.190] As taxation law is a creation of statute, its primary source lies in legislation, and the income tax part of a taxation course is based on the operation of three pieces of legislation: Income Tax Assessment Act 1936 (Cth) (usually referred to as the ITAA 1936), Income Tax Assessment Act 1997 (Cth) (usually referred to as the ITAA 1997) and Fringe Benefits Tax Assessment Act 1986 (Cth) (usually referred to as the FBTAA). This section of the chapter explains why there are two income tax laws and a separate fringe benefits tax law. A fourth piece of legislation, A New Tax System (Goods and Services Tax) Act 1999 (Cth) (usually referred to as the GST Act), is also relevant to the study of Australian tax law although it does not tax income but instead is a tax on final consumption. The background to the GST Act is described at [1.250]–[1.260] and the operation of the GST system is described in Chapter 25. Four further laws are relevant: an “income tax act” contains the law which imposes the tax on the base set out in the two Income Tax Assessment Acts, a “rates” act sets out the actual rates of income tax, a “tax administration” act sets out the administrative rules for all tax laws, and an “international agreements” act modifies the income tax laws in the case of income derived overseas or by a non-resident taxpayer, as explained in [1.245].
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14 [1.200] PRINCIPLES OF TAXATION LAW 2020
Income tax legislation [1.200] Parallel Commonwealth and State laws. The first Commonwealth income tax in Australia was adopted in 1915. All six States had previously adopted State income taxes, and, when the Federal Government adopted its income tax in 1915, the Commonwealth law operated in parallel to the State laws. As the States had already established income tax administrations, it was agreed that the States would collect the Commonwealth income tax on behalf of the Commonwealth. The Commonwealth law differed in some respects from the State laws and these, in turn, differed between each State. As a result, State income tax administrators had to deal with two sets of laws and also had to divide revenues, where businesses operated across State borders. An attempt to better harmonise the laws in the 1920s brought the different laws somewhat closer together for a brief period, and in 1936, the States and Commonwealth agreed on a fully harmonised model that was enacted in each State and by the Commonwealth to replace the differing laws. The Commonwealth adopted as a part of the harmonisation program the ITAA 1936.
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The parallel State and Commonwealth income taxes remained in effect only for a short time. In 1942, in the midst of the WWII, the Commonwealth effectively appropriated the exclusive power to levy income tax as a “temporary” wartime measure, instituting a system of transfer payments to the States to replace their lost revenue. The income tax has since remained a Commonwealth-only tax. [1.210] Tax law rewrite. The gaps in the Australian income tax laws caused by the somewhat narrow tax base (constrained by reliance on the judicial concept of ordinary income) provided numerous opportunities for avoidance. Rather than address the underlying problems that gave rise to resulting avoidance schemes, the legislature usually responded to costly avoidance arrangements with narrow and very ad hoc rules, including many piecemeal rules that brought different types of receipts into assessable income as statutory income. A deluge of avoidance arrangements in the late 1970s and early 1980s led to an explosion of complicated tax provisions, and by the mid-1980s, the income tax law was, in the eyes of many, extraordinarily complex. Reforms in the mid-1980s led to further income tax complexity, and in the early 1990s, the Government announced a project to rewrite the income tax law using plain- English drafting style. The Government hoped the different drafting style might simplify the law. The first parts of the rewritten law were released as the ITAA 1997. Over the following three years, many measures were shifted from the 1936 Act to the 1997 Act, but the plans to move the entire income tax law across stalled by 2000, when a major Business Tax Review known as the Ralph Review (named
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after the chairman of the review) proposed a range of amendments to tax laws. Since that time, drafting resources have been divided between enacting ongoing changes to the income tax law and moving existing measures in the 1936 Act to the 1997 Act and more than two decades after the process started, many important measures remain in the 1936 Act. [1.220] Concurrent Income Tax Assessment Acts. Accordingly, there are two separate income tax Acts that tax students must consider when answering income tax law problems: the ITAA 1936 and the ITAA 1997. Students will mostly be concerned with the ITAA 1997 as the key statutory income measures have been moved from the ITAA 1936 to the ITAA 1997. As a general rule, it is easy to differentiate the provisions of the two principal Acts because each Act adopts a different numbering system. The sections of the ITAA 1936 are not hyphenated (eg, s 44, s 63) while sections in the ITAA 1997 are hyphenated (eg, s 6-5, s 8-1).
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[1.230] Capital gains tax. Almost as soon as the Commonwealth income tax was enacted and the courts read the law as applying only to the category of gross income that they labelled “ordinary income”, the legislature started broadening the tax base. From 1915 until 1985, the broadening of the tax base was achieved through a continual stream of new inclusion amendments. Almost all amendments were narrow measures targeted at particular types of receipts or particular schemes aimed at taking taxpayers out of the tax net. The growth of statutory income sections was matched on the deduction side by the adoption of many provisions designed to recognise expenses that the courts had labelled capital expenses and which therefore fell outside the scope of the general deduction provision. Despite a growing array of statutory income and capital expense provisions, many gains and outgoings remained outside the tax system. In 1985, the Government shifted its approach from the use of piecemeal inclusion and deduction provisions to a more comprehensive solution, with the adoption of broad-based capital gains measures designed to sweep up most gains and losses that remained outside the tax base. The provisions, which became known as the “capital gains” measures, were complex because they used many artificial deeming rules to capture gains that did not fall in the basic capital gains rules. The original capital gains rules were replaced in 1998 by a revised capital gains regime, labelled the “capital gains tax” or CGT provisions. A key feature of the new rules was the replacement of the artificial deeming rules found in the original provisions with a set of rules that described different CGT “events”, each aimed at a different type of capital gain to be brought into the income tax. The new CGT rules were placed in the ITAA 1997. The name of the new rules, the CGT or capital gains “tax” rules, is the source of some confusion as it suggests that capital gains are subject to a separate tax. This is not the case. The
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16 [1.240] PRINCIPLES OF TAXATION LAW 2020 CGT rules are discrete in the sense of matching gains and losses to determine a net capital gain included in assessable income. But despite its misleading name, the CGT is not a separate tax. It is fine to talk about a gain being subject to the CGT, but it is important to understand that any gain brought into the tax system via the CGT will actually be taxed as part of assessable income subject to income tax under the ITAA 1997.
FBT legislation [1.240] The judicial concept of “ordinary income” under the income tax legislation only included cash or non-cash benefits that could be converted to cash. A receipt that otherwise would be treated as income from labour, business or property would not be considered ordinary income if it did not take the form of cash or a benefit that the recipient could turn into cash. The effect of this restriction on the ordinary income concept was to exclude from the tax base many types of fringe benefits (non-cash benefits) provided by employers to employees. The legislature initially responded to the problem by inserting a provision in the income tax law that included non-cash fringe benefits in assessable income. However, the original provision was not well drafted and, to the extent that it could function, it was poorly administered. As a consequence, many non-cash benefits continued to escape tax.
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Rather than amend the income tax provision to repair its shortcomings, in the mid-1980s, the Government decided to copy a New Zealand precedent and move most employment fringe benefits into a separate assessment Act, the FBTAA. FBT is collected from employers providing the benefits, rather than the employees receiving them. The income tax law explicitly excludes from an employee’s income for income tax purposes the value of any benefits that are fringe benefits as defined by the FBTAA. Since fringe benefits are explicitly excluded from the income tax, the FBTAA is the starting point for any problem involving a benefit to an employee other than salary or wages and, if the benefit satisfies the definition of a fringe benefit under the FBTAA, it is not necessary to consider other tax laws. The income tax law must be considered only if the problem involves a cash benefit that does not fall within the broad understanding of salary or wages since salary and wages are not a fringe benefit according to the FBTAA.
Rates Act, Administration Act, and International Agreements Act [1.245] Four supplementary laws play important roles in the income tax system. The first of these is the Income Tax Act 1986 (Cth). It is thought that the
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1: SoUrces of taxation law [1.260]
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Australian Constitution requires two separate laws to levy an income tax: an assessment Act that measures taxable income that will be subject to tax and an imposition Act that then imposes tax on that base. The Income Tax Act 1986 imposes a tax on taxable income at the rate of tax set out in a second supplementary Act, the Income Tax Rates Act 1986 (Cth). Third, the Tax Administration Act 1953 (Cth) contains the administration rules for collection of the tax and various penalties to ensure compliance with the tax laws. The fourth law is the International Tax Agreements Act 1953 (Cth). When Australian residents derive income overseas, they will be potentially subject to two tax systems. Australian residents are taxed on their worldwide income, including income derived abroad. The country in which the income was earned may also levy income tax as the “source” jurisdiction. Similarly, non-residents who derive income in Australia will be subject to Australian tax on income with a source in Australia and quite possibly to their own country’s income tax on their worldwide income. While both countries’ tax systems can solve the problem of double taxation through their own various credit or exemption rules, the normal practice that has emerged in the international arena is an agreed division of taxing rights through a bilateral (two country) tax treaty. Australia has signed more than 40 tax treaties. The taxing rules in these treaties are given effect by the International Tax Agreements Act 1953, which allows the treaties to override the normal income tax assessment laws.
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GST legislation [1.250] To bolster tax revenues during the economic downturn that became the Great Depression, the Commonwealth Government adopted in 1930 a wholesale sales tax that applied to the sale of goods. The tax was problematic in many respects, causing significant economic distortions by levying different rates on different types of goods and not applying to services at all. Over the following 70 years, there were many calls for its replacement with a broad- based consumption tax that would apply to final consumption only. This was finally achieved in 1999, with effect from mid-2000, when the wholesale sales tax was replaced by the goods and services tax (known as GST). While the GST is intended to be a tax on final consumption only, it is levied at every level of the supply chain and then reimbursed by way of credits or refunds to registered businesses in the chain, leaving the full burden to be borne by the final consumer. [1.260] The GST system operates independently of income tax and FBT systems. In other words, there is little reason to be concerned about GST when thinking of income tax or vice versa. However, for practical reasons, the two must be viewed in parallel as both GST liability (and entitlement to credits for
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18 [1.270] PRINCIPLES OF TAXATION LAW 2020 GST included in the price of purchases) and certain income tax payments (in particular an employer’s liability for income tax withheld from the wages of employees) are reported on the same tax interim return known as a Business Activity Statement (BAS). FBT liability is reported separately. One point of intersection between the BAS and GST is the treatment of GST payments in the income tax. In most cases, a business paying GST on its purchases will be entitled to credit for the tax or a refund. Because the GST paid on acquisitions will be returned to the business, it is not considered a cost of doing business. Consequently, the income tax contains a provision denying a deduction for GST that will be credited or refunded back to the taxpayer. In some situations, a business is not entitled to credits or refunds of GST on purchases. In those cases, the tax is deductible as a cost of doing business for income tax purposes.
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Case law [1.270] We have seen that the meaning of the words in tax laws derives from judicial precedents or decisions of courts interpreting the provisions in past cases. How binding the precedents will be depends on the level of the court. Decisions of the Australian High Court, the final court of appeal in Australia, are the strongest authority for interpretation of law. Decisions of the Federal Court or State courts are followed if there is no High Court decision on a point. In each case, the appeal levels (the “Full Federal Court” in the first case and State “Supreme Courts” in the second case) take precedence over decisions of lower courts. At the bottom of the precedent pole are decisions of the Administrative Appeals Tribunal or its predecessor in tax cases, the Board of Review. These are (or were, in the case of the Board) administrative bodies with less authority than a court. In the early days of tax jurisprudence in Australia, there was a significant reliance on precedents of UK courts. It is far less common today to look at UK decisions to interpret the provisions of the Australian tax law. However, many earlier UK cases continue to be influential, and you will find a number of instances of reliance on decisions by UK courts in the chapters which follow.
Rulings [1.280] Australia’s income tax administration is built upon a somewhat unusual foundation. The tax laws are administered by a government agency, the ATO. However, the tax law does not actually create the agency. Rather, it empowers a statutory officer (a government official whose appointment is protected by a statute or public law) to administer the tax laws. That person is known as the Commissioner of Taxation (Commissioner). The ATO is the agency that carries out the actual administration, but in theory, it is doing so
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1: SoUrces of taxation law [1.310]
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on behalf of the Commissioner. As a result, it is common to refer to actions of the ATO as acts of the Commissioner and to refer to advice from the ATO as coming from the Commissioner. Australia’s income tax law, FBT law and GST law all operate on what is known as a “self-assessment” system. Under this system, taxpayers are responsible for interpreting the tax law and applying it to their transactions when they complete a tax return. The laws provide sometimes severe penalties for incorrect reporting of tax liability as an incentive for taxpayers (or, in reality, in most cases their professional advisers) to get it right.
Private rulings [1.290] Taxpayers who are genuinely unsure how the law will apply to a particular transaction can protect themselves from the risk of a penalty by asking the Commissioner for a “private ruling” on how the ATO would apply the law to that transaction. These rulings are “binding” on the Commissioner, meaning that the Commissioner must honour the ruling and shield a taxpayer from any penalties if the taxpayer follows the advice in the ruling, even if a court later decides the ruling was not a correct interpretation of the law. While private rulings are delivered directly to taxpayers who request them, the ATO often produces a “sanitised” version that describes the question asked and the Commissioner’s answer without identifying the taxpayer who originally posed the question. These published versions of private rulings placed on the website are known as ATO IDs, an acronym for ATO interpretative decisions.
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Public rulings [1.300] In addition to providing individual taxpayers with private rulings on request, the Commissioner often issues public rulings which set out more generally the ATO’s views on the way in which a provision of an Act should be applied to determine the extent of tax liability. A public ruling may also be used to explain which factors will be taken into account by the Commissioner when exercising a discretion provided in the tax law and how those factors will affect the decision the Commissioner is empowered to make. Like private rulings, public rulings are binding on the Commissioner, meaning that a taxpayer who relies on the view in a public ruling to complete a tax return cannot be penalised if that view is later found by a court to be an incorrect interpretation of the law.
Using this chapter [1.310] This chapter outlines some of the key differences between commerce and accounting units and the tax law subject. Understanding these differences
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20 [1.310] PRINCIPLES OF TAXATION LAW 2020 is important to understanding how to study for a tax law exam and how to answer a tax exam question. Chapter 2 provides some details on how to study taxation law and prepare for exams. This chapter contains examples of issues that will be covered in more detail in your tax law course. It only touches upon these issues for the purpose of showing two things: how tax law contains many borderlines between competing rules and how precedents will be used in an exam answer to characterise a transaction and explain on which side of the border a particular set of facts is likely to fall. The other chapters in this book explain in much more detail the tax rules mentioned in the examples in this chapter and the tests established in case law precedents that are used to decide which tax rule will apply to a transaction straddling the border between competing provisions.
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Return to this chapter periodically during the course. There is a risk that, as you learn about sections of the tax legislation and the case law tests used to interpret those sections, you will lose sight of how this information should be digested and used in an answer to a final exam question. Regular reviews of this chapter may help remind you of the bigger picture and provide guidance on translating what you learn about tax legislation and case law precedents into higher grades in the exam.
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2 Study skills for taxation law
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Key points...................................................................................................... [2.00] Introduction.................................................................................................. [2.10] Course aims.................................................................................................. [2.20] Level of understanding required........................................................... [2.30] Nature and timing of assessment.......................................................... [2.40] Format of the examination.................................................................... [2.50] Prepare a study plan..................................................................................... [2.60] Notes and summaries.................................................................................. [2.70] Overviews............................................................................................... [2.80] Detailed notes........................................................................................ [2.90] Additional textbook resources............................................................ [2.100] Assignment writing for tax law................................................................. [2.110] Research............................................................................................... [2.120]
Step 1: Understand the question and the facts...................................... [2.130] Step 2: Identify the issues....................................................................... [2.140] Step 3: Research the relevant legislation and cases............................. [2.150] Step 4: Apply law to the problem........................................................... [2.180] Step 5: Form a conclusion....................................................................... [2.190] Planning and writing............................................................................ [2.200] Plan .......................................................................................................... [2.210] Introduction.............................................................................................. [2.220] Body of the assignment........................................................................... [2.230] Cite appropriate authority........................................................................ [2.240] Referencing and secondary sources....................................................... [2.250] Conclusion................................................................................................ [2.260] Check you have answered the question................................................. [2.270] Exam preparation....................................................................................... [2.280] Identifying examinable material.......................................................... [2.290] Preparing revision notes and summaries........................................... [2.300] Developing problem-solving skills...................................................... [2.310] Working in small groups.......................................................................... [2.320] Traps to avoid........................................................................................... [2.330]
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22 [2.00] PRINCIPLES OF TAXATION LAW 2020 Examination techniques............................................................................. [2.340] Reading time........................................................................................ [2.350] Open-book exams................................................................................ [2.360] Answering multiple choice.................................................................. [2.370]
Strategy.................................................................................................... [2.380]
Answering problem questions............................................................ [2.390]
Identify the relevant law.......................................................................... [2.400] Apply the law to the facts........................................................................ [2.410] Present a conclusion................................................................................ [2.420] Sample examination answers and analysis........................................... [2.430] Additional examination tips..................................................................... [2.460] Using this chapter...................................................................................... [2.470] Resources.................................................................................................... [2.480] Internet................................................................................................. [2.480] Glossary of terms used in assignments and exams................................ [2.490]
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Key points [2.00] • Have a clear understanding of the requirements of your course, including the level of knowledge required for each topic and the assessment requirements. • Construct and implement a study plan. • Prepare reliable notes after each class. • Practise applying legislation and case precedent to tax law problems. • Instructors are normally looking for you to show an understanding of the law rather than answering a problem question with a simple “yes” or “no”. • In problem-type questions, first identify the tax law issue(s) that are raised by the facts. • If you are having problems identifying the tax issue(s) in problem-type questions, review your summaries of the law and look for key words in the facts. • In problem-type questions, do not form your conclusion until you have explored and applied the law to the facts. • Prepare broad summaries of your notes, legislation and cases as preparation for the examination. • Organise your notes for open-book exams and do not rely too heavily on the material you can take in; your summaries are your best support in the exam. • Practise sound exam technique so that you do not waste time in the exam.
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2: StUDY sKills for taxation law [2.20]
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• In problem-type exam questions, remember to: – clearly understand the facts and the question; – state the tax issue(s) you have identified from the facts; – identify the relevant law, legislation and cases; – apply the law to the facts; – form your conclusion based on your discussion of the law and state additional information that may be needed to clarify your conclusion.
Introduction [2.10] To gain the most from the content of this chapter, it is important that you practise these skills early in your course so that you are well prepared to develop a sound study plan. However, it is also useful to return to this chapter to help with specific study or assessment issues that you may face during the course.
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The techniques presented in this chapter aim to improve the efficiency and effectiveness of your study skills to enable you to gain the most from your taxation law course and to perform your best in assessment tasks. These techniques can also be adapted to suit existing study and learning patterns. Practical examples are provided to help explain some aspects of these study skills, and these may make reference to taxation law which you have not covered when you are reading this chapter. It is not important that you understand the law used in these examples as they are for illustration purposes only. It is more important to concentrate on the approach outlined, rather than on the law used in the example.
Course aims [2.20] Considerable variation exists between the approaches taken in taxation law courses at various institutions and between courses undertaken by accounting students, law students and legal studies students. Differences also exist between introductory and advanced courses as introductory courses are intended to provide an overview of the fundamentals underlying taxation law rather than an in-depth understanding. The principles covered in a basic course may then be applied in advanced courses to explore more complex areas of the law and possibly tax planning techniques. Therefore, to help you construct your study plan, you should first identify the: • aims of the course; • level of understanding required;
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24 [2.30] PRINCIPLES OF TAXATION LAW 2020 • nature and timing of the assessment; and • format of the examination. Identifying the course aims early will guide you in how you should approach your preparation for assessment and the examination. Course aims will usually be included in the subject outline or the reading guide. They may also be found in the institution’s handbook in the description of the subject; however, these are often brief and may not be sufficient. If you cannot determine the aims of the course from the materials provided, you should immediately contact your lecturer or tutor.
Level of understanding required
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[2.30] Having identified the aims of the course, you should then determine the level and detail of knowledge required to meet these aims. In particular, you should establish the level of knowledge required with respect to legislation, texts, case law and other readings. It is common in introductory courses for this level to vary from topic to topic and even between areas in the same topic. You must therefore note the level of knowledge for each segment of the course before preparing your notes and other materials. Indication of the level of understanding required will be evident from the amount of legislation covered and the level of case law reading expected by your lecturer. Other indications include the amount of class time allocated to a particular topic or legal issue and any particular emphasis made by your lecturer. For example, it is likely that considerable class time will be spent on developing an understanding of the general assessable income provision (s 6-5 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997)) and the general deduction provision (s 8- 1 of ITAA 1997). However, other more specific provisions may only be mentioned in passing and therefore require less study time.
Nature and timing of assessment [2.40] To plan your study approach and to determine the level of your note- taking, you should ascertain early in your course the assessments required and their due dates. You can then ensure that all relevant topics are prepared at the appropriate level well in advance of assignments or examinations. Ascertain the type of assessment and whether it is optional. Commonly, tax law assessment concentrates on problem-type questions, where a set of facts is presented and you are required to discuss the relevant law and determine the likely application of the law to these facts. Other forms of assessment include multiple-choice questions, short answer questions and theory-type questions, which may require case analysis or commentary on controversial legal issues.
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2: StUDY sKills for taxation law [2.60]
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If you are required to research areas not covered elsewhere in the course, you will need to allow extra time for independent research using library and online resources: see [2.150] and [2.480].
Format of the examination [2.50] Preparation of your notes and summaries will also depend upon the format of the examination paper(s) set for the unit. Taxation law exams tend to be either open book or a limited open book. Closed-book examinations for taxation law are rare because of the breadth of material to be covered and because students need to refer to legislation. You should determine, before you commence your study, exactly what may be taken into the examination room. Knowing this, influences how resource materials can be marked during your studies. If underlining alone is permitted, you must not annotate or include any summaries in your texts or legislation. If you discover this late in your course, you will not be able to use material you have already annotated. If there are no restrictions on annotation, then it is very helpful to place page tabs in your texts and notes so that you can find major legislation and relevant summaries quickly.
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Prepare a study plan [2.60] It is important to construct your study plan early in the teaching period to help map how you intend to cover the materials in the course. This will assist you to be well prepared for timely submission of assessment tasks and examinations. The plan should be based around a timetable appropriately dividing the available course time between the topics to be covered. The plan should allow for: • reading and annotating texts and materials; • preparing summaries of these readings and lecture notes; • note variation in time required for more or less difficult topics or course segments; • preparation time for examinations and assessments; and • critical workload periods for other subjects. Taxation law courses normally require a large amount of reading, so it is important to prepare your notes and summaries as you go as there will not be sufficient time at the end of the teaching period. A study plan is of no use unless you carry it out. Ideally, the plan should be sufficiently flexible so that it can be modified during the course if your
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26 [2.70] PRINCIPLES OF TAXATION LAW 2020
Notes and summaries [2.70] Developing the reliable topic notes and summaries is essential in studying taxation law and will be the most effective preparation for the exam. Summaries are a powerful tool for building an understanding of the fundamental issues within a topic. Without a clear awareness of the important issues, you may find it difficult to use general legal principles to solve unfamiliar problems of the kinds set in assessments. For example, Figure 2.1 shows the essential elements of the decision as to whether an expense is deductible or not. This summary, in a diagram form, shows that you need to consider whether the deduction could fall under the “general” or “specific” provisions and reminds you to consider any possible exclusion from deductibility and relationships with other provisions. This is a very broad summary, and each area listed would need to be expanded with more detailed notes. However, having such a broad overview of deductions is very valuable as it puts all the components into perspective and would be an excellent reminder in an examination.
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Figure 2.1: Map of basic issues relating to tax deductibility
Reliable summaries also enable you to identify the key taxation law issues in problem questions and the steps to their solution. To be most useful, each summary should:
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• provide you with an overview of the topic; • identify the important issues in the topic; • list and summarise the key sections of the legislation; and • list and summarise relevant cases. Writing summaries is a skill that can be learned and you can develop your own specific approaches, but the essential components of good summary notes are to: • provide an overview of the law and list the main headings and essential issues raised in the topic: see [2.80]; and • develop more detailed notes on the broad topic areas to enable you to build a better understanding of the relevant law: see [2.90]–[2.100].
Overviews [2.80] A logical and thorough approach to addressing a tax problem begins with identifying the legal issues raised by the facts presented. Your lectures and texts are the starting point for providing overviews of particular areas of taxation law. Wider reading of case law and other set readings are then vital for gaining a more in-depth understanding. When studying taxation law, there is no substitute for careful reading of the Acts and cases. Practical guide books and tax law case extracts are also useful resources. Overviews of a topic can take many forms, which could include: Copyright © 2019. Thomson Reuters. All rights reserved.
• maps of the essential issues relating to a topic: see Figure 2.1; • flowcharts of the decision processes required (eg, residency of a company): see Figure 2.2; • lists of issues that the courts may use to define a term, such as “ordinary income”: see Example 2.1; • structure diagrams showing the steps required to apply relevant sections to a particular area of law: see Figure 2.2; and • lists of relevant cases with a very brief reminder of the facts and decisions.
Detailed notes [2.90] The materials assigned for a tax course are generally intended to be adequate for normal study needs. However, you may wish to undertake further research to help clarify issues that you find confusing. When reading material from texts and other references, you should concentrate on recognising and
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28 [2.90] PRINCIPLES OF TAXATION LAW 2020 understanding the legal principles that are being discussed. These principles are the most important aspect of the study of taxation law because they provide the rules for the application of the law in practice. When you are planning answers to problem questions, you will need to apply these rules to the facts so that you can support your arguments as to the likely outcome should these facts be considered by a court.
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Figure 2.2: Flowchart of decision to determine residency of a corporation
Example 2.1: Summary of legal principles –distinction between capital and revenue expenditure Relevant cases: Sun Newspapers; Broken Hill Theatres (list all those that are relevant) Main issues to consider: • Is it a once-off expense? • Does the expense have an enduring benefit? • Has the expense altered the profit yielding structure? Consider:
– the character of the advantage sought;
– the manner in which the benefit is used;
– the means adopted to obtain the benefit.
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Identifying these key principles from the relevant cases provides the basis of the analysis and discussion of a problem question relating to the distinction between a capital expense (not deductible under s 8-1 of ITAA 1997), and an expense related to the operation of the business which may be deductible under s 8-1 of ITAA 1997.
Some students find it difficult to identify the major legal principles and tend to become frustrated by the detail. Taxation law is a very broad and complex area of study, and it is therefore important that you are clear about which areas your course concentrates on and which are of lesser or no importance. You can help yourself focus on the major principles by: • noting carefully the emphasis placed on different issues in classes and study material; and • following the basic heading structure of your text or study guide. You should avoid spending too much time on minor issues as there is so much material to be covered. If you are in doubt about the significance of a particular issue, clarify this with your instructors.
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Additional textbook resources [2.100] To support your note preparation, you may also find practitioner guidebooks a helpful complement to your textbooks. These guidebooks are designed to assist practitioners preparing tax returns for clients and tend to give broader coverage of the technical aspects of the legislation. Guidebooks are best used as a starting point for identifying relevant legislation for particular issues, but where general legal principles need to be understood, it is advisable to also refer to texts and other more comprehensive references. Taxation law casebooks are also a valuable reference for obtaining more detail of the facts and decisions in important tax law cases. Various styles of casebooks provide case summaries, case extracts and commentary. In courses where the emphasis is on practical problem-solving, question and answer books may also be quite helpful. It is important to use a current edition of question and answer books as tax law is constantly changing. For a list of other resources that may be helpful during your studies, see [2.480].
Assignment writing for tax law [2.110] Taxation law assignments are commonly set to assess whether you understand the law and its application. Most assessors are not looking
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30 [2.120] PRINCIPLES OF TAXATION LAW 2020 for wrong or right answers nor do they want you to recite directly from the legislation. Instead, you should demonstrate that you can recognise the legal issues raised by the question and then apply the law in an attempt to predict the outcome should this go to court. Do not concentrate on the conclusion to an assignment question, but rather on demonstrating your knowledge of the law, your ability to recognise issues and your ability to apply the law to the facts in the problem. Your conclusion should then develop as you apply the facts to the problem. Assignment writing should be undertaken in two distinct steps. The first step is to carry out the necessary research which will provide the basis of the content for the second step, which is to plan and write the assignment. Each of these two stages plays a vital part in the development of a logical legal argument. However, the suggested approach is only a guide and may not exactly suit all students and styles of preparation. Different assignment types may require different approaches: see [2.40]. In these cases, it may be useful to adapt part(s) of the approach outlined into your existing style. If this is done, it is important to make certain that all requirements of the assessment are still covered.
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Research [2.120] Tax research requires a “broad principles” approach as the range of questions is limitless, and it is rare that questions can be substantially answered directly from secondary materials such as texts and legal reporting services. You will typically be asked to apply the law to a set of facts not previously encountered. This type of question requires you to apply legislation and legal principles to new situations and draw conclusions as to how the law may apply to these new facts. This type of analysis is extremely important because this is what is required in the application of taxation law when advising clients. Mistakes in your research approach often lead to poor assignment answers. Some common mistakes include: • Trying to find a case with similar facts and answering on that basis. Questions based on a set of facts are often best approached by identifying the relevant taxation law issue(s), rather than trying to find cases with similar facts. • Scanning the index of the Act or secondary sources, such as texts, journals and legal reporting services. This approach can lead you to irrelevant areas of the law and cause the broader general principles to be overlooked. Use indexes after the legal issues have been identified. • Trying to give a direct answer to the problem without identifying the relevant legal principles needed to resolve the problem. This approach
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is commonly seen in assignment answers that begin “the receipt is assessable because …” or “the expense is deductible because …”. It is important to first identify the issues and then discuss all aspects of these issues. The conclusion should then develop out of this discussion. To avoid these common mistakes, Figure 2.3 sets out the steps that can be used when researching and answering a taxation law problem.
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Figure 2.3: Steps to answer tax law problems
Each of these steps in the research process is mirrored in the preparation of the written assignment, but it is vital that these steps are first taken in the research stage so that the arguments presented in the written assignment are developed logically.
Step 1: Understand the question and the facts [2.130] Poor answers to problem-type questions often originate from a misreading or incomplete understanding of the question and related facts. Avoid this by reading questions carefully and highlighting key words. Complex facts can be better understood if they are summarised as a list of events, with a timeline showing when each transaction occurred or a diagram
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32 [2.130] PRINCIPLES OF TAXATION LAW 2020 showing the transactions between parties. In Figure 2.4, the diagram of the facts helps highlight the flow of funds and the transfer of property to the parties concerned. For example, the fact that Kim’s guarantee of the rent is shown as a transaction should draw attention to whether it is relevant for income tax purposes.
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Figure 2.4: Diagram of assignment problem facts
As well as understanding the facts presented in the problem, it is also very important to understand the requirements of the question itself: see [2.490]. The first step is to understand who the question relates to. For example, are you required to discuss the tax consequences for all parties or just one of them? Where the question only requires discussion of one party, make certain that only the relevant transactions are discussed. Do not waste your time researching the other party’s tax situation unless their circumstances influence the tax of the taxpayer. Questions may also require only part of the law to be discussed, such as “whether the transaction gives rise to ordinary income” or “discuss the capital gains tax consequences only”. Where the requirements of the question are limited, it is important to restrict your discussion to these areas as marks will not be allocated for the discussion of irrelevant issues. You may also face the problem that the facts presented in the question are vague. This is often a deliberate mechanism used by instructors to test whether you can recognise which facts are essential to the conclusion. Irrelevant facts may also be included with the same intent. It is an important skill in taxation law to be able to ascertain which facts are relevant and to appreciate that part of the role of the tax adviser is to obtain these facts from the client.
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Step 2: Identify the issues [2.140] Once the question and the facts are clearly understood, the next, and perhaps most critical stage, is to determine the legal issues that are relevant to the facts. If any legal issues are overlooked or are irrelevant to the question, your answer will be incomplete or irrelevant. Assessors cannot award marks for irrelevant discussion, and you lose marks for missing issues. Where a question requires discussion of the tax consequences of the transaction presented (eg, “Are the receipts assessable?”), there is a strong tendency for students to begin by answering “yes” or “no”. Avoid reaching a conclusion before identifying the relevant legal issues, as this approach does not show an understanding of the operation of the law. Most assessors are looking for you to first demonstrate that you recognise the legal issues raised by the facts and second, apply the relevant law to show that you understand how these issues may be resolved. A conclusion is important, but it is not the most important stage. In fact, if you use the approach suggested here, you may find that the conclusion becomes apparent from your research of the issues, rather than from a deliberate search for the so-called answer.
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Most students need to actively work on the problem- solving nature of taxation law studies and need to develop effective and efficient strategies for identifying the relevant legal issues in problem- type questions. The most reliable method of developing these skills is through practice and by obtaining a broad understanding of the content of the subject. This can be achieved through consistent study and regular preparation of notes and summaries: see [2.70]. Practising this type of question through practical exercises is also important in developing these skills because it helps reinforce the legal principles and concepts being studied. Practice also assists with the recognition of key terms used in questions that point to the relevant issues.
Example 2.2: Identifying tax issues through key words An exam question states: Ashley has worked for his current employer for the past ten years and recently announced his engagement to his boss’s daughter. In his last pay packet Ashley was surprised and delighted to see an amount of $500 in addition to his normal pay and a note from his boss indicating that the additional amount was a gift from the firm in recognition of his engagement.
One of the factors affecting whether a receipt is assessable as ordinary income is whether it is earned as a result of work performed or whether it is a personal gift. The terms “gift” and “earned” therefore have specific
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relevance to the law. So, in this question, your starting point would be to identify the phrase “was a gift” as an important pointer to the relevant issue. Complex questions may also contain a range of legal issues, with some being more important than others and some only being relevant after other issues are decided. For instance, some provisions of the legislation only apply once it has been determined that the transaction is not taxed under another provision. It is therefore very important that all issues are identified and followed through to their logical conclusion. A common mistake made by students is to identify a legal issue and discuss it fully and, having reached a conclusion, not realise that the conclusion raises other issues. For example, if you conclude that an expense is capital in nature and not deductible under the general deduction provision, you then need to consider whether a deduction is available under another specific provision of the Act, such as the capital allowances sections.
Step 3: Research the relevant legislation and cases
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[2.150] Legislation. Taxation law only exists because of legislation, and therefore, all relevant legal principles originate from a specific provision of this legislation. Consequently, all the issues identified in Step 2 must now be related to relevant sections of the legislation. Where more than one section is applicable to the same transaction, it is important that you show an understanding of how these sections relate to each other and, ultimately, which must be applied to the facts under consideration. For reasons of both cost and practicality, condensed paper versions of the legislation may be prescribed, but if a full version of the legislation is required for your research, these can be accessed electronically from various sources: see [2.480]. The advantage of using online legislation is that it is usually more up to date than printed versions. Researching tax law issues is made easier because there is a wealth of resources available. These resources are commonly accessed in an electronic format, and excellent indexing makes researching these materials relatively easy: see [2.480]. Australian tax law is very well serviced with online primary research materials and commentary services. These services provide detailed commentary on taxation law, as well as full citation of all relevant tax cases decided by Australian courts and some leading overseas cases. They also report up-to- date consolidated legislation and all public rulings issued by the Australian Taxation Office. Your institution will usually have access to these electronic
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databases for use in your research, and your librarian will be able to guide you on how to use the search facilities provided by these services. [2.160] Case law. Relevant case authority should be introduced at this stage to support the legislation and legal principles used in your answer. Although the primary source of taxation law is legislation, the interpretation of this legislation by the courts is critical for the application of the law in practice. Cases relevant to the issues and principles that need to be discussed will arise from a variety of situations. Therefore, when identifying relevant cases, you should not only look for cases with similar facts but you must also research cases, where similar legal issues were considered by the court. For example, if the question requires discussion of the nature of a capital receipt, then look for the cases that consider this broader issue. A good starting point is to use prescribed texts and follow-up the cases that they refer to. Once the relevant cases have been identified, it is essential that you read the cases carefully to obtain a detailed understanding of how you can use these legal principles in your discussion of the problem. Cases referred to in the decision should also be pursued if they are significant to the law being discussed.
Example 2.3: Sample search using AustLII (Australian Legal Information Institute)
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To search for the case Commissioner of Taxation v Hart:
1 Go to the AustLII website: http://www.austlii.edu.au.
2 Click on “LawCite” which is located in the top red heading menu.
3 LawCite provides a number of options for finding a particular case. For example, if you know the full citation of the case (shown in the index or body of this text), this will be the most reliable search approach. To find FCT v Hart, you enter the citation “217 CLR 216” in the “Citation” search box and click “Search”. There will be a link to the full case shown under the case name at the top of the page and there is also a list of cases, where FCT v Hart has been cited.
4 If you do not have the full citation, you can enter the party’s name in the appropriate search boxes. The search may provide a list of cases with that name, so it is important to select the correct one. For example, FCT v Hart went all the way to the High Court, so unless you are looking at the history of the case, you need to select the High Court decision ([2004] HCA 26) rather than one of the lower court decisions.
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5 If the search returns too long a list of cases, you can limit the search by entering the court the case was decided in, for example, High Court of Australia. 6 LawCite can also be used to search for articles on areas of taxation law that you are researching. For example, if you type “avoidance” in the “Article Title” search box, a range of articles and cases will be returned and you can select any that seem to be relevant for your research. If you cannot easily find the case you are looking for on “LawCite”, there are other legal databases that may report the case and which may be available via your institution’s library: see [2.480]. [2.165] Reading and understanding cases. If you have difficulties reading and summarising cases, you may find the following approach helpful: see Figure 2.5. This approach breaks the process into a number of steps that are aimed at gradually building up your understanding of the facts, issues and legal principles arising from the judgment. Although this approach may be helpful, it cannot be overemphasised that there is no substitute for practice. You should read cases carefully until you have a good understanding of them.
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Figure 2.5: Steps for reading tax law cases
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Step 1: Gather basic information about the case before reading it in full. This ensures that when you read the case in full, you will have some understanding of the decision and the facts. This can be done from the headnotes (summary at the beginning of the case) or the first reading of the case. A basic summary should be made of the following: • The parties involved and who is the plaintiff (appellant) and who is the defendant (respondent). This is important as the judges may not refer to the parties by name but as “plaintiff” or “defendant”. • The transactions under consideration –for example, Sale of shares. • The taxation issues in dispute –for example, Was the sale capital or revenue in nature? • The decision of the court –for example, The sale was of a capital nature. Step 2: Summarise the relevant facts. One or more judges will describe the facts in detail, and this is usually found at the beginning of each judgment. Different judges may emphasise different facts, and this can impact on the decision reached by the particular judge(s). Once the facts are fully understood, it is important to summarise them in a diagram, a table or in text form: see Example 2.4.
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Example 2.4: C of IR (NZ) v Europa Oil (NZ) No 1 [1971] AC 760
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38 [2.170] PRINCIPLES OF TAXATION LAW 2020 Step 3: Identify the legal issues that are the basis of the dispute. Read the majority decision(s) first. This will be identified in the headnote. The goal in reading the case at this point is to clearly understand the taxation law issues that are the basis of the case. For example, in Europa Oil No 1, the central issue was whether the general deduction provision allowed a deduction for the full amount of an expense, which was clearly excessive, even though it was related to the operation of the business. Step 4: Read the majority decision(s) to understand the reasons for the court’s decision and any legal principles arising from the decision. More recent case reports may include headings, which can be very useful for identifying where in the judgment the reasoning for the court’s decision is explained. However, in older reports, this is not the case, and it is therefore important to mark these parts of the judgment.
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[2.170] Take detailed notes with references. As you read and research material for your assignment, you must take good notes and keep clear references of where you found your ideas and material. It can be very frustrating to remember that you read something relevant on a particular issue and then spend hours trying to find it again. It is also important to keep accurate references so that you are able to complete the necessary referencing when writing up your paper: see [2.250]. Keeping good notes will also help you organise the material into a logical sequence as the notes can be sorted and re-sorted into the appropriate order before you begin writing the paper. Experience has shown that taking notes, either electronically or in handwriting, is far more effective than highlighting text on photocopies of cases, etc. Highlighting text does not force you to write the ideas and concepts gleaned from your readings in your own words and can mean that you need to read the material again so that you can recall the importance of the highlighted text. Making reliable notes will save time and help you understand what you have read.
Step 4: Apply law to the problem [2.180] After identifying the relevant tax issues in the problem, applying the law to the facts is the second most important stage in your research. Some students perform poorly in their assessments because, even though they correctly identify the relevant law, they fail to apply it to the question asked. At this stage, it is critical that you apply the legal principles identified in the previous steps to the facts in the question. During the research phase, it is important to remember that the relevant legal principles need to be applied to the facts in the question. If this is done, it will assist with the final writing of the assignment because the relevance of the legislation and case authority will be constantly reviewed.
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When applying the law to the facts of the problem, it is essential that you consider both sides of any issue and never deliberately argue for the taxpayer or the Commissioner (unless asked to do so). Always research conflicting cases so as to gain a balanced and detached view of the law. A starting point in applying the law is to refer back to the facts being considered. You should then select one issue at a time and work on applying the relevant law to it. Example 2.5: Applying the case precedent to the facts Imagine a case where the relevant issue is whether the taxpayer is a resident of Australia for taxation purposes. How would you approach it? Here are the suggested steps: 1 consider which facts the courts have previously considered relevant when deciding this issue;
2 then consider to what extent these facts are present in the situation presented in the assignment;
3 then look in turn at each of the factors used by the court; and
4 this should help you reach a conclusion, as this approach often makes it apparent, where the strongest arguments lie.
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Tax rulings may be investigated at this stage to determine whether a ruling has been issued, which expresses the Commissioner’s view on how the law should be applied. It is important to remember that rulings are not legally binding on the courts and should mainly be used to obtain ideas on the types of legal issues that are raised by the facts. Rulings must not be used as the sole justification for your conclusion as they are not the legal authority but they can be referred to as an indication of the Commissioner’s view on the issue. When applying the law to the assignment question, do not avoid conflicting points of view simply because they fail to support your current line of argument. Generally, assessors are looking for you to demonstrate that you can consider conflicting authorities and recognise that there are other points of view.
Step 5: Form a conclusion [2.190] This is the final stage of assignment preparation. Although you should consider your possible conclusion during the writing process, it is important that you keep an open mind throughout the research phase so that you do not get locked into a narrow line of argument. It is dangerous to jump to conclusions as this can prevent different views emerging. The final stage of forming a conclusion is discussed in more detail at [2.260].
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Planning and writing [2.200] Once the research stage is completed, the actual preparation of the assignment should be quite straightforward, but before you begin writing the final paper, it is advisable to prepare a plan so that your paper is logically presented: see [2.210]. Then you need to work on:
• • • • •
the assignment’s introduction: see [2.220]; the body of the assignment: see [2.230]; citing authority: see [2.240]; referencing: see [2.250]; and the assignment’s conclusion: see [2.260].
Plan
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[2.210] It is important that you prepare a plan or a structure of how the assignment question is to be answered and how your arguments are developed. Much of the work for this plan has already been completed through the research stage, but now it is important that you organise the information collected into its logical structure. In your plan, briefly list the content of the introduction, the headings to be used in the body of the assignment and the main points to be made in the conclusion. Also, check that the order of headings is logical so that the assessor can follow the arguments presented. It is also important to gather together the information that you have on each of the issues and determine whether sufficient argument has been developed to support the conclusions. Some issues may be more important and require more discussion, but avoid concentrating on one issue and neglecting others.
Introduction [2.220] Having completed the research and developed a plan for the assignment, it should be a relatively straightforward task for you to write the paper. The introduction serves the important role of providing the assessor with an overview of the assignment and facilitate a better understanding of the arguments you are about to present. The content of an introduction may vary depending on the style required for the course, so it is important to follow any style guides provided. Different style requirements may require a summary of the question, an indication of the relevant facts and the assumptions made and a brief summary of the conclusion drawn. These variations in style should be noted from faculty style guides. However, it is wise to keep an introduction as brief as possible as it is
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only intended to provide an overview. It certainly should not contain any of the arguments presented in the body of the assignment.
Body of the assignment [2.230] Before writing the body of your assignment, check the requirements of the question to determine if any specific form of presentation is required, such as “advise the client”. Always present your answer using correct grammar and formal legal terms. Write using complete sentences and do not use slang. Assessors do not appreciate flippant assignments as they reflect badly on your attitude. Various approaches may be used for the body of the assignment. The essential objective, however, must be to discuss the law in relation to the issues identified in the introduction. If appropriate, the law should then be applied to the situation presented in the assignment question. It often helps use headings which will enable you to inform the marker about the particular aspect of the law or facts that are being discussed.
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Cite appropriate authority [2.240] Appropriate authority must be used to support all answers to taxation law problems. As the primary source of income tax law is legislation, the first authority given must be the relevant legislation. Relevant legislation should be cited early in the discussion, and it is important to make certain that sections are cited correctly. If a section is not cited correctly, it is not possible for an assessor to ascertain the level of knowledge shown in the answer because the information provided is incorrect. Where more than one provision is applicable, it is also important to show that you understand which provision has precedence and how this is determined. However, if your institution specifies a different style guide, please follow it, for example, whether to use footnotes or in-text referencing of legislation. The legal principles needed to resolve the issues arise from the legislation and, where relevant, appropriate case authority must be cited to show how the legislation has been interpreted. However, the extent of the discussion of these cases will vary depending on their importance to the resolution of the issue. It may be helpful to categorise cases as those to be discussed in detail because of their relevance to the problem and those merely cited to support a legal principle. When applying cases that are important to the discussion, it is not sufficient for you to summarise the facts and the decision of the court. What is required is an analysis of the decision and discussion of the court’s reasoning as applied to the facts. The aim is to show your understanding of the legal principles derived from the case and their application.
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42 [2.250] PRINCIPLES OF TAXATION LAW 2020 Where conflicting authority exists, discuss this conflict and give an explanation of why one authority was found to be more persuasive than another. Care should also be taken to identify differing facts that may have affected these decisions. If there is evidence to support the view that a case would not now be followed, this should be presented, but it is important not to disregard cases simply because they do not support your line of argument.
Referencing and secondary sources [2.250] Most assignments will require referencing, usually in the form of footnotes. This is essential to provide the assessor with details of your sources and to avoid claims of plagiarism. You must ascertain what referencing is required and the form of referencing expected. The Australian Guide to Legal Citation is an excellent reference for guidance on correct citation, and it is available online: https://law.unimelb.edu.au/mulr/aglc/about. However, if your institution specifies a different style guide, please follow it. Textbooks or other secondary sources must never be cited as authority because they themselves are interpretations of the law; only primary authority from legislation and cases should be referenced. Texts that are not primary authority should be listed only in the bibliography and not in the body of the assignment.
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Tax rulings are also not authority as to the law, but are the Commissioner’s view as to how the legislation could be applied to certain facts. Consequently, rulings must never be cited as authority and should only be used to report the Commissioner’s view, which may or may not be supported by your arguments.
Conclusion [2.260] Your written answer must contain a conclusion that addresses the question asked in the assignment. It is not sufficient to cover all the issues and then avoid coming to a conclusion. It is also important that your conclusion is supported by your arguments, rather than being merely an afterthought. Do not introduce new arguments or discussion in the conclusion as this indicates poor planning or uncertainty about the validity of the arguments already presented. When forming a conclusion, it is very important that you make certain that it follows from the discussion and is not based on a preconceived notion formed before researching the assignment. At all stages, try to avoid jumping to conclusions as this often leads you into an approach, where the conclusion is formed at the start and then the body of the assignment attempts to justify the conclusion. This approach is dangerous because it creates a narrow view of the problem and limits the breadth of research and discussion. Also, if the
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original conclusion is poorly formulated, the whole direction of the answer could be wrong. If you determine that the conclusion depends on information that is not provided in the question, it is important not to make assumptions that avoid answering the question. A better approach is to state what information would be needed to assist in forming a reliable conclusion and explain why this information is important. A brief comment could then be made on the different conclusions that may be reached depending on the additional information. Taxation law questions often do not have precise answers. It is important to come to grips with this reality and recognise that it is not the conclusion, but the discussion of the law that normally contributes to the bulk of the assessment. Where no clear conclusion can be formed, discuss all the arguments for and against the issues that arise. However, following the approach set out above should help you to develop a supportable conclusion.
Check you have answered the question [2.270] Finally, always ensure that you performed the precise task you have been set. A common mistake is that students merely outline the relevant area of law without actually applying it to the facts of the problem. Be thorough and logical in your analysis of the problem and ensure that you provide a clear justification, supported with authority, and explanation for each conclusion reached.
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Exam preparation [2.280] Previous discussion in this chapter detailed methods of developing general study skills and techniques during your course: see [2.70]. In addition to these general skills, particular attention is required throughout your studies towards preparation for the examination. Preparation for the examination presents two very specific challenges. The first is identifying the key examinable issues in the course and the second is developing problem-solving skills so that the key issues can be applied to new and unfamiliar tax law problems. The exam preparation techniques discussed at [2.290]–[2.330] focus on these critical areas.
Identifying examinable material [2.290] It is simply not possible for an examiner to cover every aspect of income tax law covered during your course in the final examination. Instead, the examiner will normally concentrate on the issues encountered in basic
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44 [2.300] PRINCIPLES OF TAXATION LAW 2020 transactions of normal employment, business or investment arrangements, as well as specific areas such as depreciation, capital gains tax, fringe benefits tax and goods and services tax. If a transaction contains elements that may point towards more specialised rules, you might be expected to demonstrate to the examiner that you are aware of those rules, but you would not normally be expected to apply them in detail in an introductory unit. Keeping a realistic perspective on the materials and, in particular, identifying which issues are almost certain to arise will help you allocate your revision time more efficiently. It will also help you to organise your revision notes so that you have covered the points that will earn you marks in the exam and to avoid detail highly unlikely to be examined. It is therefore very important to ascertain from staff and unit resources, which are the key areas to be studied and which require less detail. Clues to identify the most important areas of study can be obtained from the structure of lectures and the headings used in subject study guides, textbooks and the type of questions set for tutorial discussion and for assignments. Preparing your own summaries is also an important method of identifying which issues are critical and which are less important: see [2.70].
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Preparing revision notes and summaries [2.300] Preparing your own notes and summaries is crucial to your understanding of tax law, as merely reading your texts, however many times you do it, is generally not a reliable method of exam preparation. The exam lasts only a few hours, which means some 35 or more hours of lectures and many more hours of reading must be condensed into a manageable form. Preparing summaries will help you memorise key points and gain a better understanding of the law so that you are better equipped for answering problem- type questions. Thinking about how to express a point concisely and clearly, and writing it down once you have done this, will also embed the concept into your memory far better than continued reading of the same point. Preparing a summary will also help you quickly make the connections between differing arguments and differing issues. As you organise your notes by subject matter and issues, you will pull together all the arguments that must be raised in an exam answer. The importance of identifying key issues has already been made, and this must be your major objective when preparing summaries and review notes. Ideally, the final version of your review notes will be a summary of no more than 15–20 pages that acts as a checklist of arguments to raise, whatever the facts of the question. In the exam, you would not have time to research the issues to be discussed in a problem question. However, a checklist of issues or steps will enable you to
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simply apply the key points from your summary to the tax law issues raised by the facts of the question: see Figure 2.6. Organising your review notes into a checklist of arguments to be raised in an exam will take time because it requires a thorough understanding of the materials being studied. However, once done, it will improve your understanding, increase the chances of recall and provide a valuable reminder in open-book examinations.
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Figure 2.6: Summary of steps required to calculate net capital gain
Developing problem-solving skills [2.310] Taxation law is inherently complex and also considerably different from many other courses because it raises more questions than answers. However, there are some areas of certainty in tax law. For example, at one end of the spectrum are receipts that are unquestionably subject to tax (eg, wages and salaries) and at the other end are gains that are clearly not (eg, normal lottery winnings). Between these black and white ends of the spectrum is a vast range of murky greys. It is this grey area that provides the opportunity for assessors to set examination questions that require you to demonstrate your
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46 [2.320] PRINCIPLES OF TAXATION LAW 2020 knowledge and application of the law. Therefore, it is important to develop the skills needed to identify these doubtful areas of the law. Technical aspects of tax law, such as indexation of capital gains, discounting of capital gains, depreciation calculations and valuation rules for trading stock, are less contentious and can provide an opportunity to provide a precise answer. Much more difficult are the troublesome intermediate questions, such as: “Can this receipt be characterised as ordinary income or a capital receipt?” More often than not, there are no clear answers to this type of question. As a result, examiners are not looking for definitive answers, but will give most marks for sound discussion of the competing arguments that will influence the final decision.
Working in small groups [2.320] Working in a small group to practise past exam questions and problems set during the semester is a valuable means of developing and reinforcing the skills needed to identify the issues in problem-type questions. If you sit and practise old questions yourself, you may catch one-third of the issues raised by the questions. If you are very good, you may discover half the issues. But if you study with two or more other students, together you are more likely to find 80%–90% of the issues.
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Traps to avoid [2.330] There are no shortcuts to good exam preparation. Students who attempt to avoid the essential steps of preparing reliable and complete review notes and who do not practise identifying the issues in problem-type questions, generally do not perform well. The following approaches are to be avoided as they can lead to a false impression as to your ability to write a high-quality examination paper: • preparing answers to past exam questions or other problem questions before preparing and studying summaries can be very discouraging as it may lead you to think that the task is impossible; • using answers to past exam papers prepared by other students or supplied by instructors can lead to a false sense of security. When reminded of the issues, most students recognise the issues but are falsely led to believe that they could have recognised these issues themselves. Answers prepared by other students may also be wrong or incomplete; • preparing complete answers to past examination questions in the hope that similar questions will be asked in the current examination. Doing this tends to cause some students to hope that the prepared answer is relevant to the question and use it regardless;
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• trying to remember and understand cases and notes from just underlining and highlighting. Preparing summaries in your own words is a far more reliable method of study as it develops a better level of understanding.
Examination techniques
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[2.340] Most students can improve their performance in any examination simply by applying basic exam techniques. Sitting examinations is a very stressful experience, and strategies need to be learned and practised so that they are automatically followed in an exam regardless of the level of stress. The following examination techniques comprise an effective strategy for tackling any exam. Using these guidelines should always enable you to present your best possible examination paper: • Well before the exam, carefully read the materials provided in subject outlines, etc that explains the structure and format of the examination. Finding the examination is not as expected can add to the level of stress experienced: see [2.50] and [2.490]. • Only spend the amount of time on a question that is indicated by the marks allocated to it. For example, if a question is worth one-third of the marks, then only one-third of the time allowed for the exam should be spent on the question. In most cases, you will earn most of your marks in the early part of your answer, and if you are struggling with your answer, there is no point persevering. You will typically earn more marks if you go on to a question you can answer. • Make the best use of reading time. • Select the easiest question and do that first. This can have a number of advantages: it allows you to earn marks easily, it reduces your level of anxiety and you may be able to complete the question more quickly, thereby allowing more time for other questions. • Structure your answer so that you come to the point immediately. Do not give background, repeat the question or restate parts of the legislation or facts from cases. • Plan your answers with an outline of the relevant issues, cases and sections. However, do not waste time on an outline and remember to come to a supported conclusion. • Always list relevant sections of the legislation and case names. Check with your lecturer what level of citation is required for the examination. • Wasted time is your greatest enemy, and this is a particular problem in open-book examinations. Do not expect that you will have time to research an answer to a question during the examination time.
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Reading time [2.350] In some taxation exams, reading and/ or noting time is provided before the writing time commences. If this is available, it could turn out to be the most important 10 or 15 minutes in the exam. When the exam starts, there is an inevitable moment of panic. You can react to this phenomenon in one of the two ways. Some students switch into worry mode, losing valuable time and taking precious minutes to settle down to the point at which they can concentrate on the problems in front of them. Others exploit the time, turning directly to the exam questions and mentally noting (make notes if permitted) every point that comes to mind as they read through the questions.
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On the initial read through, you should, if permitted, use your summary notes and checklists to recall issues relevant to the problem. If writing is permitted during reading time, make brief notes to remind you of those issues when you later attempt the question. Also, use this time to make important decisions in relation to the time allocated to each question and which is the easiest question to start answering. During this time, you should also start to mentally prepare a plan for the first question you are going to attempt. If no separate reading or noting time is provided, it is important that you create your own reading and noting time by first reading the question carefully and then planning your answer. Avoid the temptation to immediately start writing and then find what you have done is incorrect. Too often, exam markers see large sections of an answer crossed out and started again. This is a serious waste of time. The only danger to be aware of when planning your answer is not to spend too much time on this task; a few minutes should be all that is necessary.
Open-book exams [2.360] Taxation exams are normally an open-book exam, meaning you will be allowed to bring into the exam any notes or texts or, at the very least, legislation. It is vital that you ascertain the conditions of the final examination at the start of the course because this will influence whether texts and Acts can be tabbed, noted and/or cross-referenced. Open-book exams in tax are in some ways something of a sham. The more you are permitted to bring into the exam room, the less opportunity there will actually be to use the materials. Students rarely finish tax exams early, and it is much more common to see students still writing as time runs out. With time an overwhelming constraint, making effective use of texts, notes or study aids means knowing exactly when and how to use the extra materials.
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Most importantly, you should realise that the materials are there mostly as a crutch to jog your memory or remind you of the steps to take in answering a question. There will not be time in an exam to look for the answer to a question. You either know the tax issues and just need your notes to remind you of the relevant sections or cases or you do not know how to tackle the problem. If you do not know what law is relevant, you are far better off moving on to the next question than trying to research the area from scratch. It is unlikely you will win more than a mark or two from panicked research in the exam room, and the effort may cost you many more marks you could have earned in other questions.
Answering multiple choice [2.370] Multiple- choice questions are sometimes used in taxation law examinations to enable the assessment of a wide range of the material covered in the subject. This type of question allows the examiner to broaden the coverage of the course content, enabling some of the more specific and technical areas to be examined. However, tax law differs from many other subjects in that there may not be a definitive answer to a question. This means that, in a multiple-choice question, more than one answer could appear to be correct, and the trick is not to look for the “right” answer, but rather for the “better” or “most appropriate” answer.
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Good preparation for answering multiple-choice questions is similar to the preparation used for most types of tax law examination questions. Reliable and concise summaries will enable you to quickly access the detail needed to answer these questions in an open-book examination or to study for closed- book examinations. Before commencing multiple- choice questions, check whether marks are deducted for incorrect answers. It is important to do this because it is unwise to guess if marks are lost for wrong answers. Deducting marks for incorrect answers is not very common and is usually only the case, where you are not informed how many of the options are correct and you are required to select one or more of the options presented. It is also important to determine, before commencing, the amount of time that should be allowed for each question and whether all questions carry the same marks.
Strategy [2.380] Most multiple-choice questions commonly have four to five alternative answers to select from and, because of the nature of taxation law, more than one of the answers may appear to be correct, but only one will be the most appropriate. For example, if the facts presented in a question mean that more
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50 [2.390] PRINCIPLES OF TAXATION LAW 2020 than one provision of the Act is applicable, the examiner is testing whether you understand which provision has precedence. More than one alternative may be correct, but the alternative that is the most appropriate is the one that applies the correct legislation. Example 2.6: Test of the most appropriate legislation Section 15-2 of ITAA 1997 only applies if a benefit is not ordinary income under s 6-5: see s 15-2(3)(b). Therefore, if s 6-5 makes the benefit in the question assessable, then s 15-2 does not apply and would be an incorrect answer even if s 15-2 is also applicable. Where more than one alternative is correct, another strategy used by examiners is to include statements such as “none of the above” or “all of the above”. These alternatives need to be considered very carefully because they may be used to test whether you recognise alternative arguments. One of the most important tips in answering multiple-choice questions is to first identify the possible answers by eliminating the obviously incorrect answers. For example, if the question requires a decision as to whether a receipt is assessable, two alternatives may say that it is assessable and two may say that it is not. In this case, it is first necessary to decide whether or not it is assessable and then to select the best answer from the remaining two options.
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Answering problem questions [2.390] The notes on preparing for tax exams at [2.280] and preparing for assignments at [2.110] have stressed the importance of finding the legal issues used to answer questions, rather than finding the answers themselves. Problem questions test your ability to identify the law relevant to the problem and to distinguish competing arguments and then form a well-supported conclusion. The facts of a problem question are very deliberately chosen, and so no clear- cut answer is possible. At the back of an assessor’s mind, there is probably an idea of a preferred conclusion. However, full marks could still be given to a student coming up with the different conclusion, provided the answer canvasses all the arguments and puts forward a persuasive conclusion using relevant cases and sections that support the answer. Problem questions are not marked according to a “right” answer. Instead, marks are awarded for developing arguments and pursuing any possible tax implication arising from the facts.
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Identify the relevant law [2.400] A well-constructed answer to a problem question first requires you to identify the relevant taxation law issues that relate to the facts presented in the problem: see [2.140]. This step is essential as problem-type exam questions are meant to test your ability to apply the law to unfamiliar fact situations. If there is a range of issues raised by the facts, you should first identify all these issues and then commence to discuss the most important first. Example 2.7: Legal expenses Consider a question in which a taxpayer incurs a legal expense akin to a fine but which is not actually a fine or a penalty covered by the legislation. To approach this question, the first step would be to consider whether the expense satisfies the positive limbs of s 8-1(1) of ITAA 1997. In other words, does the expense have a nexus with the derivation of assessable income either directly or through a business?
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There is some doubt about the tax effect of various types of legal expenses, and while generally the courts have been sympathetic to taxpayers seeking deductions for these expenses, in some situations, the outgoings have been characterised as quasi-personal or insufficiently connected with income derivation to satisfy the positive limbs.
If a problem question appears to have a very clear and definite answer, it would be wise to give the question additional thought as it is unlikely that an instructor would set a 20 or 30 mark question if the answer were that simple. In practice, the instructor will have deliberately chosen facts designed to give you the hooks on which you can hang a whole range of issues, so it is vital that you use your summaries to identify all these issues.
Apply the law to the facts [2.410] It is not sufficient in the exam to just identify the issues and discuss the relevant law in general. Problem questions require you to apply the law to the facts and reach a supportable conclusion. At this point in your answer, it is necessary to describe the competing views and support your answer with case references. It is important not to immediately form a conclusion, but to explain the competing arguments so that the marker can see that you understand the alternative views that may exist.
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Example 2.8: Explore all options Every time you reach an apparent end of the road, you must look for and pursue all other possibilities. Following on from Example 2.7, if you conclude that an expense does not satisfy the positive limbs of s 8-1(1) of ITAA 1997, be prepared to concede the matter is not certain and still consider what would be concluded if it does satisfy the positive limbs. At that point, you should move on to the negative limbs in s 8-1(2). Some of these lead to their own dead ends. If the expense is personal, there is no deduction; if the expense is incurred to derive exempt income, there is no deduction; and if a deduction is expressly prohibited by another section of the Act, there is no deduction. However, the capital exclusion opens the door to a range of possibilities, all of which should be considered. For example: • It may be that the expense can be depreciated or amortised under one of the capital allowance regimes; for example, the depreciation provisions. • In some instances, the expense can be added to the cost of another asset for capital gains tax (CGT) purposes. • In other cases, a capital expense may be eligible for deduction under the “black hole” provisions in s 40-880.
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Present a conclusion [2.420] Having presented the competing arguments, it is important to arrive at a view as to which case is stronger and therefore what you believe would be the outcome if the issue was decided by a court. The conclusion is important to show the examiner that you have weighed up the arguments and are able to ascertain what you believe is the stronger argument. If you believe the facts are too vague to be able to form a well-supported conclusion, then you should explain what additional information would help to form a more certain conclusion. Examiners are not looking for a so-called right answer, but will award marks for the identification of the correct issues, the appropriate application of the law supported by case and legislative authority and, finally, the formation of a well-supported conclusion. Students who form different conclusions on the same question may still receive high marks provided they have made a well- argued case to support their analyses. In taxation law problems, it is not the conclusion that normally earns the majority of the marks, but the analysis used to support that conclusion.
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Sample examination answers and analysis [2.430] To illustrate the important aspects of preparing sound exam answers, the following examples are used to highlight some of the common mistakes made and the characteristics of a well-argued answer. The first example does not necessarily demonstrate a poor knowledge of the law, but it is poorly structured and shows poor exam technique. The question to which the following answers were given is in part as follows:
Example 2.9: Sample examination question and answer Microhard is a computer software company. Its principal product was a database program called Xhell. Microhard decided to expand its line of software to include a word-processing program. It worked on the design of the new software, which it decided to release under the brand name “Wurdperphect”. The following events followed that decision. Soon after the release of the program, a competitor, the “Courelle” company, sued Microhard, claiming the name of its word-processing program was copied off Courelle’s word-processing software, “Wordepurfex”. Microhard incurred $500,000 legal fees to fight the action, which was eventually settled when Microhard paid Courelle $4 million to drop the suit. Required: Discuss the deductibility of the above transactions and events.
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To assist with the analysis of the answer, it has been broken down into parts, with each section identified by a letter. These letters are used as a reference for discussion. In some parts, the full answer has not been reproduced. ANSWER 1: A A taxpayer’s taxable income is determined by aggregating all assessable income and then deducting from such all allowable deductions (s 4-15(1)). Under s 8-1, there are six limbs to the general deduction provision, two positive and four negative limbs. Microhard would be seeking to claim the $500,000 and $4 million payments to Courelle as deductions therefore lowering its assessable income.
B Under s 8- 1(1)(b), you can deduct a loss or outgoing if it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income or for carrying on a business for the purpose of gaining or producing assessable income.
C As a general rule, the Commissioner cannot decide whether the expense incurred by the taxpayer was warranted. His only power is to decide whether it is wholly or partially deductible.
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D In Magna Alloys & Research v FCT (1980) 11 ATR 276, four agents and three directors were accused of conspiracy. Prosecutions went ahead against the company, and Magna Alloys incurred numerous costs. The question put was whether the company was able to deduct costs involved in defending the directors. E The Court held yes because: “necessarily does not mean that the loss of outgoing was unavoidable or essentially necessary, rather the expenditure must be appropriate given the taxpayers business and adapted for the ends of the business carried on, for the practical purposes and within the limits of reasonable human conduct, it is for he who conducts the business to decide what is necessarily incurred and what is not …” (more quotes from a text). F … Microhard appears to be relying on Magna Alloys, however the Commissioner will rely on the judgment in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 (H&WT). In this case, certain articles … . G The compensation appears to replace some of the income stream; therefore, it is assessable under s 15-30. However, in McLaurin v FCT (1961) 104 CLR 381, its assessability depends on whether the components of capital and income can be separated. It appears they cannot. H Thus, I believe the $500,000 will be held to be deductible because it was a necessary expense, and the $4 million will not be deductible because it is not a necessary expense in carrying on a business. [2.440] It is evident that the answer in Example 2.9 has not been planned. There is no clear identification of the critical issues that require discussion and no headings have been used. Consequently, the answer is disjointed and vague. Because no clear issue is first identified, there is no purpose or clear direction to the discussion. An obvious alternative approach to this question would have been to recognise that there are two different expenses and to discuss them separately, identifying the issues relevant to each. Failure to do this has made the answer disjointed, and it has been difficult to formulate the arguments for and against these issues. The introduction in paragraph A is irrelevant to the question. It does not come directly to the point of stating the issues that require discussion; instead, it makes a general statement that does not show that the student understands the question. Paragraph B comes the closest to identifying an issue “is the expense necessarily incurred?”, but unfortunately, this is not the primary issue and it does not state which expense it relates to and the section number is quoted incorrectly. It is difficult to understand why this issue was selected as
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the main area for discussion, but from later parts of the answer, it may be speculated that it is because it was taken directly from a text and that the real issues had not been understood. The statement made in paragraph C is an extension of the issue cited, but does not add to the answer and is no more than the obvious statement that the taxpayer will be arguing for the expenses to be deductible. Discussion in paragraphs D and E is relevant to the issue stated in paragraph B, but it is little more than a restatement of the facts and the decision of one case, and the language used suggests that it may have been copied directly from a secondary source. The case used is relevant to the issue, but paragraph E does not relate to the Court’s decision to the problem. The point in paragraph F that the Commissioner would rely on the case H&WT shows a lack of understanding of the case as it would also support the taxpayer’s view. Paragraph G is the first attempt to apply the law to the facts, but it is done without justification and introduces a new section of the Act without any discussion. The issue of whether the expense is a capital or income in nature (one of the main issues) is first mentioned, but in relation to an assessable income issue which is totally irrelevant given that this is a deduction question. Finally, in paragraph H, a conclusion is drawn, but it is based on a statement of belief, rather than deriving from the arguments.
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[2.450] The following sample answer given in Example 2.10 demonstrates how the question could be answered in a more structured form, separately discussing the main issues raised. This answer also follows the analysis process described at [2.120]. Example 2.10: Sample examination question and answer ANSWER 2 $4 million settlement 1. Does it satisfy the positive limbs of s 8-1? Is it incidental and relevant to the earning of assessable income? In H&WT, the Court said damages for defamation are an ordinary expense for a newspaper as it is impossible to publish a daily paper and not defame someone now and then. This may be distinguishable from our case, as releasing new products and passing off someone else’s name is not an ordinary day-to-day event for this company the way writing articles is for a newspaper. However, releasing products is part of a software business and you always run the risk of someone claiming your name is similar to theirs, so this should be considered ordinary enough to satisfy the positive limbs.
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The argument that “damages” or similar payments are non- deductible “quasi-personal” expenses, that is, they are not incurred in a business capacity since businesses were not supposed to commit wrongs, appears to be defeated by H&WT. Damage expenses for wrongs can be ordinary business expenses and satisfy the positive limbs of s 8-1 (H&WT).
2. Do any of the negative limbs deny the deduction?
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The only relevant negative limb is the “capital” exclusion. Could this be a capital expense? It is not regular, which suggests capital sometimes. Applying the Sun Newspaper arguments, it could be argued that the expense goes towards the income- earning process. In the highly competitive world of software, new products and new releases are an essential part of doing business and the risk of associated legal suits is a normal incident of the income-earning process. The contrary argument is that this product is at the heart of the taxpayer’s business. This goes to structure more than process because it is not part of the software development and marketing process, but rather deals with the right to sell the product itself. In contrast, it could be argued that no-one is stopping them from selling the product, just disputing the name they are using to label the product, so damages to use the name goes with the day-to-day marketing of the product. Both arguments are valid, but, in this day and age of rapid and changing product development, the name is less likely to be part of the profit-earning structure itself and is more likely to be part of the process of operating the structure.
3. What if it is capital?
It is concluded above that this expense is not likely to be capital, but if it is, it is necessary to determine if any specific provision allows a deduction in part or in full. In this case, no specific provision is applicable unless the expense can be included in the cost base of an asset for CGT purposes. Legal expenses
1. Does it satisfy the positive limbs of 8-1?
The Commissioner used to argue legal expenses incurred as a result of wrongdoing did not meet the positive limbs because they were not connected with the income-earning process but rather with wrongdoing by the taxpayer. Snowden & Wilson and Magna Alloys show that courts have not accepted this argument, and legal expenses can be legitimate business expenses provided they are appropriate or adapted to the business activity.
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Since all business carries the risk of civil litigation and if you are sued in business you have to defend yourself, it is reasonable to conclude that Microhard is doing just that. Its legal expenses are therefore incidental and relevant, thus satisfying the positive limbs. This argument is similar to that presented for the damages. 2. Is it knocked out by a negative limb? The arguments about revenue versus capital for the damages apply equally to the legal expenses. However, there is an additional element to consider for the legal expenses. There is a line of cases that holds expenses incurred to defend title to an asset are capital expenses. Originally, these were current expenses (Hallstroms), but this was changed by the tests in Sun Newspaper, which characterised them as capital expenses as in the Broken Hill case. The facts in this problem imply that Microhard is defending title to the name, and therefore, the legal expense is most likely capital. 3. What if it is capital? No specific provision allows any deduction in part or full for this expense. However, the fifth element of cost base for CGT (s 110- 25(6)) allows the inclusion of the costs of defending title of an asset. In this case, if Microhard has registered the name Wurdperphect, they can add the litigation costs to the cost of the asset (being their rights to use the name), meaning they will recognise the cost if they dispose of the name.
Additional examination tips [2.460] Following are some additional points that you should bear in mind when preparing answers to problem-type examination questions: • Marks are given for developing an argument and counterargument. Never quote assertions from a text or handbook to back up an argument. The guides and handbooks contain summaries of the law generally, but they are not authority on the resolution of particular fact situations. • Identify cases sufficiently so the instructor will know which case you are referring to (check if there are rules on the citation required for exams at your institution). • Do not repeat the facts of the case without using them. Normally, there are no marks for explaining what happened in a case. Marks are usually awarded for showing how the facts support one conclusion or are distinguished to support another conclusion.
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58 [2.470] PRINCIPLES OF TAXATION LAW 2020 • Do not quote from the legislation. Marks are allocated for the application of the legislation to the problem, not quoting from the legislation. It is essential to cite legislation correctly, but it is a waste of time quoting words from the Act. • Do not stop at your first answer. Remember, this is a problem question and there may be further issues. If you have prepared your review notes properly, you should be able to run through a full flowchart of issues likely to be raised by income and deduction problems. Every time you reach an apparent end of the road, you must look for other possible forks in the road and consider all the possibilities. • Organise your answer using headings and subheadings. An organised answer makes the instructor realise you appreciate the range of issues raised by the problem and helps ensure you do not miss any flow-on issues. If you think of an additional point later, jot it down so you do not forget it and add it on at the end of the answer.
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• Write neatly. It seems trite to advise anyone to write legibly, but the importance of having a legible exam answer cannot be underestimated. If your handwriting is difficult to decipher, the instructor will lose the trail of your argument as too much effort is needed to actually read the words themselves. By the time the instructor reaches the end of a point, he or she could have forgotten points made earlier. Take the time to make it legible. • Who are you advising? In a general question, you might be expected to canvass all the tax consequences of a transaction for all parties. But if you are asked to give advice to a particular person, many issues can be ignored. For example, if the question says “Advise the employee”, it is irrelevant to the problem whether the employer can deduct an expense mentioned in the problem. In some cases, however, the impact on other persons might be important. For example, if the question asks you to advise the employee on the assessability to the employee of a non- cash benefit, you would first have to determine whether the benefit is a fringe benefit to the employer to determine if the benefit is excluded from the assessable income of the employee.
Using this chapter [2.470] To gain the most from the content of this chapter, it is important that you use it early in your course so that you are well prepared to develop a sound study plan. However, it is also useful to continue to return to this chapter to help with specific study or assessment issues that you may face throughout the course. The techniques presented in this chapter aim to improve the efficiency and effectiveness of your study skills to enable you to gain the most from your
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taxation law course and to perform your best in the assessment. These techniques can also be adapted to suit existing study and learning patterns.
Resources Internet [2.480] Internet resources are a very valuable source of information relating to current tax issues. Listed below are some useful sites.
General • Australian Taxation Office: http://www.ato.gov.au. This site contains valuable information, such as rulings, court and tribunal decisions and information guides. These can be accessed from the “Legal Database” tab at the top of the page.
Reported cases • Australasian Legal Information Institute (AustLII): http:// www.austlii. edu.au. This site has an extensive case database, as well as journals, consolidated legislation, Bills and Explanatory Memoranda to Bills. See Example 2.3.
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Legislation • Australian Taxation Office: http://www.ato.gov.au. At the top right of the page, click on “Legal Database”. Then click on “Quick access” and then “Legislation”. Select the correct Act from the drop-down box and type in the section you are looking for in the “Provision” box. • Parliament of Australia Bills: http://www.aph.gov.au/bills. This site contains the content of Bills (including income tax Bills) that have not yet become legislation. You can also track their progress through this website. • Australasian Legal Information Institute (AustLII): http:// www.austlii. edu.au. This site publishes consolidated legislation, Bills, Explanatory Memoranda to Bills and cases. Use the search option at the top of the page to find a particular Act. • ComLaw: https:// www.legislation.gov.au/ . This site contains consolidated legislation, Bills, Explanatory Memoranda to Bills, Legislative Instruments and Statutory Rules. After selecting the appropriate area use the alphabetic list to find the required legislation etc.
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60 [2.490] PRINCIPLES OF TAXATION LAW 2020
Policy
•
Tax reform: https://treasury.gov.au/review/tax-white-paper/why-tax- reform-and-why-now. This site brings together the submissions and discussion towards a review of the Australian taxation system.
• Australian Treasury –Taxation policy: https://treasury.gov.au/policy- topics/ taxation. This site details Tax Bills and current and future initiatives for the Australian taxation system. • Australia’s Future Tax System Review Panel: International Comparison of Australian Taxes: http://comparativetaxation.treasury.gov.au. This site contains a 2006 Government study that compared Australia’s tax system to those of other developed countries. • Federal Budget: http:// www.budget.gov.au/ . This site contains the most recent Federal Budget. • Board of Taxation: taxboard.gov.au. This site contains information on proposed tax law changes. • Tax Practitioners Board: http://www.tpb.gov.au/. This site contains the policies and requirements for registration as a tax agent, BAS agent and Tax (financial) Advisor.
Copyright © 2019. Thomson Reuters. All rights reserved.
Glossary of terms used in assignments and exams [2.490] The following glossary lists some of the terms commonly used in assignments and exam questions. Note that a glossary of terms may be included with your course outline and the meanings given there should be used ahead of this list. • Analyse –You should break the topic or case into its component parts or show the essential components of the topic or case. • Compare –You are to show how the two (or more) things are alike. Note that it is sometimes necessary to show how they differ so that the essential likenesses are stressed. For example, “Compare the decisions of the High Court in Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430 and FCT v Isherwood and Dreyfus Pty Ltd (1979) 9 ATR 473”. • Contrast –You are to show how the two (or more) things differ. Note that it is sometimes necessary to show how they are similar so that the essential differences are stressed. For example, “Contrast the decisions in Myer Emporium v FCT (1987) 163 CLR 199 and Westfield v FCT (1991) 21 ATR 1398” or “Contrast the reasoning of the majority and the dissenting judgment of Brennan J in FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277; 16 ATR 567”.
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• Critically examine (or critically discuss) –You are required to write a study of the good and bad points and come to some conclusions. • Define –You should distinguish this topic from all others like it. The clarity of your definition will be the main consideration. • Discuss –You should explain and assess the importance of the features of the topic with a fairly full treatment of all the main points. It may be necessary to introduce specific illustrations, quotations or details of cases where relevant. Any implications of the topic should be covered.
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• Explain –You are to show the examiner that you understand the particular issue mentioned. • Evaluate –You are required to weigh the topic carefully and make some judgments or come to some definite conclusions about the topic. For example, “Evaluate the significance of Lord Denning’s judgment in Newton v FCT (1958) 98 CLR 1 on the effectiveness of s 260 of ITAA 1936”. • Justify –You are required to produce evidence for your decision or view. • Summarise –Present briefly, but leave out nothing of importance. For example, “Summarise the reasoning of Barwick CJ in Curran v FCT (1974) 5 ATR 61 on why bonus shares have a cost to the person receiving them”.
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3 The taxation formula
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Key points...................................................................................................... [3.00] Introduction.................................................................................................. [3.10] Power to tax.................................................................................................. [3.20] Australian taxes............................................................................................ [3.30] Medicare levy................................................................................................ [3.40] Basic levy payable.................................................................................. [3.50] Relief for low-income earners............................................................... [3.60] Exemptions............................................................................................. [3.70] Medicare levy surcharge....................................................................... [3.80] Government study and training support loans.......................................... [3.90] Introduction to income tax........................................................................ [3.100] Income tax burden...................................................................................... [3.110] The income tax formula............................................................................. [3.120] Taxable income.................................................................................... [3.130]
Assessable income.................................................................................. [3.140] Deductions................................................................................................ [3.180] Income tax rates................................................................................... [3.190] Individuals................................................................................................ [3.200] Other entities............................................................................................ [3.210] Tax offsets............................................................................................ [3.220] Questions..................................................................................................... [3.230]
Key points [3.00] • The primary aim of the taxation regime is to provide government revenue and fund government expenditure, although the tax system also has broader socio-economic purposes.
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64 [3.10] PRINCIPLES OF TAXATION LAW 2020 • Over 90% of total Commonwealth Government revenue is sourced from taxation revenue, primarily income tax revenue. • Section 51(ii) of the Australian Constitution grants the Commonwealth Parliament the power to “make laws … with respect to … taxation”. • The income tax system also serves as a basis for the collection of certain other amounts, such as the Medicare levy and repayments under the higher education government assistance programs. • Section 3-5 of ITAA 1997 provides that income tax is payable for each year by each individual, company and certain other entities. • Taxpayers are required to calculate their income tax for the financial year according to the formula: Income Tax = (Taxable Income × Rate) –Tax Offsets, which is set out in s 4-10(3). • Taxable income is calculated according to the formula: Taxable Income = Assessable Income –Deductions, which is set out in s 4-15.
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Introduction [3.10] This chapter provides an overview of the Australian tax regime, in particular, the income tax system. The Australian tax system plays an important role in Australian society as it is the main source of funding for government expenditure. Government revenue is required to fund the provision of goods and services which are considered “public goods”. These are goods and services which the market is unlikely to satisfactorily provide due to the fact that there is no additional cost from additional use of these goods and services, and it is not possible to exclude a person from using these goods and services. One example of a public good is a lighthouse. It is not possible to exclude any ships at sea (or anyone in the area) from seeing the lighthouse, and there is no additional cost incurred for additional ships at sea using the lighthouse. A second function of government is to provide social goods, such as education, health and defence services. These are goods which could potentially be provided by the private sector, but which Australians have generally chosen to provide universally through government using universally paid tax revenue rather than user-pays levies. A third function of government is one of redistribution. Through the welfare and social security systems funded by tax revenue, the government transfers funds from those who have benefited from the market and enjoy a greater ability to pay to those who have been less fortunate in the market economy. Chart 3.1 illustrates the distribution of projected Australian Commonwealth Government expenditure of $500.9 billion for the 2019–2020 income year.
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Chart 3.1 Projected Commonwealth Government expenditure 2019–2020
In addition to funding the government functions discussed above, the tax system also has broader socio-economic purposes. The tax regime may also be used for the purposes of social engineering, that is, encouraging certain behaviour and discouraging other types of behaviour. For example, the provision of a tax deduction for donations to charities is designed to encourage taxpayers to donate to needy causes. Similarly, tax offsets for expenditure on research and development are intended to promote research and development activity in Australia. On the other hand, the so-called “sin taxes” on alcohol, tobacco and gambling are designed to discourage particular types of consumption. The “alcopops” tax is an attempt at curbing excessive alcohol consumption among younger Australians. The introduction of a tax on fast food or sugar is often suggested as a means of reducing obesity. Taxes on petrol are intended in part to discourage excessive usage of polluting fuel and to encourage manufacturers to produce more fuel-efficient (and hence cheaper-to-operate) vehicles. When used in these ways, tax tends to be a blunt instrument with varying degrees of success. For the 2019–2020 tax year, the income year we are focusing on, it is predicted that total taxation receipts will be approximately $466.4 billion. This amount is expected to contribute approximately 92% of total government revenue. Table 3.1 highlights the importance of taxation revenue in Australia.
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66 [3.10] PRINCIPLES OF TAXATION LAW 2020 TABLE 3.1 Australian Government general government receipts Actual
Estimates
Projections
2017– 2018
2018– 2019
2019– 2020
2020– 2021
2021– 2022
2022– 2023
418.1
448.8
466.4
486.4
514.3
528.7
Growth on previous year (%)
10.2
7.4
3.9
4.3
5.7
2.8
Per cent of GDP
22.6
23.1
23.3
23.4
23.7
23.3
354.9
383.2
399.2
416.4
440.8
451.3
Growth on previous year (%)
11.1
8.0
4.2
4.3
5.9
2.4
Total taxation receipts ($b)
Tax receipts excluding GST ($b)
Per cent of GDP
19.2
19.7
19.9
20.0
20.3
19.9
Non-taxation receipts ($b)
28.9
36.3
39.1
35.9
36.7
38.2
Growth on previous year (%)
−5.7
26.0
7.6
−8.1
2.1
4.0
1.6
1.9
2.0
1.7
1.7
1.7
446.9
485.2
505.5
522.3
551.0
566.9
9.0
8.6
4.2
3.3
5.5
2.9
24.2
25.0
25.2
25.1
25.4
25.0
Per cent of GDP Total receipts ($b) Growth on previous year (%) Per cent of GDP
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Source: Table 1, Budget Paper No 1 2019–20, Statement 4: Revenue
As indicated by Table 3.1, non- taxation revenue contributes a very small percentage of total government revenue. In Australia, non-taxation revenue generally consists of income from the sale of goods and services (privatisation or user-pays levies) and returns on investments. Other means by which governments can raise revenue include nationalisation (where governments appropriate private assets for public good) or simply printing more money. However, these options are suboptimal as they are likely to have negative effects. Nationalisation deters private investment while printing money will cause inflation. Privatisation is one option for raising revenue, but also raises problems in that there are some goods or services which cannot or should not be privatised, and there are a finite number of goods and services which can be sold. User-pays levies are one alternative to taxation, but are not appropriate for “public goods” and may be considered unsuitable for certain social goods and services. For example, a user-pays levy for healthcare may result in low-income individuals being unable to obtain adequate healthcare services. Governments can also fund expenditure through loans from international organisations, other governments or private investors.
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However, there is a limit as to how much debt countries can enter into, and debt funding incurs interest expenses which further increase government expenditure. As such, taxation is generally the largest source of government revenue in most countries.
Power to tax [3.20] The Commonwealth Government’s power to impose taxes stems from the Australian Constitution. Section 51(ii) of the Constitution grants the Commonwealth Parliament the power to “make laws for the peace, order and good government of the Commonwealth with respect to … taxation”. Section 51(ii) also provides the Commonwealth Government with the power to impose laws regarding the collection and administration of taxes. For the purposes of making tax laws, “taxation” is generally defined as a “compulsory exaction of money by a public authority for public purposes, enforceable by law, and is not a payment for services rendered”: Matthews v Chicory Marketing Board (1938) 60 CLR 263 at 270. It has also been said that “tax” is not a penalty and it cannot be arbitrary (ie, a tax liability must be capable of being determined in accordance with specific criteria): MacCormick v FCT (1984) 15 ATR 437 at 446.
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Section 51(ii) also specifies that any laws with respect to taxation cannot discriminate between the States or parts of States. Section 114 prevents the Commonwealth Government from imposing any tax “on property of any kind belonging to a State”. When passing taxation laws, the Commonwealth Parliament must ensure that the laws imposing taxation deal only with the imposition of taxation and deal with one subject of taxation only: s 55 of the Constitution. Any provision in an imposition Act which deals with another matter will have no effect. This explains why we have so many different Commonwealth Acts which impose different types of taxes. Taxation revenue is raised through a number of different taxes, such as income tax, fringe benefits tax, goods and services tax (GST), excise duties, customs duties, luxury car tax, wine equalisation tax and other indirect taxes, each of which is imposed in a separate Act. For each type of tax, we generally have an imposition Act (which imposes the liability for the tax), a rates Act (which specifies the applicable rate of tax) and an assessment Act (which sets out the rules for working out what is subject to tax or how to calculate the tax payable). For example, we have the Income Tax Assessment Act 1936 (Cth), the Income Tax Assessment Act 1997 (Cth), the Income Tax Rates Act 1986 (Cth) and the Income Tax Act 1986 (Cth), all of which deal with the income tax. We have the Fringe Benefits Tax Assessment Act 1986 (Cth) and the Fringe Benefits Tax Act 1986 (Cth) for the fringe benefits tax and A New Tax System (Goods and Services Tax) Act 1999 (Cth) and A New Tax System (Goods and Services Tax
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68 [3.30] PRINCIPLES OF TAXATION LAW 2020 Imposition –General) Act 1999 (Cth) for the goods and services tax. As required by the Constitution, the imposition Acts (eg, Income Tax Act 1986; Fringe Benefits Tax Act 1986) are relatively short and only deal with the imposition of tax and with only one type of tax. The Constitution also addresses the distribution of taxing rights between the Commonwealth and State Governments. Some taxes may be imposed at only one level of government (State or Commonwealth), while other taxes may be shared by both levels of Government. For example, s 90 of the Constitution stipulates that customs and excise duties can only be imposed by the Commonwealth Government. Income tax, on the other hand, may be shared by both levels of government and, from 1915 until 1942, both State and Commonwealth Governments imposed income tax in Australia. Prior to 1915, only State Governments imposed income tax, and since 1942, only the Commonwealth Government has imposed income tax. State Governments continue to impose a number of taxes, such as stamp duty, land tax, payroll tax and various transaction-based taxes, but the revenue from these taxes is insufficient to fund the services provided by State Governments, such as health and education. The introduction of the GST in 2000 was, in part, an attempt to provide State Governments with a guaranteed source of funding. Although GST is imposed and collected by the Commonwealth Government, all GST revenue is distributed to State Governments under an agreement between the Commonwealth and State Governments.
Australian taxes
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[3.30] Australia’s taxation revenue comprises a number of different taxes. Chart 3.2 illustrates the different sources of revenue in Australia.
Chart 3.2 Projected sources of revenue in Australia 2019–2020
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As the Australian income tax system is the largest contributor to Australian taxation revenue, it is the primary focus of this book. The Commonwealth Government’s 2019–2020 Budget estimates that income tax will contribute approximately 73% of total taxation revenue for the 2020 income year. We generally think of income tax as tax that we pay on common receipts, such as salary, wages, business income, interest, dividends and rent received. However, also included in the estimates of total income tax revenue is revenue collected through the taxation of capital gains. This is commonly referred to as capital gains tax, but it is important to note that, as discussed in Chapter 11, capital gains tax is not a separate tax. Rather, net capital gains form part of the taxpayer’s assessable income for the purposes of determining the taxpayer’s income tax liability.
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Related to the imposition of income tax on services income is the fringe benefits tax. As discussed in Chapter 7, this is a tax imposed on employers on the provision of benefits to employees (ie, in substitution of income). Although the fringe benefits tax only raises a small portion of total revenue, it serves an important role by ensuring that all benefits received in a services context are subject to tax. The most recent substantive change to Australia’s tax regime was the introduction of a GST in 2000. GST, as discussed in Chapter 25, is different to income tax in that it is an indirect tax. An indirect tax is one which is embedded in the price of goods or services and collected by an intermediary from the entity which ultimately bears the economic burden of the tax. In Australia, for example, GST is collected by suppliers of goods or services when they receive payment for their supplies. This aspect of the GST (and other indirect taxes) makes it attractive from an administrative perspective as it is easier to calculate and collect taxes owed, and there are fewer taxpayers to look after. Other examples of indirect taxes include customs duties (eg, on imports such as motor vehicles or clothing and footwear), excise duties (eg, on petrol, diesel, beer, tobacco and other alcoholic beverages) and agricultural levies (eg, on chicken meat).
Medicare levy [3.40] The Australian tax system also serves as a collection mechanism for various other amounts that may be payable by Australian tax residents. In addition to the various taxes mentioned above, most Australian resident individual taxpayers with incomes above a minimum threshold are also required to pay the Medicare levy. The Medicare levy is imposed under the Medicare Levy Act 1986 (Cth) with the criteria for determining the Medicare levy liability contained in Pt VIIB of ITAA 1936.
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70 [3.50] PRINCIPLES OF TAXATION LAW 2020 Medicare is the universal healthcare scheme that provides Australians with access to healthcare services. The tests for residency for the imposition of the Medicare levy are the same as the income tax tests for residency discussed in Chapter 4. A part-year resident is required to pay the Medicare levy for the part of the year when they are resident. However, note that the tests for residency for the imposition of the Medicare levy are not the same as the tests for residency for the purposes of determining an individual’s entitlement to Medicare benefits: Ruling IT 2615. The entitlement to Medicare benefits is determined in accordance with ss 3(1), 10 and 21 of the Health Insurance Act 1973 (Cth). Therefore, it may be the case that individuals are required to pay the Medicare levy as they are Australian residents for tax purposes although they may not be entitled to Medicare benefits as they are not “residents” for the purposes of the Health Insurance Act 1973. This is in part addressed by the exemptions to the Medicare levy: see [3.70].
Basic levy payable [3.50] The Medicare levy is generally calculated at a flat rate on taxable income: s 251S(1)(a) of ITAA 1936. The applicable rate is 2% from 1 July 2014 (previously 1.5%). The increase in the Medicare levy was introduced to fund the National Disability Insurance Scheme (NDIS), which provides support for people with permanent and significant disability and their families and carers.
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The Medicare levy is imposed on the whole of the individual’s taxable income, including any amount that may be subject to the tax-free threshold. There is no maximum limit in respect of an individual’s Medicare levy. Example 3.1: Calculation of Medicare levy Elisabeth has taxable income of $50,000. The Medicare levy is calculated at 2% of Elisabeth’s taxable income. Therefore, she will be liable to a levy of $1,000.
Example 3.2: Calculation of Medicare levy Roger has taxable income of $2 million. The Medicare levy is calculated at 2% of Roger’s taxable income. Therefore, he will be liable to a levy of $40,000.
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Relief for low-income earners [3.60] A taxpayer who qualifies as a low-income earner is either fully or partially exempted from the Medicare levy. The amount of the exemption will depend on the individual’s taxable income and whether they qualify for the seniors and pensioners tax offset (SAPTO). Individuals with taxable income equal to or less than the “threshold amount” receive a full exemption from the Medicare levy. Individuals with taxable income greater than the “threshold amount”, but less than the “phase-in limit”, pay the Medicare levy at a rate of 10 cents on every dollar of taxable income above the “threshold amount”. Individuals with taxable income above the “phase-in limit” are subject to the full Medicare levy, as discussed at [3.50], but may be eligible for Medicare levy reduction based on family taxable income in certain limited circumstances. The “threshold amount” and “phase-in limit” for the 2018–2019 income year are given in Table 3.2. TABLE 3.2 Medicare levy low-income earner thresholds Threshold amount
Phase-in limit
Individual entitled to the seniors and pensioners tax offset
$35,418
$44,272
All other taxpayers
$22,398
$27,997
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At the time of writing, any changes to the “threshold amount” and “phase-in limit” for the 2019–2020 income year were yet to be announced.
Example 3.3: Medicare levy –low-income earner Rupert has taxable income of $12,000. He is not entitled to the seniors and pensioners tax offset. Rupert is not required to pay the Medicare levy as his taxable income is below the “threshold amount”.
Example 3.4: Medicare levy –low-income earner Jacky has taxable income of $25,000. She is not entitled to the seniors and pensioners tax offset. Jacky’s Medicare levy is calculated as ($25,000 –$22,398) × $0.10. Therefore, Jacky will have to pay a Medicare levy of $260.20.
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72 [3.70] PRINCIPLES OF TAXATION LAW 2020
Exemptions [3.70] Under ss 251T and 251U of ITAA 1936, the following individuals are exempt from the Medicare levy: • members of the Australian Defence Forces and their relatives who are entitled to free medical treatment in respect of every incapacity, disease or disabling condition; • persons entitled under the Veterans’ Entitlements Act 1986 (Cth) or the Military Rehabilitation and Compensation Act 2004 (Cth) or the Australian Participants in British Nuclear Tests and British Commonwealth Occupation Force (Treatment) Act 2006 (Cth) to full free medical treatment for all conditions; • persons who receive a sickness allowance; • persons who receive certain pensions or income support supplements in specified circumstances;
•
non-residents;
• members of diplomatic missions or consular posts in Australia and members of their families who are not Australian citizens and are not ordinarily resident in Australia; and
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• any person who would not have been entitled to Medicare benefits in respect of services, treatment or care to which Medicare benefits under the Health Insurance Act 1973 relate. The individual must provide a certificate from Medicare Australia to qualify for the exemption. The Medicare levy exemption certificate can be obtained from Medicare Australia by submitting the appropriate application form. A separate application is required for each financial year. Individuals with dependants may need to satisfy additional requirements to qualify for the exemption. A partial exemption may be available where the individual satisfies one of the exemption categories for only part of the income year.
Example 3.5: Medicare levy –exemption Yang is an international student studying at a university in Australia. She is an Australian resident for tax purposes as determined by the residency tests in s 6 of ITAA 1936 (see Chapter 4). However, under the Health Insurance Act 1973, Yang is not entitled to Medicare benefits in respect of health services provided in Australia. Yang has taxable income of $40,000. Prima facie, Yang is required to pay the Medicare levy in respect of her taxable income of $40,000 as she is a resident of Australia for tax purposes and her taxable income is above the “threshold amount” (she is not
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entitled to the seniors and pensioners tax offset). However, as she is not entitled to Medicare benefits, she can obtain a Medicare levy exemption certificate from Medicare Australia, which will exempt her from paying the Medicare levy. Yang will have to obtain a separate certificate for each financial year to obtain the Medicare levy exemption.
Medicare levy surcharge [3.80] In addition to the Medicare levy, a Medicare levy surcharge is payable by taxpayers, where their income is above a certain threshold and they do not have private health cover through a registered private health insurance provider for the entire income year. The Medicare levy surcharge is imposed in addition to the Medicare levy. Individuals who are exempt from the Medicare levy are also exempt from the Medicare levy surcharge (eg, foreign residents).
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Taxpayers must calculate their “income for surcharge purposes” to determine whether they have to pay the Medicare levy surcharge. “Income for surcharge purposes” includes the taxpayer’s: • taxable income (including the net amount on which family trust distribution tax has been paid); • exempt foreign employment income; • reportable fringe benefits amount; • total net investment loss (includes both net financial investment loss and net rental property loss); and • reportable super contributions (includes both reportable employer super contributions and deductible personal super contributions). Taxpayers aged between 55 and 59 years old can deduct from this amount any taxed element of a super lump sum, other than a death benefit, which they received and does not exceed the low rate cap on super lump sum benefits to determine their “income for surcharge purposes”. The “income for surcharge purposes” is only used to ascertain a taxpayer’s liability for the Medicare levy surcharge and the applicable rate. Once it is determined that the taxpayer is liable for the Medicare levy surcharge, the Medicare levy surcharge payable is calculated as follows: Taxable income (including the net amount on which family trust distribution tax has been paid and total reportable fringe benefits) × Surcharge rate
At the time of writing, the Medicare levy surcharge income thresholds and rates are as given in Table 3.3.
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74 [3.90] PRINCIPLES OF TAXATION LAW 2020 TABLE 3.3 Medicare levy surcharge rates Income ($)
Surcharge rate (%)
Singles
Families*
0 –90,000
0 –180,000
90,001 –105,000
180,001 –210,000
1
105,001 –140,000
210,001 –280,000
1.25
140,000+
280,001+
1.5
0
* For families with more than one dependent child, the relevant threshold is increased by $1,500 for each child after the first.
Example 3.6: Medicare levy surcharge Pierre is an Australian resident with taxable income of $150,000. He is single. He had private health insurance for 90 days of the income year. He did not have any reportable fringe benefits or any amounts on which family trust distribution tax has been paid. Pierre must pay the Medicare levy surcharge because his “income for surcharge purposes” exceeds the threshold and he did not have private health insurance for the entire income year. The amount of the surcharge is calculated as follows: $150,000 × 1.5% × (365 –90)
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365
= $1,695.21
The Medicare levy surcharge in effect serves as an incentive for taxpayers to have private health insurance as the surcharge is not payable in respect of any days when a taxpayer has private health insurance. In addition, taxpayers with private health insurance receive a private health insurance tax offset as a further incentive. The amount of the offset depends on the taxpayer’s age and level of income and can be claimed as a reduction in premiums or, if the full premium amounts are paid up-front, as a cash payment from Medicare or as an offset on the annual income tax return. See Chapter 15.
Government study and training support loans [3.90] The government provides financial assistance in the form of loans to people undertaking higher education, trade apprenticeships and other
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training programs (eg, Higher Education Loan Program (HELP)). The Australian Taxation Office (ATO) is also responsible for the collection of these loans through the tax system. The loans must be repaid once the person’s income exceeds the repayment threshold. The compulsory repayments are collected through the tax system, but voluntary repayments can also be made to reduce the loan balance faster. Minimum repayments are required at the rates given in Table 3.4.
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TABLE 3.4 Repayment income thresholds and rates for the 2019–2020 income year Repayment income (RI*) ($)
Repayment rate (%)
Below $45,881
Nil
$45,881 –$52,973
1.0
$52,974 –$56,151
2.0
$56,152 –$59,521
2.5
$59,522 –$ 63,092
3.0
$63,093 –$66,877
3.5
$66,878 –$70,890
4.0
$70,891 –$75,144
4.5
$75,145 –$79,652
5.0
$79,653 –$84,432
5.5
$84,433 –$89,498
6.0
$89,499 –$94,868
6.5
$94,869 –$100,560
7.0
$100,561 –$106,593
7.5
$106,594 –$112,989
8.0
$112,990 –$119,769
8.5
$119,770 –$126,955
9.0
$126,956 –$134,572
9.5
$134,573 and above
10
* RI is the sum of taxable income plus any total net investment loss (which includes net rental losses), total reportable fringe benefits amounts, reportable superannuation contributions and exempt foreign employment income.
From 1 July 2017, individuals with an outstanding government education loan who are living overseas are also required to make loan repayments similar to if they were living in Australia. The onus is on the person with an outstanding government education loan to provide the ATO with their overseas contact details within seven days of leaving the country if moving overseas for longer than six months.
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76 [3.100] PRINCIPLES OF TAXATION LAW 2020
Introduction to income tax [3.100] The rest of this chapter provides an overview of the income tax in Australia and basic information as to how income tax is imposed and calculated. Each of the elements introduced here is discussed in further detail in subsequent chapters.
Income tax burden
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[3.110] Section 3-5 of ITAA 1997 provides that income tax is payable for each year by each individual and company and certain other entities. In Australia, personal income tax is imposed on each individual. Some countries may impose personal income tax on a family unit or a couple, but this can sometimes prove difficult in practice as it is not easy to define the family unit or couple. For example, the family unit may encompass biological children, stepchildren, dependent children under 18, non-dependent children under 18 and so on. Similarly, a couple could be a married couple, a de facto couple, a same-sex couple and so on. Although personal income tax is imposed on an individual basis in Australia, family circumstances may be taken into consideration for the purposes of determining certain welfare benefits delivered through the tax system (eg, the family tax benefit). Note that partnerships and trusts are not included in s 3-5. Although subject to the income tax system and required to lodge an annual income tax return, partnerships and trusts are not separate taxpayers. Rather, the liability to pay income tax on net gains gained or produced through partnerships and trusts is generally borne by the individuals or entities that are partners in the partnership or trustees and beneficiaries of the trust. The taxation of partners and partnerships is discussed in Chapter 19, while Chapter 20 discusses the taxation of trusts and beneficiaries. A company is treated as a separate taxpayer and pays income tax. However, company tax is in effect a prepayment of the individual income tax of the company’s shareholders. This is due to the operation of a credit arrangement known as the dividend imputation system. The imputation system and the taxation of companies and its shareholders more generally are discussed in Chapter 21. The ITAA 1997 generally uses the term “you” in referring to taxpayers. For example, s 4-10 is in relation to “how much tax you must pay”. The meaning of “you” is stipulated in s 4-5 which states that “you” applies to entities generally, unless its application is expressly limited. A list of “entities” is provided in s 9-1 and includes an individual, a company, a superannuation provider, a corporate limited partnership and a trustee of a public trading trust or corporate unit trust.
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The income tax formula [3.120] To calculate a taxpayer’s income tax liability, it is necessary to start at the basic formula in s 4-10 of ITAA 1997. Taxpayers are required to calculate their income tax for the financial year as follows: Income Tax = (Taxable Income × Rate) –Tax Offsets
The “financial year” is defined as the 12-month period beginning on 1 July: ss 4-10(1) and 995-1 of ITAA 1997. Taxpayers with a different financial year for accounting purposes can use a “substituted accounting period” as their income year if allowed by the Commissioner: s 4-10 Note 1 of ITAA 1997; s 18 of ITAA 1936. The Commissioner will generally grant an application for a substituted accounting period, where the taxpayer’s business needs demonstrate that 30 June is an inappropriate or impractical balance date: Practice Statement PS LA 2007/21. For example, multinational companies may seek to utilise a substituted accounting period to align subsidiary companies’ accounting periods with that of the head company. Such taxpayers are commonly referred to as a “SAP taxpayer”.
Taxable income
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[3.130] It can be seen from the above formula that taxable income is fundamental to the calculation of a taxpayer’s income tax liability as it is the basis upon which the amount of tax payable by a taxpayer is calculated. Taxable income is determined under s 4- 15 according to the following formula: Taxable Income = Assessable Income –Deductions
The method statement in s 4- 15 refers the reader to Div 6 in relation to assessable income and Div 8 in relation to deductions.
Assessable income [3.140] Assessable income consists of ordinary income and statutory income: s 6- 1(1) of ITAA 1997. However, some amounts of ordinary and statutory income may be categorised as “exempt income” or “non-assessable non-exempt” (NANE) income, in which case they are not assessable income: s 6- 1(2)– (4). As such, Assessable Income = Ordinary Income + Statutory Income, but not Exempt Income or NANE Income. Ordinary income essentially refers to amounts which have been held to be assessable by the courts because they demonstrate certain characteristics,
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78 [3.150] PRINCIPLES OF TAXATION LAW 2020 while statutory income is those amounts that the legislature has stipulated are assessable. Exempt and NANE income are those amounts that the legislature has stipulated as not assessable. [3.150] Ordinary income: Ordinary income is defined in s 6-5(1) of ITAA 1997 as income according to ordinary concepts. “Ordinary concepts” is the term used to describe receipts that have an income character as set out in doctrines that have been developed in the courts. The specific provision is as follows: 6-5 Income according to ordinary concepts (ordinary income) (1) Your assessable income includes income according to ordinary concepts, which is called 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.
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As is apparent from s 6-5(2) and (3), the determination of a taxpayer’s ordinary income depends on whether the taxpayer is an Australian resident or a foreign resident and the source of the income. These fundamental concepts of residence and source are discussed in Chapter 4. Section 6- 5(4) ensures that taxpayers cannot avoid paying income tax by directing that the income be paid to a different person and not receiving the money themselves. This is known as the “constructive receipt rule”, whereby the taxpayer is deemed to have derived the income when it is dealt with per the taxpayer’s directions. Example 3.7: Constructive receipt rule Johnny provides his employer with instructions to pay half of his salary each month to his elderly parents. Johnny is deemed to have derived the salary under s 6-5(4), even though he did not physically receive the money, as it has been dealt with per his directions.
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The determination as to what constitutes ordinary income is a fundamental issue in tax. The legislative reference to “income according to ordinary concepts” alludes to Sir Fredrick Jordan’s statement in Scott v C of T (NSW) (1935) 3 ATD 142 at 144: The word “income” is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts.
Case law has developed a number of characteristics of ordinary income to assist in determining whether an amount constitutes ordinary income. Chapter 5 outlines these principles.
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[3.160] Statutory income: Statutory income consists of amounts that are included in the taxpayer’s assessable income by a specific provision in the income tax legislation: s 6-10(2) of ITAA 1997. The statutory income of an Australian resident includes statutory income from all sources, whether in or outside Australia, whereas the statutory income of a foreign resident only comprises statutory income from all Australian sources and any other statutory income which is assessable on some basis other than having an Australian source. As with ordinary income, there is a constructive receipt rule in s 6-10(3) which deems that the taxpayer has derived a statutory income amount if it is dealt with as per the taxpayer’s directions. Division 10 lists the statutory income provisions contained in the income tax legislation. Most types of statutory income are amounts that the legislature wished to include in the income tax base but which fell outside the concept of ordinary income. For example, s 26(e) of ITAA 1936, which is now s 15-2 of ITAA 1997, was introduced to capture non-convertible benefits provided to employees. The courts had held that the value of such benefits was not ordinary income and therefore such benefits would not be subject to tax in the absence of a statutory income provision. Similarly, s 102-5 includes net capital gains in assessable income. Capital gains would not otherwise be assessable as the courts have long accepted that capital gains are not ordinary income. However, in some cases, statutory income provisions capture amounts that would otherwise be assessable as ordinary income, but the legislature has considered it necessary to include a specific statutory income provision. For example, dividend income would likely satisfy the requirements of ordinary income, but it is also made assessable under s 44 of ITAA 1936. Where an amount of income constitutes both ordinary and statutory income, s 6-25(1) ensures that the amount is only included in the taxpayer’s assessable
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80 [3.170] PRINCIPLES OF TAXATION LAW 2020 income once. The amount will generally constitute statutory income unless a specific provision indicates otherwise: s 6- 25(2). For example, dividend income which is likely to constitute ordinary income but is also assessable under s 44 would be included in assessable income as statutory income under s 44. However, s 15-2 of ITAA 1997, for example, which includes in assessable income allowances and other payments for services, only assesses such amounts to the extent that they are not ordinary income (ie, the section gives precedence to ordinary income): s 15-2(3)(d). From a practical perspective, it generally does not matter whether an amount is included in a taxpayer’s assessable income as ordinary income or statutory income. In either case, the amount is assessable and subject to tax. [3.170] Non-assessable income: If an amount is not ordinary income and not statutory income, then it is non-assessable income (ie, it is not subject to tax): s 6-15(1). An amount will also be non-assessable income if the legislation stipulates that it is “exempt income” or NANE income: ss 6-15(2) and (3); 6-20; 6-23. Amounts that are classified as “exempt income” or NANE income may or may not constitute ordinary or statutory income in the first place.
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It must be noted that the term “non-assessable non-exempt” income is simply the name of another category of income. While NANE amounts are not assessable income, they are also not classified as “exempt income”. Although both exempt income and NANE income are not subject to tax, it is necessary to distinguish between the two categories due to other tax consequences. For example, exempt income may be taken into account in working out the amount of a tax loss under s 36-10, whereas NANE income is not taken into account in working out the amount of a tax loss. Subdivision 11-A lists the classes of exempt income, while subdiv 11-B lists the particular kinds of NANE income. There are two classes of exempt income: • where the entity is exempt regardless of what type of income it has: s 11-5 (eg, certain charitable institutions, local governments, etc); and • where the ordinary or statutory income is of a kind that is exempt: s 11- 15 (eg, certain education scholarships, family assistance benefits and qualifying foreign employment income). The provisions in the legislation which make an amount NANE income are listed in s 11-55. Examples of NANE income include GST payable on a supply (s 17-5) and the receipt of fringe benefits by employees (s 23L(1) of ITAA 1936).
Deductions [3.180] Deductions are generally expenses which are incurred by the taxpayer in gaining or producing assessable income and therefore reduce the tax
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payable by a taxpayer on their assessable income. There are two categories of deductions: general deductions (s 8-1) and specific deductions (s 8-5). Where an expense is deductible as both a general deduction and a specific deduction, s 8-10 ensures that the taxpayer can only claim the deduction once under the most specific provision. General deductions are discussed in Chapter 12, while specific deductions are discussed in Chapter 13. Some expenses that are not immediately deductible may be deductible over a number of years: see Chapter 14. The “value” of a deduction to a taxpayer depends on the taxpayer’s top marginal income tax rate. See Example 3.8 for an illustration as to the “value” of a deduction.
Income tax rates [3.190] The applicable rate of income tax depends on the type of taxpayer and is set out in the Income Tax Rates Act 1986. The different types of taxpayers include: • individuals who are Australian residents: see [3.200]; • individuals who are foreign residents: see [3.200]; • individuals who are working holiday-makers: see [3.200]; • companies below the turnover threshold: see [3.210]; and • companies above the turnover threshold: see [3.210].
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Individuals [3.200] Individuals are subject to a progressive tax rate structure, whereby the taxpayer’s tax burden increases as their taxable income (a measure of the taxpayer’s ability to pay tax) increases. Under a progressive rate structure, all individuals benefit from the different tax rates for different income brackets. For example, the first $18,200 for an individual with $200,000 of taxable income is tax-free. An individual’s tax rate generally depends on whether the individual is a resident of Australia for income tax purposes or not. Both resident and foreign resident individuals are subject to the progressive rate structure but at different rates. Tables 3.5 and 3.6 set out the applicable tax rates for Australian resident taxpayers and foreign resident taxpayers for the year ending 30 June 2020.
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82 [3.200] PRINCIPLES OF TAXATION LAW 2020 TABLE 3.5 2019–2020 income tax rates for Australian resident individuals Taxable income ($)
Tax on this income
0 –18,200
Nil
18,201 –37,000
19c for each $1 over $18,200
37,001 –90,000
$3,572 plus 32.5c for each $1 over $37,000
90,001 –180,000
$20,797 plus 37c for each $1 over $90,000
180,001 and over
$54,097 plus 45c for each $1 over $180,000
The above rates do not include the Medicare levy or the Medicare levy surcharge discussed earlier in the chapter.
Example 3.8: Calculating Australian resident individual income tax Jack has assessable income of $200,000 and Bobby has assessable income of $50,000. They both have deductible expenses of $10,000 and no tax offsets. They are residents of Australia for income tax purposes. Jack’s taxable income = $200,000 –$10,000 = $190,000. Jack’s tax payable is calculated as follows: $0–$18,200 = no tax payable $18,201–$37,000 = $18,800 × 19% = $3,572 $37,001–$90,000 = $53,000 × 32.5% = $17,225
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$90,001–$180,000 = $90,000 × 37% = $33,300 $180,001–$190,000 = $10,000 × 45% = $4,500 Therefore, Jack’s total tax payable will be $3,572 + $17,225 + $33,300 + $4,500 = $58,597. Without the deductions, Jack’s taxable income would be $200,000 and his tax payable would be $3,572 + $17,225 + $33,300 + ($20,000 × 45%) = $63,097. Therefore, the $10,000 of deductions has reduced Jack’s tax liability by $4,500, which is $10,000 × 45% (Jack’s highest marginal tax rate). Bobby’s taxable income = $50,000 –$10,000 = $40,000 Bobby’s tax payable is calculated as follows: $0–$18,200 = no tax payable $18,201–$37,000 = $18,800 × 19% = $3,572 $37,001–$40,000 = $3,000 × 32.5% = $975
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Therefore, Bobby’s total tax payable will be $3,572 + $975 = $4,547. Without the deductions, Bobby’s taxable income would be $50,000 and his tax payable would be $3,572 + ($13,000 × 32.5%) = $7,797. Therefore, the $10,000 of deductions has reduced Bobby’s tax liability by $3,250, which is $10,000 × 32.5% (Bobby’s highest marginal tax rate). As mentioned above, it is apparent from the example that the “value” of a deduction (ie, the reduction in tax payable) will depend on the individual’s highest marginal tax rate. In this case, the “value” of the deduction will be even greater as Jack would also be liable for the 2% Medicare levy and his highest marginal tax rate is effectively 47%.
TABLE 3.6 2019–2020 income tax rates for foreign resident individuals Taxable income ($)
Tax on this income
0 –90,000
32.5c for each $1
90,001 –180,000
$29,250 plus 37c for each $1 over $90,000
180,001 and over
$62,550 plus 45c for each $1 over $180,000
As discussed at [3.40], foreign residents are not required to pay the Medicare levy.
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Example 3.9: Calculating foreign resident individual income tax Pedro is a foreign resident for Australian income tax purposes. He had $100,000 of Australian sourced assessable income. He did not have any deductions or offsets. Pedro’s taxable income = $100,000. Pedro’s tax payable = ($90,000 × 32.5%) + ($10,000 × 37%) = $29,250 + $3,700 = $32,950. While foreign residents are still subject to a progressive rate structure, they do not get the benefit of the lower marginal tax rates or the tax-free threshold. There is a special category of individuals whose income tax obligations do not depend on their residency for tax purposes. These are “working holiday- makers” (ie, backpackers) who are in Australia on a “Working Holiday” or “Work and Holiday” visa. The following tax rates given in Table 3.7 apply to the Australian sourced income of working holiday-makers regardless of their tax residency.
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84 [3.210] PRINCIPLES OF TAXATION LAW 2020 TABLE 3.7 2019–2020 income tax rates for working holiday-makers Taxable income ($)
Tax on this income
0 –37,000
15c for each $1
37,001 –90,000
$5,550 plus 32.5c for each $1 over $37,000
90,001 –180,000
$22,775 plus 37c for each $1 over $90,000
180,001 and over
$56,075 plus 45c for each $1 over $180,000
Other entities [3.210] Companies are generally subject to tax at a fixed rate on their taxable income, regardless of their total amount of taxable income. This is known as a flat or proportional tax. The applicable company tax rate depends on the entity’s turnover. The corporate tax rate is being progressively reduced for companies with a turnover of less than $50 million. Table 3.8 sets out the progressive changes to the company tax rate. TABLE 3.8 Progressive changes to the company tax rate
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Income year
Turnover threshold ($m)
Company tax rate for entities under the threshold (%)
Company tax rate for entities over the threshold (%)
2019–2020
50
27.5
30
2020–2021
50
26.0
30
2021–2022 and later income years
50
25.0
30
However, the lower company tax rate does not apply to a company if more than 80% of the company’s assessable income is passive income (eg, dividends, royalties and interest), even though the company’s turnover may be below the turnover threshold. Example 3.10: Company income tax Big Profits Pty Ltd had taxable income of $10 million, while Small Profits Pty Ltd had taxable income of $1 million for the 2019–2020 income year. Assume that Big Profits Pty Ltd had an annual turnover of $100 million, while Small Profits Pty Ltd had an annual turnover of $10 million. Big Profits tax payable = $10 million × 30% = $3,000,000. Small Profits tax payable = $1 million × 27.5% = $275,000.
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The tax rates which apply to superannuation funds and trustees are discussed in Chapters 18 and 20 respectively.
Tax offsets [3.220] Tax offsets or rebates are deducted from income tax payable and reduce the amount of income tax which must be paid by the taxpayer. Tax offsets are not the same as deductions as tax offsets reduce income tax payable, whereas deductions reduce taxable income. Example 3.11: Tax deductions vs tax offsets Using the facts from Example 3.8, assume that, instead of having $10,000 of deductions, Jack and Bobby have $10,000 of tax offsets. Jack’s tax payable on taxable income of $200,000 = $63,097 –$10,000 = $53,097. Bobby’s tax payable on taxable income of $50,000 = $7,797 –$10,000 = – $2,203. Bobby will receive a refund of $2,203 if the tax offset is a refundable tax offset, or he will have no tax liability for the current year and tax offsets of $2,203 to be carried forward to the next year if the tax offset can be carried forward.
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The example illustrates two important points. First, both Jack and Bobby have significantly lower tax payable with tax offsets of $10,000, rather than deductions of $10,000. Second, Jack and Bobby receive equal benefit from the tax offset (reducing their tax liability by $10,000), as opposed to the deductions, where the value of the benefit corresponds with the taxpayer’s applicable marginal tax rate. Tax offsets generally do not reduce the Medicare levy for individual taxpayers and may only be refundable in certain limited circumstances. Tax offsets are listed in s 13-1 of ITAA 1997 and are discussed further in Chapter 15.
Questions [3.230] 3.1 What is the basic income tax payable for an Australian resident individual with taxable income for the 2019–2020 income year of: (a) $15,000? (b) $40,000? (c) $100,000? (d) $300,000?
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86 [3.230] PRINCIPLES OF TAXATION LAW 2020 3.2 What is the basic income tax payable for a foreign resident individual with taxable Australian income for the 2019–2020 income year of: (a) $15,000? (b) $40,000? (c) $100,000? (d) $300,000? 3.3 Calculate the Medicare levy payable (if any) for the year ending 30 June 2020 on the following amounts for a single Australian resident taxpayer who is not entitled to the SAPTO (assume the same “threshold amount” and “phase-in limit” as for the 2018–2019 income year): (a) $15,000 (b) $27,000 (c) $40,000 3.4 Calculate the Medicare levy surcharge payable (if any) on the following taxable income amounts for a single Australian resident taxpayer who does not have private health insurance for the entire income year: (a) $50,000 (b) $100,000 3.5 Following on from 3.4, calculate the Medicare levy surcharge payable if the individual had private health insurance for 100 days in the income year. 3.6 Jill is an Australian resident for tax purposes. She has assessable income of $500,000. She has deductions of $100,000 and franking credit tax offsets of $30,000. What is Jill’s tax payable for the 2019– 2020 income year? 3.7 Acme Pty Ltd has determined that its assessable income for the year is $789,000 and it has deductions of $300,000. What is Acme’s tax payable for the 2019–2020 income year? Assume that Acme’s turnover is in excess of $50 million. 3.8 Linley is an Australian resident for income tax purposes. She has taxable income of $277,000. She has been provided with a receipt for an expense in the amount of $10,000. This expense will constitute a deduction. How much tax will Linley save for the 2019–2020 income year as a result of the additional deduction? 3.9 Following on from 3.8, Linley has a HELP debt of $25,000. How much of the HELP debt would she be required to repay for the 2019–2020 income year?
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4 Residence and source
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Key points...................................................................................................... [4.00] Introduction.................................................................................................. [4.10] Legislative framework.................................................................................. [4.20] Income tax rates for individuals.................................................................. [4.30] Residence...................................................................................................... [4.40] Residence of Australia –individuals...................................................... [4.50]
Residence according to ordinary concepts............................................... [4.60] Domicile test............................................................................................. [4.100] 183-day test.............................................................................................. [4.130] Superannuation test................................................................................. [4.140] Period of residence.................................................................................. [4.145] Temporary residents –individuals...................................................... [4.150] Working holiday makers...................................................................... [4.155] Foreign residents –individuals............................................................ [4.160] Residence of Australia –companies................................................... [4.170] Place of incorporation test....................................................................... [4.180] Central management and control test.................................................... [4.190] Controlling shareholders test.................................................................. [4.210] Dual residency and tie breaker provisions.......................................... [4.220] Source ........................................................................................................ [4.230] Sale of goods –trading stock.............................................................. [4.240] Sale of property other than trading stock........................................... [4.250] Services................................................................................................ [4.260] Interest.................................................................................................. [4.270] Dividends.............................................................................................. [4.280] Royalties............................................................................................... [4.290] Questions..................................................................................................... [4.300]
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88 [4.00] PRINCIPLES OF TAXATION LAW 2020
Key points [4.00] • Residence and source are the bases upon which income tax is levied on taxpayers under Australian domestic tax law. • Australian residents are taxed on income from all sources. • Foreign residents are taxed on income sourced in Australia. • An individual is an Australian resident if he or she satisfies one of four tests: the ordinary concepts test, the domicile test, the 183-day test and the superannuation test. • A company is a resident of Australia if it satisfies one of three tests: the place of incorporation test, the place of central management and control test and the controlling shareholder test. • Source requires a geographical connection with Australia. There are both statutory rules and common law rules which determine whether the geographical connection exists. • International tax treaties to which Australia is a party may override the domestic principles of source. • Determining the source of income requires the income to be categorised. • For the purposes of source, a receipt is generally considered to fall within the categories of income from the sale of goods or the sale of property other than goods, income from the provision of services, or passive income in the form of dividends, royalties or interest.
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Introduction [4.10] This chapter introduces the two key concepts upon which income tax is imposed in Australia: residence and source. At the outset, students need to remember two broad principles: • A resident of Australia for tax purposes will be taxed on worldwide income, that is, income from all sources. • A foreign resident for tax purposes will be taxed on income sourced in Australia only. Both of these broad principles contain the concepts of residence and source. Figure 4.1 explains how these concepts fit together. It is necessary to understand what is meant by these concepts to be able to determine a taxpayer’s assessable income. Before we look at the meaning of residence and source, we need to consider the reason why they are so important in our income tax regime.
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Figure 4.1: Overall guide
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Legislative framework [4.20] In order to understand the concepts of residence and source, it helps to consider the legislative framework in which they operate. Both concepts are contained in Div 6 of ITAA 1997, dealing with ordinary and statutory income. Students should revise Div 6 of ITAA 1997 as outlined in Chapter 3. It is from these provisions that we find our general principles that Australian residents are taxed on their worldwide income, while foreign residents are taxed on income sourced in Australia. This is the first reason why residency is important. There is a second reason why residency is important: where the taxpayer is an individual, the applicable tax rates depend on residency status.
Income tax rates for individuals [4.30] The income tax rates applied to individuals are different according to whether the taxpayer is an Australian resident or a foreign resident. Students
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90 [4.40] PRINCIPLES OF TAXATION LAW 2020 should revise the individual rates of tax set out in Chapter 3. The differences are as follows: • foreign residents do not get the benefit of the tax-free threshold on any Australian sourced income; • the tax payable on the first bracket of income is at a higher rate; • foreign residents do not have access to many personal tax offsets; and • foreign residents are not liable for the Medicare levy. Now that we know why it is so important to establish a taxpayer’s residency and source of income at the outset, we can consider what is meant by each of these concepts.
Residence [4.40] Section 995-1 of ITAA 1997 provides that “Australian resident” means a person who is a resident of Australia for the purposes of the ITAA 1936. If we refer to the ITAA 1936, we find a definition of “resident” in s 6(1). Before we consider that definition, note that: • the status of an individual in migration law is not conclusive of his or her residency status for taxation purposes; • a taxpayer who does not fall within the legislative definition of “Australian resident” is automatically considered a foreign resident for taxation purposes;
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• for tax purposes, a taxpayer may be a resident of more than one country; • consistent with liability to tax being determined on a year- by- year basis, a taxpayer’s residency status is also considered yearly; and • events may be examined after year end to determine residency status.
Residence of Australia –individuals [4.50] The definition of “resident” in s 6(1) of ITAA 1936 contains four separate and exhaustive tests for determining whether an individual is a resident of Australia for taxation purposes. It provides that: 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
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is satisfied that his usual place of abode is outside Australia and 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 (Cth); or (B) an eligible spouse for the purposes of the Superannuation Act 1976 (Cth); or (C) the spouse, or a child under 16, of a person covered by sub- subparagraph (A) or (B).
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A taxpayer needs to satisfy only one test to be considered a resident of Australia. If a taxpayer does not satisfy any of the tests, he or she is considered a foreign resident for taxation purposes. The four tests, one common law test and three statutory tests, can be summarised as follows: • A person who resides in Australia –This test is referred to as the ordinary concepts test and is based on the common law: see [4.60]. • The domicile test –A person whose domicile is Australia, unless the Commissioner is satisfied that his or her permanent place of abode is outside Australia, is considered a resident of Australia: see [4.100]. • The 183- day test –A person 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 or her usual place of abode is outside Australia and that he or she does not intend to take up residence in Australia, is considered a resident of Australia: see [4.130]. • The superannuation test –A person who is a member of a superannuation scheme established by deed under the Superannuation Act 1990 (Cth) or an eligible employee for the purposes of the Superannuation Act 1976 (Cth) or the spouse, or a child under 16, of a person covered by those Acts, is considered a resident of Australia: see [4.140].
Residence according to ordinary concepts [4.60] The primary test for determining whether an individual is a resident of Australia is the “residence according to ordinary concepts” test. It is a common law test that is somewhat circular and which requires a consideration of where a person resides. The term “resides” is not defined in the ITAA 1936 or ITAA 1997 and, as such, its ordinary meaning is ascertained from a dictionary. Two examples are the Macquarie Dictionary, which defines “reside” as “to dwell permanently or for a considerable time; have one’s abode for a time” and the Shorter Oxford English Dictionary, which defines it as “to dwell permanently or for a considerable time, to have one’s settled or usual abode, to live, in or at a particular place”:
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92 [4.70] PRINCIPLES OF TAXATION LAW 2020 Ruling TR 98/17, para 14. The definition clearly covers migrants but will also extend to persons dwelling in Australia for a considerable period. [4.70] The question of whether a person resides in Australia is a question of fact and degree: Miller v FCT (1946) 73 CLR 93. The leading authorities on what constitutes ordinary residence are the UK cases of Levene v IRC [1928] AC 217 and IRC v Lysaght [1928] AC 234.
Case study 4.1: Residency –temporary visits abroad In Levene v IRC [1928] AC 217, the taxpayer, who had always been a resident of the UK, retired from business and sold his house. For the two years following he lived at hotels in the UK. For the five years after that he lived in hotels both in the UK and abroad. During this time he spent four or five months a year in the UK to obtain medical advice, visit relatives and attend religious ceremonies. The House of Lords held that, until the taxpayer took a lease on a flat in Monte Carlo in 1925, he was a UK resident. This conclusion was based on the fact that the purposes for going abroad were nothing more than temporary. Taking into account his ties with the UK, together with the temporary nature of the time abroad, the taxpayer was a resident of the UK for taxation purposes until 1925.
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Case study 4.2: Residency –moved abroad IRC v Lysaght [1928] AC 234 also involved a taxpayer who spent considerable time abroad. In this case, the taxpayer partially retired and moved from England to an inherited estate in Ireland. He sold his home in England but remained a non- executive director of the family company. He travelled to England for approximately one week per month, staying in hotels, to attend board meetings. It was held that the taxpayer was resident and ordinarily resident in the UK. Lord Buckmaster said (at 248): “If residence be once established ordinarily resident means in my opinion no more than the residence is not casual and uncertain but that the person held to reside does so in the ordinary course of life”.
Consistent with the UK decisions, the Administrative Appeals Tribunal (AAT) decision of Joachim v FCT (2002) 50 ATR 1072 highlights the approach adopted in Australia.
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Case study 4.3: Residency –family home in Australia and intention to treat Australia as home In Joachim v FCT (2002) 50 ATR 1072, the taxpayer and his family had migrated to Australia in 1994. The taxpayer, a qualified master mariner, was unable to find work in Australia so he obtained employment on various Sri Lankan vessels which resulted in him being outside Australia for 316 days. His family, who had Australian permanent residency, remained in Australia during this time. The taxpayer claimed that he was not a resident of Australia as he had a permanent place of abode outside Australia. The AAT concluded that the taxpayer was a resident of Australia as he maintained a home for his family in Australia and, despite his absence, his intention to treat Australia as his home had not changed.
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[4.80] The cases illustrate that a broad range of factors will be considered in determining ordinary residence, with relative weight given to each. The factors considered by the courts are as follows: • Physical presence in Australia –As a general principle, it is necessary that the taxpayer spends at least some time physically present in Australia during the year of income to be considered a resident under this test, although see Case Study [4.3]. • If the person is a visitor, the frequency, regularity and duration of visits – IRC v Lysaght [1928] AC 234 is an example of a taxpayer living in one jurisdiction (Ireland) but visiting another (England) with frequency and regularity. The duration of the visits will also be considered. • The purpose of the visits to Australia and abroad –If the person is a visitor to Australia, the purpose of the visit may be considered. Conversely, if the person is outside Australia for part of the income year in question, the purpose of the absence may also be relevant. • The maintenance of a place of abode in Australia for the taxpayer’s use –Whether a person has a home available for use in Australia is an important factor in deciding whether he or she continues to be a resident in Australia. • The person’s family, business and social ties –Similar to the maintenance of a place of abode, the location of a person’s family, business and social ties will provide evidence of residence: Levene v IRC [1928] AC 217. • The person’s nationality –A person’s nationality will not normally be a relevant factor in considering residency where other factors are clearly decisive. However, if a case is borderline, nationality may be considered.
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94 [4.90] PRINCIPLES OF TAXATION LAW 2020 [4.90] Many of the factors above are discussed in Ruling TR 98/17, which considers the residency status of individuals entering Australia, including migrants, academics, students studying in Australia, visitors on holiday and workers with pre-arranged employment contracts. The Ruling discusses the facts and circumstances of an individual’s behaviour that the Commissioner considers relevant in determining whether a person is an Australian resident. While the taxpayer’s circumstances as a whole are relevant, and no single factor is decisive, the Commissioner places emphasis on: • intention or purpose of presence; • family and business or employment ties; • maintenance and location of assets; and • social and living arrangements. In addition to a person’s behaviour while in Australia, emphasis is placed on physical presence in Australia. Generally, the Commissioner considers that there must be sufficient time elapsed to demonstrate continuity, routine or habit. This is a question of fact. However, it is considered in the Ruling that a period of six months is considerable time for deciding whether an individual resides in Australia.
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Example 4.1: Residence according to ordinary concepts –Australian resident Promising Swedish soccer player Bjorn is offered an 18-month contract to play for a club in the National Soccer League in Australia. Bjorn lets out his house in Sweden, sells his car and redirects the mail to Australia, where he intends to remain for the full 18 months of the contract. The club provides accommodation in Australia for Bjorn and his family, his children attend school and, along with his wife, they become involved in sporting activities. However, Bjorn has trouble adapting to Australian conditions and is warned to perform “or else”. Eventually he is playing so badly that the club’s management seeks to terminate his contract on the ground of non-performance. The contract is paid out for an agreed sum. Bjorn and his family return to Sweden four months after they arrived in Australia. Bjorn explains to the Commissioner that, although he was only in Australia for four months, he was residing here for that four months and he argues that he is entitled to be taxed as an Australian resident. The Commissioner rules that Bjorn is a resident because Bjorn established that he intended to live here for 18 months with his family and his behaviour over the four months was consistent with that intention. Source: Adapted from Example 1, Ruling TR 98/17.
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Example 4.2: Residence according to ordinary concepts –foreign resident Michael, a South African diamond corporation executive, comes to Australia to participate in an intensive eight- month advanced management development program at a university. His wife and children don’t come with him. While he is in Australia, he stays in basic on-campus accommodation. Michael is in Australia solely to do the course and spends his time studying or writing reports for his company. At the end of the eight-month course, he returns to South Africa. Michael is a foreign resident because he does not exhibit behaviour that is consistent with residing in Australia. Note: Ruling TR 98/17 only deals with the application of the residence according to ordinary concepts test. However, as Michael is in Australia for more than 183 days, we must also consider the second statutory test. The Commissioner is likely to conclude that Michael is not a resident under this test either, as Michael has a usual place of abode outside of Australia and does not intend to take up residence in Australia. Source: Adapted from Example 2, Ruling TR 98/17.
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Example 4.3: Residence according to ordinary concepts –Australian resident Jane is a Professor of Biology at the University of Warsaw. She comes to Australia under a contract to work for five months on a research project. She is single. Although she intends to leave after five months, she takes on a six-month lease for a small furnished flat near work. She also buys an old car. She spends time outside of work seeing films, attending occasional dinner parties at her colleagues’ houses, reading books and writing letters to everyone at home. Jane intends to return to Warsaw at the end of the project. The project extends and lasts for seven months, so she negotiates an extra month on her flat’s lease. Apart from depositing her salary into an Australian bank account to cover living expenses, Jane retains all assets and investments in Poland, her country of domicile. As her behaviour over the seven months in Australia is consistent with residing here, Jane is regarded as a resident from the time she arrives in Australia. Jane will be a resident for part of the year only, that is, from the time she arrives in Australia until the time she leaves Australia. Source: Adapted from Example 3, Ruling TR 98/17.
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Example 4.4: Residence according to ordinary concepts –foreign resident Michelle is a viticulturist. She comes to Australia for five months to conduct research, but actually stays seven months to complete it. She stays in a hostel and uses credit cards for living expenses. Her husband and children stay in their home in Bordeaux and, from Australia, Michelle helps her husband run the family business. Michelle’s research is often interrupted because she has to frequently communicate with her husband about their emerging business problems. Eventually she needs to go home for a week to sort out a major business issue. Although Michelle is in Australia for a considerable time, the quality and character of her stay are closer to that of a visitor who is temporarily in Australia than someone residing here, so she is a foreign resident. Source: Adapted from Example 4, Ruling TR 98/17.
Domicile test
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[4.100] The first statutory test, known as the domicile test, provides that a person is a resident of Australia if his or her domicile is in Australia, unless the Commissioner is satisfied that the person has a permanent place of abode outside Australia. The domicile test generally applies to outgoing individuals where that person moves overseas (usually as a work posting), but does not change his or her domicile. “Domicile” is a legal concept to be determined according to the Domicile Act 1982 (Cth) and the common law rules. It broadly means the jurisdiction with which a person has permanent legal ties. A person acquires a domicile of origin at birth (usually the place of the father’s permanent home), but may acquire a domicile of choice. Section 10 of the Domicile Act 1982 (Cth) provides that the intention that a person must have in order to acquire a domicile of choice in a country is the intention to make his home indefinitely in that country. For example, obtaining Australian permanent residency is likely to demonstrate a domicile of choice in Australia. On the other hand, a fixed period student visa or working visa would not satisfy the test for domicile of choice. As this test generally applies to individuals leaving Australia, the person will have an Australian domicile. Therefore, the individual will be a resident of Australia only if it is demonstrated that he or she does not have a “permanent place of abode outside Australia”. Consequently, cases involving this test deal
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with the question of “permanent place of abode outside Australia”, rather than domicile. Whether a person has a permanent place of abode outside Australia is a question of fact based on the individual circumstances of the case. [4.110] The leading case on what constitutes a permanent place of abode outside Australia is FCT v Applegate (1979) 9 ATR 899.
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Case study 4.4: Permanent place of abode In FCT v Applegate (1979) 9 ATR 899, the taxpayer was a solicitor in Sydney who had been sent by his employer to Vanuatu to open and operate a branch. The taxpayer gave up the lease on his flat and, leaving no assets in Australia, left Sydney with his wife in November 1971. A lease was obtained on a house and the taxpayer, who obtained residency status, was admitted to practice in Vanuatu. In June 1973, the taxpayer became ill and returned to Sydney for medical treatment. After returning to Vanuatu for a short period, he came back to Australia in September 1973. Subsequently, the Vanuatu office was closed. It was always the intention of the taxpayer and his employer that he would return to Australia eventually. While no time frame was specified, it was intended to be substantial. The issue was whether, during his time in Vanuatu, the taxpayer had a permanent place of abode outside Australia. The Full Federal Court held that the taxpayer had a place of abode outside Australia. The question therefore, was whether it was a permanent place of abode. The Court concluded that permanent meant something less than everlasting or lasting forever, but rather took its meaning from its context, in particular by reference to a person who had retained his or her domicile. In this sense, permanent should be contrasted with temporary or transitory. As such, the Court concluded that the taxpayer had a permanent place of abode outside Australia and was not a resident.
Case study 4.5: Permanent place of abode A similar issue arose in FCT v Jenkins (1982) 12 ATR 745, where the taxpayer, a bank employee, was transferred to Vanuatu for a fixed three- year period. Prior to leaving Australia, the taxpayer attempted to sell the family home but was unsuccessful. He maintained a bank account in Australia but cancelled his health insurance policy. Due to the taxpayer’s inability to efficiently perform his duties, he was repatriated back to Australia by his employer at the end of 18 months. The taxpayer claimed that he was not liable to income tax on earnings
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while he was in Vanuatu as it was income derived by a non-resident from a source outside Australia. The Court, applying the decision in FCT v Applegate, concluded that the taxpayer had a permanent place of abode outside Australia during his time in Vanuatu. [4.120] In response to FCT v Applegate and FCT v Jenkins, the Commissioner issued Ruling IT 2650, setting out the various factors which will be taken into account in ascertaining whether a taxpayer has a permanent place of abode outside Australia. Factors considered relevant are as follows: • the intended and actual length of the taxpayer’s stay in the overseas country; • whether the taxpayer intended to stay in the overseas country only temporarily and then to move on to another country or to return to Australia at some definite point in time; • whether the taxpayer has established a home (in the sense of dwelling place; a house or other shelter that is the fixed residence of a person, a family or a household) outside Australia; • whether any residence or place of abode exists in Australia or has been abandoned because of the overseas absence;
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• the duration and continuity of the taxpayer’s presence in the overseas country; and • the durability of association that the person has with a particular place in Australia, that is, maintaining bank accounts in Australia, informing government departments such as Centrelink that he or she is leaving permanently and that family allowance payments should be stopped, place of education of the taxpayer’s children, family ties and so on. Emphasis is often placed on the length of stay overseas. To this extent, Ruling IT 2650 states that, as a broad rule of thumb, a period of two years or longer will be considered a substantial period for the purposes of a taxpayer’s stay in another country. However, a two-year rule should not be automatically relied upon without considering the other factors.
Example 4.5: Domicile test –Australian resident George is an Australian resident. He works for a mining company and is transferred overseas for two years for a temporary work assignment in order to gain wider work experience. He intends to return to Australia at the end of the two years. George’s wife and children go with him at first, but the children return to Australia to go back to school.
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George spends his annual holiday in Australia. While overseas he rents out his Australian home and maintains bank accounts in Australia. Except for what he spends on living expenses, George sends all his money to Australia for investment. He makes no investments overseas. George is not considered to be a resident of Australia under the ordinary meaning of “resident”, but is considered to be a resident under the extended definition of that term. That is, George is a resident of Australia under the domicile test. Source: Adapted from Ruling IT 2650, para 31. Example 4.6: Domicile test –foreign resident As soon as Elise finished her degree, she decided to leave Australia indefinitely. She went to work in one city in one overseas country to gain work experience. Before leaving, she closed all her bank accounts, except for a five-year interest-bearing deposit. She was sharing a rented house while she studied and she has no spouse or children. Elise became ill while she was overseas and had to come back to Australia within 18 months. Elise is a foreign resident as it was her original intention to remain outside Australia for an unspecified period of time and she is considered to have a permanent place of abode in the overseas country.
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Alternatively, after finishing her degree, Elise intended to spend and indeed did spend a year each in two countries and then travelled for a further year, living in youth hostels the whole time. In this case, she did not have a permanent place of abode in any of the overseas countries and continues to be a resident of Australia. Source: Adapted from Ruling IT 2650, para 32. Example 4.7: Domicile test –foreign resident Seth is a bank manager. He is posted to the New Hebrides for two years, where he lives with his family in a furnished house provided by the bank. He expects he will receive another overseas posting after this two-year period, so he lets out the family home in Australia and advises Centrelink that the family is leaving Australia permanently and that Family Tax Benefit payments should cease. Seth is a foreign resident because he abandoned his place of residence in Australia and formed the intention to, and did, reside outside Australia. His place of abode in Vila was intended to be and was his home for the two years. Seth will cease being an Australian resident on the day he leaves Australia. Source: Adapted from Ruling IT 2650, para 33.
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100 [4.125] PRINCIPLES OF TAXATION LAW 2020 [4.125] The Full Federal Court, in Harding v FCT [2019] FCAFC 29, decently considered what constituted a permanent place of abode outside Australia. Case study 4.6: Permanent place of abode In Harding v FCT [2019] FCAFC 29, the taxpayer had spent a considerable amount of time in Saudi Arabia as an aircraft engineer. In 2004, he acquired a house in Australia which he moved into in 2006. In 2009, he returned to Saudi Arabia to work, living in Bahrain. His wife and children remained in Australia but the taxpayer leased a two bedroom apartment for the family to visit. In the year ended 30 June 2011, the taxpayer returned to the house in Australia to visit his family for a total of 91 days. In 2011, the taxpayer’s marriage broke down and the following year he moved into a serviced apartment. The question before the court was whether the taxpayer was a resident of Australia for the 2011 income tax year. The Full Federal Court held that the taxpayer was not a resident of Australia as he had a permanent place of abode outside Australia. In coming to this conclusion, the Court found that the word “place” in the phrase “permanent place of abode” invited consideration of the town or country in which the taxpayer is physically residing “permanently”. Provided the taxpayer had permanently abandoned their residence in Australia, they were not required to be permanently located in a particular dwelling. As such, the taxpayer’s permanent place of abode in 2011 was Bahrain as that was the place where he was living.
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183-day test [4.130] The second statutory test of residence, the 183-day test, requires physical presence in Australia for more than one- half of the year. Given the requirement of physical presence, this is a test that generally applies to incoming individuals. Under the test, an individual will be considered a resident of Australia where he or she is in Australia for more than 183 days, whether continuously or intermittently, unless the Commissioner is satisfied that the person’s usual place of abode is outside Australia and that he or she does not intend to take up residence in Australia. The first part of this test is purely mathematical, taking into account hours if necessary. The second part of the test provides an exception. There are two limbs to the exception –the taxpayer has a usual place of abode outside Australia, and he or she did not intend to take up residence in Australia. Both of these limbs must be satisfied. The wording of the first limb to the exception varies from that in the first statutory test. The domicile test requires a “permanent” place of abode
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outside Australia, while the exception to the 183-day test merely requires a “usual” place of abode outside Australia. While usual place of abode will again mean something less than everlasting, the requirement under this test will be less stringent and therefore easier to satisfy than the requirement under the domicile test. The second limb to the exception requires the Commissioner to be satisfied that the person does not intend to take up residence in Australia. This requires a consideration of the factors listed in the common law test of residence according to ordinary concepts. For the application of the 183-day test to individuals on working holiday visas, see the AAT decision of Re Koustrup v FCT [2015] AATA 126. In that case, despite the taxpayer being in Australia for more than 183 days, she was held to have a usual place of abode outside Australia and was therefore not entitled to the tax-free threshold under the residency tax rates. However, we now have special rules that apply to working holiday makers: see [4.155]. As Ruling TR 98/17 (at paras 37–38) explains, “in most cases, if individuals are not residing in Australia under ordinary concepts, their usual place of abode is outside Australia”. However, “there may be situations where an individual does not reside in Australia during a particular year but is present in Australia for more than one-half of the income year (perhaps intermittently) and intends to take up residence in Australia”.
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Superannuation test [4.140] The superannuation test applies to Commonwealth superannuation fund members and their families, that is, Commonwealth public servants. This test applies to relevant individuals who generally reside in Australia but leave temporarily and are not actually in Australia during the income year. In Baker v FCT [2012] AATA 168, it was held that “member of a superannuation scheme” includes an inactive member, where the taxpayer is on leave without pay.
Period of residence [4.145] The question may arise as to whether a person is a resident of Australia for the whole year or part of the year. The Commissioner accepts that where a person is a resident under the ordinary concepts test, the person is only considered a resident from the date he or she first resides in Australia. Where a person has a permanent place of abode outside Australia under the domicile test, they are considered to be a foreign resident for the actual period they are out of Australia and a resident while in Australia. Where a person is a resident for part of the year only, the tax-free threshold will be pro-rated. Where a person is a resident under the 183-day test, it has previously been understood
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102 [4.150] PRINCIPLES OF TAXATION LAW 2020 that they are resident for the whole of the income year and therefore entitled to the full tax-free threshold.
Temporary residents –individuals [4.150] The concept of “temporary resident”, contained in subdiv 768-R of ITAA 1997, was introduced from 1 July 2006. The object of Div 768 is to provide temporary residents with tax relief on most foreign sourced income and capital gains. As such, where a taxpayer is an individual who is a resident of Australia for tax purposes but qualifies as a temporary resident, he or she generally will not pay tax on his or her foreign income. A temporary resident will pay tax at the Australian resident income tax rates. However, from 8 May 2012, temporary residents are no longer entitled to the 50% CGT discount. In the 2018–2019 Budget, it was announced that individuals who are foreign or temporary tax residents no longer have access to the CGT main residence exemption and that existing properties held before this date would be grandfathered until 30 June 2019. However, the Bill lapsed in 2019 and has not yet been reintroduced into Parliament. Taxpayers are temporary residents if:
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• they hold a temporary visa granted under the Migration Act 1958 (Cth); • they are not Australian residents within the meaning of the Social Security Act 1991 (Cth); and • their spouse is not an Australian resident within the meaning of the Social Security Act. For the purposes of the Social Security Act, an Australian resident is generally a person who resides in Australia and is either an Australian citizen or holds a permanent resident visa. Where a resident taxpayer meets the temporary resident requirements, most foreign sourced income is not taxed in Australia. An exception to this is where the income is earned from employment performed overseas for short periods while the taxpayer is a temporary resident. Further, any capital gains or losses made by a temporary resident on the disposal of assets that do not have the necessary connection with Australia, or are not taxable Australian property, are disregarded. (Note: There are special rules for capital gains on shares and rights acquired under employee share schemes.) An ancillary object of subdiv 768-R is to relieve the burdens associated with certain record-keeping and interest withholding tax obligations. As such, any interest paid by a temporary resident to a foreign resident is exempt from withholding tax and the record- keeping obligations for controlled foreign companies and foreign investment funds are partly removed.
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Working holiday makers [4.155] Income earned by a working holiday maker on or after 1 January 2017 is subject to a special rate of income tax. This tax is colloquially known as the “backpacker tax”. A taxpayer is defined as a working holiday maker, where they are in Australia under a 417 (working holiday) visa or a 462 (work and holiday) visa. Where this is the case, the first $37,000 is taxed at 15% with the balance taxed at ordinary rates.
Foreign residents –individuals [4.160] The term “foreign resident” was introduced in the ITAA 1997 and is defined as a person who is not a resident for the purposes of the ITAA 1936. Several sections in the ITAA 1936 still contain the term non-resident and, in substance, the terms foreign resident and non-resident mean the same thing. An individual foreign resident will be subject to income tax only on income sourced in Australia. Tax is paid at foreign resident rates.
Residence of Australia –companies
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[4.170] The definition of “resident” in s 6(1) of ITAA 1936 provides that a company is a resident of Australia, where it is incorporated in Australia or, not being incorporated in Australia, where it 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. The three tests are known as: • the place of incorporation test: see [4.180]; • the place of central management and control test: see [4.190]; and • the controlling shareholders test: see [4.210].
Place of incorporation test [4.180] Under the first statutory test, a company incorporated in Australia is automatically a resident of Australia regardless of any other factors. Whether a company is incorporated in Australia is a question of fact determined by reference to the Corporations Act 2001 (Cth).
Central management and control test [4.190] Under the second statutory test, a company is a resident of Australia if it carries on business in Australia and has its central management and control
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104 [4.200] PRINCIPLES OF TAXATION LAW 2020 in Australia. The recent High Court case of Bywater Investments Limited & Ors v Commissioner of Taxation [2016] HCA 45 clarifies the court’s position on this test. In that case, the court held that the central management and control of a foreign company is a question of fact and degree. Further, there is no general presumption that the central management and control of a company is the location of the directors or where board meetings take place. [4.200] Previously, Taxation Ruling TR 2004/15 set out the Commissioner’s view on how to apply the central management and control test of company residency in paragraph (b) of the definition of “resident” or “resident of Australia” in s 6(1) of ITAA 1936. TR 2004/15 has now been replaced with TR 2018/5 Income Tax: Central Management and Control Test of Residency. This ruling sets out the Commissioner’s revised view on how to apply the central management and control test of company residency following the High Court decision in Bywater Investments Limited & Ors v Commissioner of Taxation [2016] HCA 45. The Ruling states that four matters are relevant in determining whether a company meets the two criteria of carrying on business in Australia and having its central management and control in Australia:
(1) (2) (3) (4)
Does the company carry on business in Australia? What does central management and control mean? Who exercises central management and control? Where is central management and control exercised?
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The ruling can be summarised as follows: • First, the Ruling states that if a company has its central management and control in Australia, and it carries on business, it will carry on business in Australia within the meaning of the central management and control test of residency. Further, it is not necessary for any part of the actual trading or investment operations from which its profits are made to take place in Australia because the central management and control of a business is factually part of carrying on that business. • Second, central management and control is the control and direction of a company’s operations, and the question to be asked is the location of the making of high-level decisions that set the company’s general policies and determine the direction of its operations and the type of transactions it will enter. This is different from the day-to-day conduct and management of its activities and operations. • Third, identifying who exercises central management and control is a question of fact and is not determined by identifying who has the legal power or authority to control and direct a company. Rather, the crucial question is who controls and directs a company’s operations in reality.
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• Fourth, a company will be controlled and directed where those making its decisions do so as a matter of fact and substance. It is not where decisions are merely recorded and formalised, or where the company’s constitution, by-laws or articles of association require it be controlled and directed, if in reality it occurs elsewhere.
Controlling shareholders test [4.210] The third statutory test provides that a company is a resident of Australia where its voting power is controlled by Australian residents, and it carries on business in Australia. As with the second statutory test, this test also contains two limbs. First, it is necessary to demonstrate that the voting power is controlled by Australian residents. The control of voting power appears to refer to the control of a majority, that is, more than 50% of the voting power at general meetings. A shareholder is a person who is entered on the company’s register or is absolutely entitled to be registered. It does not look through to the ultimate beneficial owner of the shares: Patcorp Investments Ltd v FCT (1976) 6 ATR 420. The residence of individual shareholders is determined by reference to the tests of residency as discussed at [4.50]. The second limb of this test, the company is carrying on business in Australia, is the same as it is for the central management and control test: see [4.190].
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Dual residency and tie breaker provisions [4.220] Both an individual and a company may be a dual resident. Double tax agreements (see Chapter 22) also contain definitions of “residency” for individuals and companies, which generally provide a tie-breaker rule, where the taxpayer is considered a resident of both jurisdictions. The most common tie-breaker rule for individuals is the taxpayer’s permanent home or, if this does not resolve the issue, the place where the taxpayer has the personal social and economic ties. The most common tie-breaker rule for companies is the place of effective management.
Source [4.230] As discussed at [4.20], ss 6-5 and 6-10 of ITAA 1997 provide that a resident of Australia is taxed on ordinary and statutory income from all sources, while a foreign resident is taxed only on ordinary income and statutory income sourced in Australia or deemed to be assessable income on some other basis. Source rules are based on a combination of common law principles and statutory provisions. Different source rules have been adopted for different
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106 [4.230] PRINCIPLES OF TAXATION LAW 2020 classes of income. Therefore, to determine the source of the income, it is necessary to classify the income into its relevant class.
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Figure 4.2: Categories of income to determine source
It is often stated that the question of source is not considered a legal concept. Rather, it has been described as “something which a practical man would regard as a real source of income” and a “practical, hard matter of fact”: Nathan v FCT (1918) 25 CLR 183 at 189–190. While this is usually suggested as the starting point for ascertaining source, it does little in the way of providing guidance as to the relevant facts to be considered. Of more practical importance is the particular class of income to which an amount will be categorised and an examination of the current source rules that apply to that particular class.
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Sale of goods –trading stock [4.240] The source of income from the sale of goods is generally the place, where the trading activities take place. Where the business of the taxpayer involves a number of activities situated in different locations, the income will be apportioned between the places where the activities are carried out. To determine the source and apportionment of the income from trading stock, the question that needs to be asked is whether any part of the profits were earned or produced within the jurisdiction, that is, what income arises or accrues to the taxpayer from the business operations carried on within the jurisdiction. This is a question of fact: Commissioners of Taxation v Kirk [1900] AC 588. The income allocated to a jurisdiction based on source is generally that added within the jurisdiction. Where no value is added by one jurisdiction, there will be no income allocated to that jurisdiction for the purposes of source: C of T (WA) v D & W Murray Ltd (1929) 42 CLR 332.
Sale of property other than trading stock [4.250] The source of income derived from the sale of property will depend on the property being sold. Where the transaction involves real property, that is, land and all things attached to it, the source will be the location of the property.
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Case study 4.7: Source of income overseas In Rhodesia Metal Ltd (Liquidator) v Taxes Commr [1940] 3 All ER 422, the taxpayer was a company incorporated in England with its central management and control in England. The taxpayer was in the business of purchasing and developing immovable property in Rhodesia and the sale of that property. The taxpayer went into voluntary liquidation and sold its undertaking to another company which had also been incorporated in England. The Privy Council held that the profits were derived from sources in Rhodesia. Case study 4.8: Source of income in Australia In Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834, the Full Federal Court ignored an elaborate arrangement involving various structures and contracts outside Australia to hold that the source of profits related to the sale of land located in Australia and, therefore, the profits were sourced in Australia.
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108 [4.260] PRINCIPLES OF TAXATION LAW 2020 Where the income is derived from the sale of tangible or intangible property, the source will be determined by reference to a number of factors, for example, the place of contract, place of negotiation and place of payment. In essence, it is always a case of being a practical hard matter of fact, where the courts generally look at the location of the economic activity giving rise to the income: Cliffs International Inc v FCT (1985) 16 ATR 601. The capital gains tax provisions also need to be considered, where there is a foreign resident holding taxable Australian property: see [22.320]–[22.330].
Services [4.260] Remuneration for the provision of services under an employment contract or contract for services will be in the form of salary, wages or fees. The source of that services income is generally taken to be the place of the performance of the services. Several cases are cited as authority for this general principle. Case study 4.9: Source of services income
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In FCT v French (1957) 98 CLR 398, the taxpayer was an engineer employed by an Australian company to carry out work in New Zealand. The taxpayer claimed that he was exempt from Australian income tax because the income was sourced in New Zealand. The High Court concluded that the payment was for services performed in New Zealand; as such, the source of the payment was New Zealand.
Case study 4.10: Source of services income A similar conclusion was reached by the Full Federal Court in FCT v Efstathakis (1979) 9 ATR 867. The taxpayer, a Greek national, moved to Australia to work as a Greek Government public employee at the Press and Information Service office in Australia. The salary paid to her by cheques drawn on a Greek bank was subject to income tax in Greece. The taxpayer claimed that the salary was exempt from Australian tax under former s 23(q) of ITAA 1936 as foreign sourced income. Section 23(q) exempted residents from tax on foreign sourced income that had already been subject to tax in the source jurisdiction. The Court held that any factors supporting a finding that the income was sourced outside Australia were outweighed by the residence of the taxpayer, the performance of the services in Australia and the receipt of payment in Australia.
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The general principle that the source of services income is the place of the performance of the services must be considered in the context of the possibility of other factors being relevant. For example, where services can be performed in any location, the place of contract or place of payment may be relevant: FCT v Mitchum (1965) 113 CLR 401.
Case study 4.11: Source of services income In FCT v Mitchum (1965) 113 CLR 401, the taxpayer was a well-known US actor who entered into a contract with a Swiss company for the provision of services. The Swiss company in turn contracted with a UK subsidiary of a US film studio for the taxpayer to provide services for a movie filmed in Australia. The Commissioner assessed the taxpayer on the basis that his salary was sourced in Australia because it was paid for acting in a movie that was filmed in Australia. Although not actually reaching a decision on the source of the income, the High Court held that FCT v French did not result in the conclusion that the source of services income is always the place of performance.
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Interest [4.270] The source of interest income involves a consideration of a number of factors, including the place of contracting and the place where the funds are advanced: Commissioner of IR v Philips Gleilampenfabrieken [1955] NZLR 868. In the more recent case of Spotless Services v FCT (1993) 25 ATR 344, the Full Federal Court placed emphasis on the place where the contract for the loan was made and the place where the money was advanced.
Dividends [4.280] In the case of dividends, it is s 44(1) of ITAA 1936 which provides that dividends are assessable income. It further provides the source rule for dividends as it states that the assessable income of a shareholder in a company includes: • if the shareholder is a resident, dividends that are paid to the shareholder by the company out of profits derived by it from any source; and • if the shareholder is a non-resident, dividends paid to the shareholder by the company to the extent to which they are paid out of profits derived from sources in Australia.
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Case study 4.12: Dividends The phrase “to the extent to which they are paid out of profits derived from sources in Australia” was considered in Esquire Nominees Ltd v FCT (1973) 129 CLR 177. The taxpayer was a company incorporated in Norfolk Island and had its registered office and its central management and control located there. In the income year in question, the taxpayer, as trustee of a discretionary trust, received dividends paid on shares held in another Norfolk Island company. The dividends paid to the taxpayer were ultimately distributed after a flow of dividends through two other companies and which originated from the activities of a company resident in Australia. The Commissioner assessed the taxpayer as a non- resident trustee deriving Australian sourced income that had not been distributed to any beneficiaries. The High Court, in drawing a distinction between the source of the dividend and the source of the money which enables the dividend to be paid, held that the source of the dividends was the holding of the shares in the Norfolk Island company. Consequently, the non-resident trustee was not liable to Australian tax on the dividends paid.
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Royalties [4.290] The common law principle in relation to royalties is that the source of the royalty is the location of the industrial or intellectual property from which the royalty flows. However, where a royalty is outgoing (ie, paid by an Australian business to a foreign entity), s 6C of ITAA 1936 deems the royalty to have an Australian source. It is also necessary to consider the interaction of double tax agreements (see Chapter 22). In Satyam Computer Services Ltd v FCT [2018] FCAFC 172, the Full Federal Court held that royalty payments made to an Indian company from Australian clients was sourced in Australia under the Australia–India double tax agreement.
Questions [4.300] 4.1 What is the income tax payable for an Australian resident individual with taxable income for the 2019–2020 income tax year of $120,000? 4.2 What difference does it make to Question 4.1 if the taxpayer is a foreign resident? 4.3 Fred, an executive of a British corporation specialising in management consultancy, comes to Australia to set up a branch of his company.
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Although the length of his stay is not certain, he leases a residence in Melbourne for 12 months. His wife accompanies him on the trip but his teenage sons, having just commenced college, stay in London. Fred rents out the family home. Apart from the absence of his children, Fred’s daily behaviour is relatively similar to his behaviour before entering Australia. As well as the rent on the UK property, Fred earns interest from investments he has in France. Because of ill health, Fred returns to the UK 11 months after arriving in Australia. Discuss residency and source issues.
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4.4 Jenny is an accountant who works in Hong Kong. She is single and lives in Hong Kong with her parents. Until April 2019, her work does not involve travel. At that time she accepts an offer from her employer to travel temporarily to Australia to provide business advice to large numbers of former Hong Kong residents setting up businesses in Melbourne, Sydney and Brisbane. Jenny enters Australia on 25 April 2019. She intends to spend three months travelling between the three cities, staying in various motels. Her employer asks her towards the end of her three months to take up a position in Sydney for a further nine months. In early July, she leases a serviced executive apartment for nine months near her workplace in Sydney. The apartment is her home base during her stay here. She freights more clothing and some personal effects to Australia. Her parents visit her on two occasions. Although based in Sydney, her commitments require some limited travel. On average, Jenny travels at least once a week to meet clients outside Sydney. Is Jenny a resident of Australia for tax purposes? 4.5 Ajay is a student from India who comes to Australia to study for a four- year bachelor degree in business. Ajay lives in rental accommodation near the university with fellow students and works part-time at the university social club as a barman. After six months, he has to withdraw from his studies and return to India because his father is ill. Is Ajay considered a resident of Australia? 4.6 After Misha finishes her Bachelor of Commerce degree, she travels to the UK to work as an accountant for three years. During that time she rents a flat and makes many friends. Her UK salary is paid into a UK bank account. At the end of the three-year period, she has saved enough money to travel. Misha then spends a year travelling around Europe and a year travelling around North America. At the end of the five years, she returns to Australia. Discuss the residency of Misha. 4.7 The Big Bang Company was set up by Ed, an Australian resident. It is incorporated in Singapore and has two directors who are resident in Singapore and who hold board meetings in Singapore. Each director has two shares in the Big Bang Company, which they hold on trust for Ed. The Big Bang Company owns real property, all of which is outside Australia, and makes its profits from commercial property leases on
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112 [4.300] PRINCIPLES OF TAXATION LAW 2020 a large scale. Ed does not attend the board meetings in Singapore; however, the constitution of the Big Bang Company provides that the decisions of the directors are only effective if Ed concurs with them. The directors carry on all operational activities, such as collecting rent, paying commission, finding tenants, making minor repairs and maintaining the buildings. Is there any possible scenario in which the Big Bang Company could be considered a resident of Australia for tax purposes?
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4.8 Peter is an accountant for an international accountancy firm based in Vanuatu. He has investments in Vanuatu comprising his own home, a rental property, shares in local companies and cash deposits in high interest bearing bank accounts. On 1 February 2020, Peter was transferred to the firm’s Brisbane office on a temporary three-month secondment. The purpose of the secondment was to establish networks with existing Australian clients that have indicated the possibility of investing in Vanuatu. During the secondment period, Peter remained an employee of the Vanuatu office and his salary was paid into his Vanuatu bank account. While Peter’s intention was to return to Vanuatu at the conclusion of his secondment, he sought and was successfully offered a permanent position in Brisbane. In early June 2020, he became an employee of the Brisbane office. His relocation involved purchasing an apartment in the Brisbane suburb of Ascot, renting out his own home in Vanuatu and transferring a sum of cash to a high interest bearing bank account in an Australian bank. Discuss residency and source issues. 4.9 Your client was born in Sydney and lived in Australia until 1 July of the current tax year. At that stage, he accepted a voluntary redundancy with Qantas. A year earlier he had separated from his wife of 20 years. A few months later he started a relationship with a resident of Singapore. Upon accepting the redundancy, he began travelling overseas to perform aircraft mechanic services at various locations within Asia. Under his contract of employment with Boeing, the taxpayer was provided with either hotel or short-term apartment accommodation at each location he attended for work purposes. During the current income year, the taxpayer provided services in Hong Kong, Spain, Greece, Thailand and Indonesia. The longest time he stayed at any one place was 45 days in a serviced apartment in Indonesia. The taxpayer visited his two teenage children and his parents in Australia on two occasions for a total of 30 days and visited his new partner in Singapore on four occasions for a total of 50 days. During the tax year what had been the family home in Sydney was sold to complete a divorce settlement. While he no longer had any place in Australia in respect of which he could call his own, he also did not
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have ownership or leasehold in any dwelling outside Australia. Nor did he apply for a long-term visa or residency status anywhere outside Australia. Advise your client whether he is a resident of Australia in the current tax year for income tax purposes. 4.10 Bridget and her husband are moving from London to Australia permanently under an employer-sponsored arrangement. Bridget and her husband have a joint bank account in London which they leave open for the purposes of the rent coming from their home which they hold onto. They rent out what was the family home and the money is deposited into the London bank account. The London bank account also earns interest.
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Bridget and her husband pay tax in the UK on both the rental property income and interest income. Their UK accountant has advised them that they will not have to pay tax on the income in Australia because it is sourced in the UK. Bridget and her husband come to you to confirm whether this advice is correct. Advise your clients.
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Part 2 Income
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The first step in the taxation process is to determine assessable income. “Income” is a complex and difficult concept to understand. From an income tax perspective, assessable income is divided into income according to ordinary concepts and statutory income. Income according to ordinary concepts has been developed by the courts. A receipt is likely to be considered income when it is a product of, yet severable from, a source such as labour (or services), business or property. In addition to this basic principle, a receipt which has income characteristics, such as being periodic, expected and used for ordinary living expenses, can in some instances be considered to be ordinary income even when it is not a product of labour, business or property. Further, the courts have always held that a receipt must be a genuine gain and be money or convertible to money to be ordinary income. Many receipts will be ordinary income which is assessable income under Div 6 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997). However, over the years, it became apparent that not all receipts which should be taxable were included as ordinary income. The judicial concept of income, first adopted in Australia when federal income tax was introduced in 1915, provided a narrow tax base with opportunities to shift receipts outside this judicial concept of ordinary income. Accordingly, a second category of income developed, statutory income, which shifts many types of gains and receipts into the income tax base. Assessable income (s 6-1)
=
Ordinary income (s 6-5)
+
Statutory income (s 6-10)
–
Exempt income (s 6-10)
Traditionally, income has been categorised according to the source to which it attaches, that is, the receipt is a product of labour, business
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or property. Because this has been the traditional approach to looking at receipts, the common law has developed along these lines with the statutory regime, then broadening the tax base of each category. However, propositions which have developed to determine whether an amount is ordinary income are not unique to income from any particular category. As such, the first chapter in Part 2, Chapter 5, is an introduction to ordinary income. It outlines the principles which apply to determine the types of gains that courts of law consider to be of an income character and, in doing so, considers the general propositions for ordinary income. Chapter 6 specifically covers income from personal services and employment. An examination of the general propositions developed by the courts, discussed in Chapter 6, demonstrates that it is easy to manipulate the ordinary income category by receiving benefits rather than salary or wages. To counter this behaviour, certain types of statutory income categories were introduced. The most significant category in relation to labour is allowances in respect of employment or services in s 15-2 of ITAA 1997. Unfortunately, the statutory provisions have had limited success in taxing benefits received as a result of labour. Consequently, fringe benefits tax was introduced in 1986.
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Chapter 7 follows on from the discussion on income from personal services and employment to consider the fringe benefits tax regime. The key difference and unique feature of this regime, which is separate to the income tax regime, is that while the employee receives the benefit, it is the employer who pays the tax. Chapter 7 explains the operation of this regime, including a discussion of the various categories of benefits and the concessions or exemptions available for certain benefits. While the ordinary income concepts are generally no different, the source of the receipt introduces unique issues. In relation to income from business, the question that needs to be asked is: “What is a business for taxation purposes?” Chapter 8 details the indicia of a business established by the courts. A finding of the existence of a business is not sufficient to conclude that all receipts are assessable income. It is also necessary to consider whether the receipts arise as a result of activities within the scope of the business and to what extent isolated and extraordinary transactions are assessable. A third category of income, known as income from property, or passive income, also introduces unique issues. Chapter 9 details income from property, explaining the principles that apply to income from interest, dividends, leases, royalties and annuities. Taxpayers may receive various types of compensation payments. If the compensation is for loss of income, then generally the compensation
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payments themselves will be of an income character. Chapter 10 considers the different categories of compensation which may substitute for loss of income from labour, loss of income from business and loss of income from property. Although both statutory income and ordinary income are included in assessable income, the rules for some types of statutory income are concessional relative to those applying to ordinary income and it thus remains very important to determine whether a receipt is assessable as ordinary income or assessable income and, if the latter, which provision brings the receipt into assessable income. The most important statutory income measures are the “capital gains tax” rules which were adopted in 1985 to sweep up a wide range of receipts that had not been captured by the ordinary income concept or previously adopted statutory rules. Because of the broad coverage of the capital gains rules and their operation as a code within the broader income tax Act, these rules are often studied independently from other types of income which fall on either side of the ordinary income/capital gains borderline and, accordingly, Chapter 11 looks at these rules separately.
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Amounts that do not fall within the ordinary income or statutory income provisions are either exempt income or non- assessable non- exempt income. These amounts do not form part of the taxpayer’s assessable income and are therefore not subject to tax. It is, however, necessary to distinguish between the two due to other tax consequences.
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5 Assessable income Key points...................................................................................................... [5.00] Introduction.................................................................................................. [5.10] Ordinary income –general........................................................................... [5.20] “In accordance with ordinary concepts and usages of mankind”....... [5.20] Three categories of income................................................................... [5.30] Capital gains are not ordinary income.................................................. [5.40] Prerequisites and characteristics of ordinary income............................... [5.50] Prerequisites........................................................................................... [5.50]
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Cash or cash convertible........................................................................... [5.60] Real gain..................................................................................................... [5.70] Characteristics........................................................................................ [5.80] Regular/periodic......................................................................................... [5.90] Flow.......................................................................................................... [5.100] Examples.................................................................................................. [5.120]
Some gains are ordinary income despite having no earnings source....................................................................... [5.130] Other general principles............................................................................. [5.140] Compensation takes on the character of the loss being compensated...................................................................... [5.140] Unrealised gains are not ordinary income.......................................... [5.145] Legality of receipts does not affect their assessability....................... [5.150] Whether a receipt is ordinary income is to be characterised in the taxpayer’s hands......................................... [5.155] Constructive receipt............................................................................. [5.160] Benefit that saves taxpayer from incurring expenditure is not ordinary income..................................................................... [5.165] Principle of “mutuality”........................................................................ [5.170] Questions..................................................................................................... [5.180]
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Key points [5.00] • Gains that are ordinary income will be assessable income under s 6-5 of ITAA 1997. • Gains will be ordinary income if they are the type of gains that courts of law consider to be of an income character. • For a gain to be ordinary income, it must be cash or cash convertible, as well as a genuine gain. • A gain that comes in regularly/periodically is more likely to be ordinary income than a lump-sum gain. • A gain that flows from an earnings source is likely to be ordinary income. • Compensation takes the form of the loss being compensated. • Whether or not a gain arises from an illegal activity does not affect whether it is ordinary income.
Introduction
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[5.10] As discussed in Chapter 1, assessable income includes gains that are ordinary income and/or statutory income. This means that if a gain is ordinary income it will be assessable income except if the legislation explicitly states that it is not assessable. What if a gain is not ordinary income: will it be assessable? If a gain is not ordinary income, then it will only be assessable if it is statutory income, that is only if it comes under one or more specific statutory provisions of the ITAA 1936 or ITAA 1997 and provided the legislation does not specifically state that it is not assessable. So what is ordinary income? According to s 6-5(1) of ITAA 1997, ordinary income is “income according to ordinary concepts”. This means that a gain that is regarded by courts as being of an income character will be “ordinary income” and, as such, assessable under s 6-5. This raises the question as to when courts will regard gains as being of an income character. To determine which gains have an income character, courts have developed a range of rules and guidelines, some of which are vague and not always consistently applied. Some gains are clearly of an income character and so will constitute ordinary income (such as a salary received by an employee). Some gains are clearly not of an income character and so will not be ordinary income (such as the capital proceeds from the sale of a milk bar that you ran for the last three years). However, given the uncertainty of
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the law, with some gains it is not possible to arrive at a definitive answer as to whether they are ordinary income –in those cases the best we can do is make an educated guess. In this chapter, we discuss the prerequisites and characteristics of ordinary income. Chapters 6, 8 and 9 look at specific types of gains (eg, salaries, normal business profits and rents) and discuss which of those gains are or are not ordinary income. Before the ITAA 1997 was in force, the provision that was roughly equivalent to the current s 6-5 was s 25(1) of ITAA 1936. This means that older case law that discusses the law that applied before the ITAA 1997 came into force will refer to s 25(1) of ITAA 1936 when there is an issue of whether a gain is of an income character.
Figure 5.1: Overall guide
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Ordinary income
Prerequisites
Cash or convertible to cash
Real gain
Characteristics
Regular or periodic
Flow
Other consideration
Income from property
Personal services income
Compensation
Ordinary income
Ordinary income
Illegal transactions
Statutory income
Statutory income
Business income
Ordinary income
Statutory income
Constructive receipts
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122 [5.20] PRINCIPLES OF TAXATION LAW 2020
Ordinary income –general “In accordance with ordinary concepts and usages of mankind” [5.20] In discussing what gains are of an income character (and, as a consequence, are ordinary income) in Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 at 219, Jordan CJ said: The word “income” is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind …
What His Honour appears to be saying is that the Court’s definition of income resembles what most ordinary people would regard as income. While this concept may have derived originally from trust law (see [1.60]), it nevertheless approximately aligns with the contemporary tax law meaning of income. For instance, most people would regard salaries and rent as income, and these gains are also recognised by courts as being of an income character. On the other hand, most people would intuitively regard a personal gift or a lottery winning as not constituting income. This conclusion is also consistent with the fact that courts do not consider such gains as being of an income character. Because the ordinary meaning of income to the layperson may change over time, the scope of ordinary income for tax purposes will also evolve, as is discussed at [5.80].
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While it is useful to keep in mind that the courts’ idea of income resembles what many people intuitively regard as income, ultimately the law as to what is ordinary income is determined by case law. As seen from Figure 5.1, income is shown to have two essential prerequisites and two characteristics (discussed later in this chapter). These four elements are key to determining whether a receipt is income or not. It is also helpful to categorise income into three broad areas as shown in Figure 5.1.
Three categories of income [5.30] Income is commonly categorised into three broad areas: • income from personal services and employment (eg, salary): see Chapter 6; • income from business (eg, accounting firms selling accounting services): see Chapter 8; or • income from property (eg, rent and dividends): see Chapter 9. However, as discussed at [5.130], there are some relatively rare instances, where receipts will be ordinary income despite not belonging in any of these three categories.
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Capital gains are not ordinary income [5.40] Courts have made a distinction between gains that are capital and income (see [1.160]–[1.170]). This means that gains that are capital will not be ordinary income and gains that are ordinary income cannot be capital. It is possible in some limited circumstances for a gain that is not capital to also not be ordinary income either. So, in this context, gains can be thought of as falling into one of three categories: • ordinary income; • capital; or • not capital and not ordinary income. The distinction between capital and income is a central issue in the application of the Australian income tax legislation as it is relevant to both the question of the assessability of receipts and the deduction of expenses (see [12.160]– [12.210]). In relation to assessable income, the distinction between capital and income is often considered through the application of the “flow concept”: see [5.100].
Prerequisites and characteristics of ordinary income
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Prerequisites [5.50] For a gain to be ordinary income, it must fulfil two prerequisites (Figure 5.1). These prerequisites are necessary but not sufficient for a gain to be ordinary income. In other words, if a gain fulfils both prerequisites, then that gain might or might not be ordinary income. But if a gain does not fulfil both prerequisites, then it cannot be ordinary income. The two essential prerequisites of a receipt being ordinary income are that it is: • cash or convertible to cash; and • a real gain to the taxpayer.
Cash or cash convertible [5.60] If a gain is cash or cash convertible, it might be ordinary income. On the other hand, if it is not cash or cash convertible, then it definitely will not be ordinary income: FCT v Cooke and Sherden (1980) 10 ATR 696. For an item to be cash convertible, it needs to be readily convertible to cash. So a new or used car, real estate or even a transferrable holiday ticket would all be regarded as cash convertible. However, the courts have indicated that if it is illegal to sell a good, then receipt of that good cannot be regarded as cash
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124 [5.70] PRINCIPLES OF TAXATION LAW 2020 convertible: Payne v FCT (1996) 32 ATR 516. In practical terms, this means that for most taxpayers, a receipt of cigarettes would not be regarded as cash convertible because it is illegal to sell cigarettes without a licence. Case study 5.1: Receipt of free accommodation was not income In the UK case of Tennant v Smith [1892] AC 150, the taxpayer was an agent for a bank and lived in free accommodation supplied by the bank. The taxpayer was not allowed to sublet the accommodation. The House of Lords held that the accommodation was not regarded as income as it was neither cash nor cash-convertible.
Case study 5.2: Receipt of non-cash-convertible holiday not ordinary income In the Australian case of FCT v Cooke and Sherden (1980) 10 ATR 696, a few taxpayers sold drinks “door to door”. These taxpayers received a free holiday from the soft drink manufacturer due to them selling a certain number of soft drinks. The holidays were non-transferrable and therefore could not be sold.
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The Full Federal Court followed the principle in the case of Tennant v Smith [1892] AC 150 and held that because the holidays were not cash convertible, they were not ordinary income. As discussed at [8.160], s 21A of ITAA 1936 deems non-cash business benefits as being cash-convertible. This means that for a business taxpayer benefits can be assessable income despite not being cash or cash-convertible. Had the case of FCT v Cooke and Sherden been decided after s 21A of ITAA 1936 was introduced into the legislation, then it is very likely that the Court would have decided that the free holiday was assessable as this section would deem it to be convertible to cash. It is important to note that s 21A does not deem the non- cash receipt to be income, but rather it deems the benefit to have a cash value so that it satisfies the prerequisite that ordinary income must be cash or convertible to cash. This is in contrast to statutory income which specifically makes certain receipts assessable income through a provision of the Act (see [5.10]).
Real gain [5.70] If a receipt is a genuine gain (ie, the taxpayer is better off financially), then it could be ordinary income. But if it is not a real gain, it will not be ordinary income: Hochstrasser v Mayes [1960] AC 376 (see Case Study [5.3]).
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The principle that a receipt that is not a real gain will not be ordinary income is more likely to apply in employment situations and clubs (see [5.170]) than in other situations. In an employment situation, the courts will usually only label a receipt as not being a real gain when the receipt is related to an employment-related expense. For instance, if an employee incurred work-related public transport expenses and that expense is then reimbursed, this would not be regarded as a real gain because the employee has only been compensated for a work-related expense. The employee has effectively only been reimbursed for an expense they incurred on behalf of the employer. In contrast, an employee who is reimbursed for his or her private holiday would be regarded as receiving a real gain as he or she has effectively been provided a benefit over and above their wage. It is also important to note that an employee that has been given a predetermined amount for a specific work-related purpose and does not have to return the unspent amount will be regarded as having received an “allowance” rather than a “reimbursement”. Unlike work- related reimbursements, allowances will generally constitute ordinary income, though an offsetting deduction will be allowed to the extent that money has been spent for allowable income- producing purposes. For example, a taxpayer who receives $150 from his employer for travel purposes but ends up only spending $60 of it and is allowed to keep the rest will be assessable on the $150 allowance and will be able to deduct the $60 expenses (see Chapter 12).
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Case study 5.3: Reimbursement for work-related loss upon moving premises not assessable In Hochstrasser v Mayes [1960] AC 376, the taxpayer’s employer required him to move cities. The taxpayer sold his house in the city he was relocating from. The house was sold by the taxpayer for less than the price for which he had purchased it. The taxpayer’s employer reimbursed him for the loss from selling his house. The House of Lords held that this payment was not assessable. One of the judges, Lord Denning, said that the payment was not assessable because it was not a real gain because the taxpayer had been compensated for a work- related expense. Lord Denning also mentioned that had the taxpayer been compensated for a non- work- related loss, the receipt would have been a real gain. He gave an example that if a taxpayer’s employer compensated him for share market-related losses, then this receipt would be a real gain because in this example the taxpayer would have been compensated for a non-work-related loss.
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126 [5.80] PRINCIPLES OF TAXATION LAW 2020
Characteristics [5.80] Provided both of the prerequisites of income are satisfied a receipt or benefit will be ordinary income if it shows sufficient of the characteristics of income (Figure 5.1). However, these characteristics are not black or white rules; they are only indicators or pointers to what constitutes ordinary income. This has increasingly been the case in recent decades as courts take a wider view of what gains are regarded as ordinary income. The widening of courts’ views has been influenced by the fact that society now regards certain gains as normal due to the fact that individuals and businesses operate differently to how they did several decades ago. For example, under the first strand in FCT v Myer Emporium Ltd (1987) 163 CLR 199 (see [8.210]–[8.250]), a gain can be ordinary income even when it does not fulfil the characteristics described at [5.90]–[5.110]. The characteristics of income can be grouped into two broad areas:
•
regular/periodical receipts;
• the flow concept.
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Regular/periodic [5.90] All other things being constant, a gain that is regular or periodic is more likely to be ordinary income than a gain that is received as a once-off lump sum amount. For instance, the cases of FCT v Blake (1984) 15 ATR 1006 and FCT v Harris (1980) 10 ATR 869 (see [6.50]) involved near identical facts – except that in FCT v Blake the receipt was regular while in FCT v Harris it was regarded as a one-off receipt. Consequently, in FCT v Blake, the Court held that the receipt was of an income nature, whereas in FCT v Harris, the Court held that the one-off receipt was not ordinary income but capital. However, the regularity of a receipt is not a determinative factor in deciding if a gain is ordinary income. For example, in Premier Automatic Ticket Issuers v FCT (1933) 50 CLR 268, a lump sum was held to be ordinary income. It is easy to think of many everyday instances of lump-sum gains being ordinary income. For instance, a one-off receipt of interest under a loan agreement which provides for one interest payment at the end of the loan term would be ordinary income. Another example is someone who receives one single payment under a contract to do a one-off job. Less common but still possible is for a gain to be regular but not ordinary income, such as where a taxpayer receives instalments for the sale of a capital asset: Foley v Fletcher [1843–1860] All ER Rep 953. For example, if the taxpayer (not a property developer) sells a block of land for $100,000 (capital sale) for
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10 equal payments of $10,000, paid over the next 10 years, then these receipts will remain capital and not be ordinary income even though the receipts are regular. This is because each $10,000 receipt is a part payment for the sale of the capital asset.
Flow [5.100] When courts developed the judicial concept of what is and what is not of an income character, they borrowed concepts from trust law: see [1.160]. Under trust law, trust property may have income gains or capital gains. The two were mutually exclusive; a gain could not be both an income gain and a capital gain. To decide which trust gains were income and which were capital, the courts used a “flow” concept. The courts stated that income “flowed” from the capital. For example, if the trust property was a house, the rent “flowed” from the house. This meant that for trust purposes, the rent from an investment property was considered income, and appreciation of the value of the house was regarded as capital. To use another example, if the trust property was shares, then dividends flowing from the shares were income, but profit from selling the shares was usually capital. Tax law has used the same “flow” principle as trust law. Consequently, under tax law, rent from an investment property is income, but profit from the property’s increase in value is usually capital and not ordinary income.
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This concept of “flow” is articulated in a paragraph from the US judgment Eisner v Macomber 252 US 189 (1920) by Pitney J (at 206), where the concept of flows was expressed in terms of fruit and trees. Under this analogy, the fruit was income and the tree capital: The fundamental relation of “capital” to “income” has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time.
For an investment property, the rent is likened to the fruit and therefore considered to be ordinary income, but the sale of the property itself is likened to the sale of the tree and is capital. In an employment context, the taxpayer’s ability to work and/or the employment contract would be regarded as the tree, which means that payment for services is akin to the fruit and is ordinary income. [5.110] What exactly is meant by the concept that if a gain is likened to the fruit from the tree, it is likely to be considered to be ordinary income? There are a number of ways this concept can be viewed, but importantly the gain (ie, likened to the fruit) will have both of the following two related traits:
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128 [5.120] PRINCIPLES OF TAXATION LAW 2020 1 Having a nexus (a connection) with an earning source. Specifically, having a nexus with one of the following three: (a) property (eg, rent has a nexus with property); (b) business (eg, an accounting firm’s profit has a clear nexus with the accounting business); or (c) personal services (eg, a salary has a clear nexus with an employee providing services). 2 Being severable from its earning source. Being severable means that the gain can be extracted without affecting the underlying earnings source (capital). For example, rent is clearly severable from underlying property in that rent can be obtained from a rental property without affecting the underlying property. An accounting firm’s profit can be obtained from an accounting business without damaging the underlying accounting business. Salary can be obtained without damaging the underlying work contract or the employee’s ability to work. Although the “fruit and tree” analysis distinguishes between income and capital gains, there are some receipts that are neither income nor capital gains. Personal gifts or inheritances are examples of this. Items that are neither ordinary income nor capital generally do not fit into the “fruit” or “tree” concept.
Examples
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[5.120] Examples 5.1 and 5.2 apply the introductory principles of the prerequisites and characteristics of income. Example 5.1: Receipt of rent and proceeds of property sale A landlord owns an investment property. The rent collected from it is ordinary income as it fulfils the prerequisites of ordinary income in that it is: • cash; and • a genuine gain. Furthermore, it has the characteristics of ordinary income in that it is:
• regular (ie, rent is usually received every month);
• an amount which “flows” from the underlying property as the rent:
• has a nexus with the house; and • is severable from the house –in that it can be extracted without effecting the value of the house.
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On the other hand, profit from the sale of the house, although fulfilling the prerequisites, in that it is:
• cash; and
• a genuine gain;
does not have the characteristics of ordinary income as it:
• is not a regular receipt; and
• does not “flow” from any underlying source.
This is the sale of the underlying tree and so would be regarded as capital.
Example 5.2: Business that regularly buys and sells houses Following on from Example 5.1, the profits from selling the house would be regarded as capital, but what about a business that regularly buys and sells houses? Putting aside the trading stock implications (see Chapter 17), the sale of the houses would generate ordinary income. First, the proceeds of sale would fulfil the prerequisites of ordinary income, as they are: • cash;
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• a genuine gain.
Furthermore, they have the characteristics of ordinary income as they: • would have some regularity since this business regularly sells such houses; and • can be said to be the fruit of the underlying business. The proceeds flow from the underlying business because they: • have a nexus with the underlying business that buys and sells properties; and • are severable from the underlying business, in that selling a property does not damage the underlying business.
Some gains are ordinary income despite having no earnings source [5.130] As discussed at [5.100], one of the major characteristics of ordinary income is that it flows from an earnings source. In other words, most gains that are ordinary income will have a nexus to and be severable from an earnings source. However, this will not always be the case. For example, if receipts are regular, expected and the taxpayer is able to depend upon them for support, this will be enough to make them ordinary income even if they do not flow from an earnings source.
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130 [5.140] PRINCIPLES OF TAXATION LAW 2020
Case study 5.4: Government age pension constitutes ordinary income In Keily v FCT (1983) 83 SASR 494, a single judge of the Federal Court held that a government aged pension was ordinary income. This was because of the traits it had: it was regular, expected and depended upon by the taxpayer for support. This same logic would apply to many other regular government payments, such as unemployment benefits (eg, Newstart Allowance). Specifically, in Anstis v FCT (2010) 76 ATR 735, the High Court held that Youth Allowance payments constituted ordinary income. However, this principle is not restricted to government benefits and could apply to other regular payments. Case study 5.5: Top-up payments if employee joined the armed forces during WWII
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In FCT v Dixon (1952) 86 CLR 540, an employer offered his employees “top-up” payments if they enlisted in the armed forces during World War II. He said to them that if they ceased working for him and signed up to be soldiers for World War II, he would pay them the difference between their former salary and their military salary. The High Court held that this “top-up” payment was ordinary income. Two of the judges (Dixon CJ and Williams J) held that this was because of the traits that the payments had: they were regular, expected and depended upon by the taxpayer for personal living expenses. A third judge (Fullagar J) held that the payments were ordinary income due to the compensation principle discussed at [5.140]: since the payments were a compensation for lost salary, and the salary would have been ordinary income, the payments themselves were ordinary income.
Other general principles Compensation takes on the character of the loss being compensated [5.140] In general, compensation receipts take on the character of what they are compensating. This specifically means that compensation for loss of ordinary income is ordinary income, and compensation for loss of capital is capital. For example, salary is ordinary income, so compensation for loss of
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salary is also ordinary income. For a manufacturing business, its factories are capital, so compensation for loss of one of its factories would be capital. Compensation receipts are discussed in more detail in Chapter 10.
Unrealised gains are not ordinary income [5.145] An unrealised gain will not be ordinary income: Eisner v Macomber 252 US 189 (1920). This is related to the flow principle (see [5.100]) as unrealised gains are not yet regarded as a fruit flowing from a tree. For instance, if a taxpayer in the business of share trading owns shares that have appreciated in value but have yet to be sold, no ordinary income will have been generated until such time that the gain has been realised through the sale of the shares.
Legality of receipts does not affect their assessability [5.150] The fact that a receipt is from an illegal activity does not prevent it being assessable provided it would have been assessable had the activity been legal: Minister of Finance (Canada) v Smith [1927] AC 193; Lindsay v IR Commrs (1932) 18 TC 43; Taxation Ruling TR 93/25. This finding is reasonable as it would be rewarding illegal activities if these proceeds were not subject to tax. For instance, a taxpayer that is in the business of drug dealing is assessable on the proceeds of drug sales despite the illegality of the activities.
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Whether a receipt is ordinary income is to be characterised in the taxpayer’s hands [5.155] Whether a receipt is ordinary income or not needs to be determined in the context of the taxpayer being assessed: Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519. For instance, if an employee receives a salary, that salary would clearly be ordinary income in the hands of the employee: see [6.30]. However, if that same employee asked their employer to have the salary paid to the employee’s spouse instead, then the salary would not be regarded as ordinary income in the hands of the spouse. This is because in the spouse’s hands the receipt does not have one of the important characteristics of ordinary income –that is, it does not flow from their property, business or services they have provided: see [5.100]. In this situation, the salary would still be regarded as ordinary income in the hands of the employee due to the principle of a constructive receipt: see [5.160].
Constructive receipt [5.160] The principle of a constructive receipt is that income is treated as being derived by a person when that income has been dealt with as that person
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132 [5.160] PRINCIPLES OF TAXATION LAW 2020 directs. This means that if someone is entitled to receive income, but arranges to have someone else receive it, then the person originally entitled to receive the income has constructively received it. This means that the person originally entitled to receive the money will be assessable on it. Originally, the concept of a constructive receipt was a principle of case law, but it was later incorporated into the income tax legislation. Specifically, s 6-5(4) of ITAA 1997 covers the principle of constructive receipt for ordinary income and s 6-10(3) covers the principle of constructive receipt for statutory income. Example 5.3: Constructive receipt Alex works for an engineering firm. He is paid on a fortnightly basis. One fortnight he tells his employer, “for this fortnight, don’t pay me, pay my wife instead”. Although his wife receives his salary, it is still the ordinary income of Alex. This is because the salary is ordinary income and Alex has constructively received the salary, and s 6-5(4) applies to make the salary the assessable income of Alex. The reason Alex has constructively received the salary is because he was able to receive the salary, but instead chose to have it directed to his wife.
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Case study 5.6: ATO loses because it did not use principle of constructive receipt In Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519, Bellambi was an Australian company that owned a subsidiary, Federal Coke. Bellambi had a long-term contract to supply mineral coke to a French company Le Nickel and the mineral coke was supplied by Bellambi’s subsidiary Federal Coke. The world price for coke had declined since the contract price was set and Le Nickel wished to be released from this contract and was willing to compensate Bellambi for cancellation of the contract. Bellambi was professionally advised that this compensation payment from Le Nickel would be treated as their assessable income. As a result of this advice, Bellambi returned the compensation payment to Le Nickel and arranged for them to make the payment to Federal Coke (subsidiary of Bellambi) instead. Bellambi hoped that the compensation would not be assessable in Federal Coke’s hands. The Commissioner argued that the compensation was assessable income of Federal Coke, but the Full Federal Court found that it was not assessable income. Specifically, the court said that the receipt was not compensation, because Le Nickel did not have any contractual or other legal obligations with Federal Coke that would have made them owe
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Federal Coke compensation. Furthermore, the lack of dealings between Le Nickel and Federal Coke meant that it could not be argued that the receipt was ordinary income due to being the product of business activities. However, Chief Justice Bowen indicated that had the Commissioner assessed Bellambi rather than Federal Coke, then it was possible that the compensation would still have been assessable in Bellambi’s hands. This was because Bellambi may have assessable income through the principle of constructive receipt. The reasoning was that Bellambi could have received the compensation, but chose to have it redirected to Federal Coke. It could therefore be argued that they had constructively received the compensation payment and redirected it to their subsidiary Federal Coke. Constructive receipt of a payment that would have been ordinary income had it actually been received will constitute ordinary income. In other words, Bellambi’s position was similar to that of the husband in Example 5.3.
Benefit that saves taxpayer from incurring expenditure is not ordinary income
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[5.165] If a benefit is not received by the taxpayer, or has been received by the taxpayer but is not cash or cash convertible, then even if it saves the taxpayer from incurring expenditure, it will generally not constitute ordinary income. For instance, in the case of FCT v Cooke and Sherden (see Case Study [5.2]), the taxpayers’ receipt of a non-cash-convertible holiday would have made them better off in the sense that it saved them from spending their own funds on a holiday. Despite this, the receipt of the free holiday was not ordinary income. However, if the benefit that saved the taxpayer money could have been directly received by the taxpayer, but they had chosen to redirect it elsewhere, then it would be covered by the principle of constructive receipt and so would generally be ordinary income (see [5.160]).
Principle of “mutuality” [5.170] One of the prerequisites of income is that there must be a gain to the taxpayer: see [5.50]. It therefore follows that if a taxpayer makes a payment to himself or herself, there is no gain and the payment will not be income. The principle of mutuality shows that funds given to a club/association by its members are not assessable income of the club as the members are the club, they are one and the same. Similarly, any refund of these fees back to the members are also not assessable to the members because there is no real gain
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134 [5.170] PRINCIPLES OF TAXATION LAW 2020 as the members are only receiving back what was their money: Bohemians Club v Acting FCT (1918) 24 CLR 334; RACV v FCT (1973) 4 ATR 567. These receipts are a type of “non-assessable non-exempt income” under s 6-23 of ITAA 1997. The principle of “mutuality” will most commonly apply in situations involving non-profit recreational clubs and Owners’ Corporations (previously known as Bodies Corporate). However, receipts of clubs and associations will not be subject to the mutuality principle if those receipts are from sources other than members, such as interest on investments, income from trading, fees collected from non-members and other relevant external income: Carlisle & Silloth Golf Club v Smith [1912] 2 KB 177.
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Case study 5.7: Mutual receipts of a club In RACV v FCT (1973) 4 ATR 567, the Royal Automobile Club of Victoria (RACV) was a membership-based club that provided a number of services to members and non-members. These services included driving lessons, breakdown assistance, a journal containing commercial advertising, touring advice, vehicle testing services, insurance referral, etc. The taxpayer argued that its receipts were not assessable under the mutuality principle. The Supreme Court of Victoria held that RACV was engaged in some activities that were mutual and some that were not. The distinction between mutual and non-mutual activities was made on the basis of whether the service was provided to members only or whether it was part of the RACV’s trading activities. The breakdown services, towing services, vehicle testing, journal and travel services relating to Australian travel were mutual services, whereas advertising in the journal, financial and insurance services, overseas travel services and driving tuition for non- members were non-mutual activities.
Example 5.4: Receipts subject to mutuality principle The following are transactions involving clubs/associations, only some of which are subject to the mutuality principle:
• A local not-for-profit football club collects a $100 membership fee from each of its members. It uses these fees to organise football games that its members participate in. The collection of the fees would be subject to the mutuality principle and would not be assessable to the club.
• A football club also holds a lunch and charges its members $10 each to cover the cost of the lunch. The money collected by the club is only from members and therefore is subject to the mutuality principle and will not be assessable.
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• A wine-tasting club has in the past collected a total of $3,000 fees from its members. This club organises wine-tasting tours for its members. The club has $2,000 of the $3,000 in fees collected unspent and in the bank. The club winds up and decides to refund the $2,000 back to its members. The money refunded to the members will be subject to the mutuality principle and would not be assessable income for the members.
• An Owners’ Corporation for a block of five units collects $1,200 from each of the unit owners. The $6,000 collected will be subject to the mutuality principle and will not be assessable income to the Owners’ Corporation.
• An Owners’ Corporation earns $200 in interest from the bank on fees previously collected but not yet spent. This $200 is assessable. It is not subject to the mutuality principle as the interest is not earned from its members.
Questions [5.180] 5.1 Using the general principles discussed in this chapter, consider whether the following are likely to be ordinary income:
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(a) Salary received by an employee. (b) Compensation received by an injured worker for loss of salary because he was unable to work for four weeks. (c) A Christmas present received by a daughter from her mother. (d) Proceeds from selling the copyright to a book. The recipient was an employee accountant who wrote a novel in her spare time over a number of years. (e) Proceeds from selling the copyright to a book, where the recipient is in the business of writing books and selling his copyright. (f) Profit realised on the sale of shares that have been held for a number of years, primarily for their capital growth. (g) Unemployment benefits from the Government received by an unemployed person. 5.2 Look up some English dictionary definitions of “income”. In what respects are these definitions of income similar to what tax law regards as “ordinary income”? Why is there a similarity?
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136 [5.180] PRINCIPLES OF TAXATION LAW 2020 5.3 Consider the following situations and discuss, giving reasons, whether any of the receipts are ordinary income. The taxpayer has operated a business of purchasing vacant land that can be subdivided into housing lots and then sell either the vacant lots or the lots with a house build on it. A site office is normally built on one of the subdivided blocks and this is staffed by a sales person. Sometimes the vacant blocks are sold directly after subdivision, but in other cases, the business arranges for the construction of a house on the subdivided block and sells the property with the completed house. On less frequent occasions, the sales are what are known as a house and land package. In these cases, the purchaser agrees on a design for the house and the business enters a contract to build the house on the block and the total sale price includes the block of land plus the construction cost of the house. In the current year, the business made the following sales: • vacant blocks of land for a total of $1,600,000; • house and land packages for a total of $2,800,000; • $250,000 for the land that the site office was located on. The site office was moved to a new subdivision; • $1,300,000 worth of farm land which the taxpayer inherited from his parents. The taxpayer had leased this land to a farmer for the past 10 years. This land was not suitable for subdivision, so he sold it to the farmer who had been leasing it. 5.4 In the High Court decision in FCT v Dixon (1952) 86 CLR 540, the taxpayer’s receipts were held to be ordinary income. However, Dixon CJ and Williams J reached this conclusion based on different reasoning from Fullagar J. In relation to this chapter’s analysis of what is ordinary income under s 6-5 of ITAA 97, outline the reasons given for concluding that the taxpayer’s receipts were ordinary income, and discuss which you think is the most convincing, giving reasons.
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6 Income from personal services and employment Key points...................................................................................................... [6.00] Introduction.................................................................................................. [6.10] Ordinary income as a reward for services.................................................. [6.20] Does the receipt show a nexus with the service?................................ [6.30]
Salary sacrifice........................................................................................... [6.60]
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Prizes, voluntary payments and unexpected payments...................... [6.70]
Tips ............................................................................................................ [6.80] Personal gifts and voluntary payments.................................................... [6.90] Prizes and chance winnings.................................................................... [6.110] Non-cash benefits................................................................................ [6.130] Capital receipt or personal service...................................................... [6.140] Changes to entitlements.......................................................................... [6.150] Receipts for entering a restrictive covenant........................................... [6.160] Sign-on fees............................................................................................. [6.180] Section 15-2: Statutory income from services and employment........... [6.190] Introduction.......................................................................................... [6.190] First requirement..................................................................................... [6.200] Second requirement................................................................................ [6.210] Third requirement.................................................................................... [6.220] Can compensation receipts be assessable under s 15-2?................. [6.230] Section 15-2’s relationship with other tax provisions........................ [6.240] Section 15-3: Return-to-work payments.................................................. [6.250] Payments upon termination of employment........................................... [6.260] Employment termination payment –Div 82....................................... [6.270] When is the payment “in consequence” of termination of employment?............................................................................... [6.290] When is there a genuine termination?.................................................... [6.310]
Genuine redundancy payments and early retirement scheme payments –Div 83........................................................................ [6.320]
What is a genuine redundancy payment?.............................................. [6.330]
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138 [6.00] PRINCIPLES OF TAXATION LAW 2020 What is an early retirement scheme payment?...................................... [6.340] Further conditions for redundancy payments and early retirement scheme payments......................................................... [6.350] Threshold.................................................................................................. [6.360] Calculation of tax payable on ETP........................................................... [6.370] Payments for unused annual and long service leave –Div 83.......... [6.390] Questions..................................................................................................... [6.400]
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Key points [6.00] • Receipts that show a nexus with the provision of a service are ordinary income. It does not matter whether the service has been performed in the past or will be performed in the future or who makes the payment. • Unexpected or voluntary payments will be ordinary income if they are linked to personal services. However, they will not be ordinary income if they are paid for personal qualities rather than services. • Prizes are not normally ordinary income unless they are the direct result of an income-earning activity or a reward for particular skills. • Benefits earned from personal services that are not cash or convertible to cash are not ordinary income, but may be statutory income. • Receipts paid for giving up valuable rights may be capital receipts and therefore would not be ordinary income. Capital receipts may be subject to capital gains tax. • Some employment and services gains that are not ordinary income will be assessable under s 15-2 of ITAA 1997 if they satisfy all three of its requirements. • Payments given as an inducement for an employee to return to work will be assessable under s 15-3 of ITAA 1997. • Payments given as a consequence of termination of employment will generally be assessable under the Eligible Termination Payment (ETP) provisions in Div 82 of ITAA 1997. The relevant tax rates that apply will depend on various factors, including the taxpayer’s age, the amount received and who received the payment. • Payments given to an employee who has been made genuinely redundant or under an early retirement scheme will generally be tax free under Div 83 of ITAA 1997 as long as they are under the relevant threshold. • Payments given to an employee upon his or her termination for unused annual leave and long service leave are assessable under Div 83 of ITAA 1997 and are generally assessable at the taxpayer’s marginal tax rates.
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6: IncoMe froM personal serVices anD eMploYMent [6.10] 139
Introduction [6.10] Chapter 5 introduced the general concept of income under the income tax legislation and explained that income may become assessable as either “ordinary income” under s 6-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) or “statutory income” under s 6-10. Classifying how a particular receipt is identified for the purposes of income tax is extremely important as it may influence the amount that is assessable and the tax rate applicable to that amount. In addition to the classification of assessable income as ordinary and statutory income, Chapter 5 also outlined how the courts have categorised income according to how it is generated by way of: • income from personal services and employment (personal exertion); • income from business (Chapter 8); and • income from property (Chapter 9). This method of classification by the courts has partly been influenced by the income tax legislation as, over time, it has been necessary for the courts to categorise receipts in order to apply relevant legislation. For example, s 50 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) prior to 1 July 1987 required, in some instances, that income be identified as “income from personal exertion”, “income from property other than dividends” and “income from dividends”. Currently this categorisation is not as important for the application of the Income Tax Assessment Acts, but it remains a very useful approach for understanding how the courts have defined “ordinary income” and how statute has modified what is assessable for each of these categories.
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Figure 6.1: Overall guide
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140 [6.20] PRINCIPLES OF TAXATION LAW 2020
Ordinary income as a reward for services [6.20] Receipts earned from personal services and employment (also known as “personal exertion”, which encompasses both income from employment and services) may be assessable as either ordinary or statutory income. Amounts that are assessable as statutory income are discussed at [6.190]– [6.390]. It is also important to appreciate that non-cash benefits received in respect of employment may also be subject to fringe benefits tax (FBT): see Chapter 7. If this is the case, these benefits are exempt from income tax for the employee (s 23L(1) of ITAA 1936) and need to be considered in relation to FBT for the employer. Amounts earned directly or indirectly by virtue of a taxpayer’s personal services will constitute ordinary income: Moorhouse v Dooland [1955] 1 All ER 93; Brown v FCT (2002) 49 ATR 301. An important factor in identifying income from personal services is the connection or “nexus” that the receipt has with the taxpayer’s personal service. The term “nexus” has been used by the courts to identify this connection with an income-earning activity, but the term has a similar meaning as the phrase “reward for services”.
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Establishing that there is a nexus between the amount received and the work performed is an essential element for determining whether the receipt is ordinary income under s 6-5 of ITAA 1997. This approach was followed in Scott v FCT (1966) 117 CLR 514 and Hayes v FCT (1956) 96 CLR 47 (see Case Studies [6.4] and [6.5]), where it was held that a receipt is not ordinary income if it is not a product of employment or a reward for services: see [6.90].
Does the receipt show a nexus with the service? [6.30] Receipts in the form of wages are obviously assessable as ordinary income and provide a good example of where the nexus between the receipt and the service is clearly established. In contrast, a personal gift of cash from a friend or family member in recognition of some occasion, such as a wedding, has no nexus with any service and therefore is clearly not assessable as ordinary income. These examples illustrate two receipts that can be easily identified as either assessable or not because of the connection (or lack of a connection) with an income-earning activity. However, there are many cases in between these two extremes where it is more difficult to determine whether or not the receipt is the result of a service. It is helpful to view this distinction as a continuum with each distinct end separated by varying degrees of uncertainty. To reduce the degree of uncertainty between the two extremes, it is necessary to consider the decided cases and to identify the factors that the courts have used to assist with this decision. Generally, the courts have used a two-step
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6: IncoMe froM personal serVices anD eMploYMent [6.40] 141
Figure 6.2: Income from labour viewed as a continuum
approach to determine whether an amount is ordinary income from personal services: first, identifying the activity undertaken; and second, determining whether the receipt is a reward for performing that particular activity.
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Case study 6.1: Property received as a reward for service was assessable In Brown v FCT (2002) 49 ATR 301, the taxpayer (Mr Brown) received, free of charge from a property developer, a beachfront apartment with all the costs of transfer and fitting out the apartment paid for. The total value of the property and other costs were over $1 million. Brown played an important role in the success of a major property development project by (among other things) introducing the purchaser to the property developer. The taxpayer argued that the property received was a personal gift and not ordinary income as it was given out of friendship and did not have a nexus with any work performed or service provided. The Commissioner argued that there was a benefit equal to the value of the property received and that this benefit was as a result of the services provided by Brown (the nexus). The Full Federal Court found that the value of the benefits received was ordinary income because the benefit received resulted from the activities undertaken by Brown. It was held that the benefit provided was primarily a reward to Brown for introducing the prospective buyer to the property developer, and the nexus was established because the reward would only be forthcoming if the deal was finalised. [6.40] Once it is shown that there is a nexus between the benefit and the activity performed, it does not matter whether the payment is made before, during or after the completion of the task: Hochstrasser v Mayes [1960] AC 376. It is also irrelevant whether the benefit is provided by the entity for which the task was performed, or by an unrelated third party –it will still be ordinary income: Kelly v FCT (1985) 16 ATR 478: see Case Study [6.6]. Payments from a third party (an entity other than the one the taxpayer is employed by) will be ordinary income for the taxpayer if they are truly a reward for services, but it is also necessary to consider whether they are a personal gift (see [6.90]) given for some other reason: Hayes v FCT (1956) 96 CLR 47. An example
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142 [6.50] PRINCIPLES OF TAXATION LAW 2020 of a third-party payment would be an employee accountant who receives a voluntary payment from a client of the firm because the client is very happy with the work that the employee performed. This payment would be a third- party payment because the employee works for the accounting firm, rather than for the client. Furthermore, it has a strong nexus with the services that the employee performed and so would constitute ordinary income. Example 6.1: Income earned from personal services Phillip is a lawyer who runs his own business and does not have any employees. At 2.00 am one morning his friend Vincent phones and tells Phillip that he has just been questioned by police about a drug trafficking matter. Vincent informs Phillip that he has not been arrested, but he would like to retain his services as his lawyer so that he can call him any time he needs legal advice or representation. Vincent adds that he will pay Phillip $50,000 per year regardless of whether his services are needed.
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Phillip agrees and he anonymously receives $50,000 into his bank account some months after, even though Vincent has not called on him for any legal advice. The question of whether this is ordinary income under s 6-5 of ITAA 1997 will be resolved by looking at the activity that is performed and whether the receipt is a reward for performing that activity. The service agreed to is that Phillip will be available whenever required and, even though he may not be called on, he is still being paid to be available. As a result, the nexus between the service and the receipt is established and the $50,000 per year would be ordinary income even if Phillip did not provide any legal work for Vincent. Wages, salaries, commissions, bonuses, fees for services and other payments that are an incident of employment or a reward for service are clearly ordinary income. The characterisation of these amounts as ordinary income is based on the nexus between the activity and the benefit and is not affected by whether the amount is received regularly or as a lump- sum payment. Similarly, it is irrelevant whether the payments are from an ongoing regular employment contract or a one-off receipt contractually required to be paid for the performance of a given task: Brent v FCT (1971) 125 CLR 418: see Case Study [6.8]. [6.50] Determining whether a receipt is the product of personal services may also be explored using a negative approach, by asking whether the receipt arose for some reason other than employment or the provision of a service: FCT v Harris (1980) 10 ATR 869; Laidler v Perry [1965] 2 All ER 121.
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6: IncoMe froM personal serVices anD eMploYMent [6.60] 143
Case study 6.2: Payments to retired employee to help reduce effect of inflation on pension payments In FCT v Harris (1980) 10 ATR 869, Mr Harris, a retired bank employee, received a one-off payment of $450 from the bank, which was described as a pension top-up to counter the effects of increasing inflation. The Full Federal Court by majority held that the receipt was not a product of Harris’s past employment and therefore was not ordinary income. Bowen CJ conceded that Harris would not have received the payment had he not been a past employee of the bank, but went on to conclude that the payment was in no way related to the length or quality of his past service. The payment was related to his pension and was therefore not a product of his employment. The Court was influenced by the fact that the gift was one-off rather than regular, though this factor was not determinative. Note that s 27H of ITAA 1936 was enacted to make receipts similar to that received by Harris assessable as statutory income. Receipts arising out of employment contracts or other service agreements may also be capital in nature (see [6.140]–[6.180]) and not assessable as ordinary income, although they may be assessable as statutory income: see [6.190]–[6.240].
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Salary sacrifice [6.60] Income is only assessable in the year derived (s 6-5(2) of ITAA 1997: see Chapter 16), and employment income is normally derived when it is received and not at the time the work is performed. Consequently, if personal services income is never derived, it will never be assessable: Ruling TR 98/1. Over the years, there have been attempts by taxpayers to redirect employment income to other family members, but these attempts have invariably failed and are now specifically covered by the personal services income anti-avoidance legislation: see Chapter 23, Div 85 of ITAA 1997. However, employment income will not be derived if it is redirected through an effective salary sacrifice arrangement with the employer. For a salary sacrifice arrangement to be effective, employment income must be diverted before it is earned. This requires the employee to negotiate to forego future salary or wages in exchange for some other benefit, such as increased superannuation contributions by the employer. The Commissioner accepts that effective salary sacrifice arrangements divert remuneration before it is derived, and therefore it is not assessable to the employee: Ruling TR 2001/ 10. However, any benefit accruing to the employee under the salary sacrifice
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144 [6.70] PRINCIPLES OF TAXATION LAW 2020 arrangement will need to be considered by employers as to its possible effect on their liability to FBT: see Chapter 7. Example 6.2: Salary sacrifice Jo is aged 35 and is an employee of a large bank. His current salary is $100,000 per year. To bolster his superannuation, Jo negotiates with his employer to increase the employer superannuation contribution by $10,000 per year. Jo’s employer agrees to this on the condition that his wages are reduced to $90,000. As a result of the salary sacrifice, since Jo is on the 39% tax rate (including Medicare levy), Jo’s take-home pay will drop by $6,000 ($10,000 –$3,900) and his superannuation will increase by $8,500 per year ($10,000 less 15% tax of $1,500 –employer contributions to employee superannuation are taxed at 15%: see [18.110]). Employer superannuation contributions to employee superannuation funds are exempt from FBT: see [7.80].
Prizes, voluntary payments and unexpected payments
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[6.70] Unexpected or voluntary payments received as a reward for service are ordinary income as the benefit is an incident of employment: Laidler v Perry [1965] 2 All ER 121. However, if the payment is made for some other reason, such as for personal qualities, then the receipt is a personal gift and will not be ordinary income as there is no connection with any personal service.
Case study 6.3: Christmas bonus was ordinary income In Laidler v Perry [1965] 2 All ER 121, a Christmas bonus was paid to all current and past employees in the form of a voucher that could be redeemed for goods. These vouchers were provided regardless of the pay rate or the personal circumstances of the employee and were accompanied by a letter expressing the board’s thanks for past services. It was held by the House of Lords that the voucher was income as it arose out of employment, even though it was a voluntary payment on behalf of the employer. Lord Reid answered the question of nexus in the negative by concluding that the benefit arose out of employment because it did not arise out of anything else. Note that benefits received in kind rather than as cash are often subject to FBT rather than income tax: see [7.10].
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6: IncoMe froM personal serVices anD eMploYMent [6.90] 145
Unexpected or voluntary payments may also be classified as ordinary income based on the nature of the payment (see [5.130]), rather than any nexus with employment or services: FCT v Dixon (1952) 86 CLR 540; FCT v Blake (1984) 15 ATR 1006. In FCT v Dixon, the fact that the taxpayer relied on these receipts to support himself and his family was a factor in the Court concluding that the receipts were a replacement for income and therefore assessable as ordinary income.
Tips [6.80] Tips are an example of a third-party gift and are voluntary payments received by waiters, taxi drivers, hotel employees and others that provide a personal service to the public. These payments are made voluntarily but are made because of the level of service provided, and not for any other reason, therefore establishing the nexus with the service and making them assessable as ordinary income: Penn v Spiers & Pond Ltd [1908] 1 KB 766 (tips received by a railway dining car waiter); Calvert v Wainwright (1947) 27 TC 475 (tips received by a taxi driver).
Personal gifts and voluntary payments
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[6.90] In contrast to income that is earned as the product of personal services, a gift given for personal qualities is not regarded as ordinary income and would not normally be assessable to the recipient: Hayes v FCT (1956) 96 CLR 47; Scott v FCT (1966) 117 CLR 514. The treatment of personal gifts as non-assessable income for tax purposes is based on the general meaning of “ordinary income”, which includes the notion that income “flows” from a source such as capital. In the case of personal services, the income flows from the taxpayer’s ability to work and/or the employment contract: see [5.100]. Personal gifts therefore fall outside of this concept of income because they arise from personal qualities. However, a voluntary payment that is a reward for services will still constitute ordinary income. When distinguishing between a non-assessable personal gift and assessable voluntary payments for service, the courts have given more weight to the nature of the receipt in the hands of the recipient, rather than the motive of the giver: Scott v FCT. Viewing the receipt from the point of view of the recipient emphasises the importance of looking for any connection the receipt may or may not have with any service provided or other income-earning activity. The motive of the giver may be considered, but is less important. An unsolicited gift therefore does not become ordinary income only because it was prompted by gratitude for some service, as other factors must also be considered: Scott v FCT (1966) 117 CLR 514; Squatting Investment Co Ltd v FCT (1953) 86 CLR 570.
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146 [6.90] PRINCIPLES OF TAXATION LAW 2020
Case study 6.4: Characteristics of a personal gift In Scott v FCT (1966) 117 CLR 514, the High Court held that the gift of £10,000 paid by a client (Mrs Freestone) to Mr Scott (a solicitor) was a personal gift and not ordinary income. Scott had acted as solicitor for Freestone for some years and in this case was acting as her solicitor in relation to the estate of her deceased husband. Prior to Mr Freestone’s death, he and Scott had known each other for many years and were associated in various business activities.
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On the death of her husband, Mrs Freestone engaged Scott to carry out work in relation to the administration of her husband’s deceased estate, which included the sale of a number of properties, the main one being an area of 82 acres known as “Greenacres”. Scott played an important role in the sale of the properties by successfully negotiating to have restrictions lifted which prevented the property from being subdivided. As a result of the lifting of the restrictions on the property, its value increased substantially and it was eventually sold for a considerable profit. Following the sale of “Greenacres”, Freestone was informed by letter from Scott’s firm that the bill of costs would be prepared as soon as possible, and it was later paid by Freestone. However, before the bill was rendered, Freestone told Scott that she intended to make a number of gifts from the sale of the property and this included one to him of £10,000. In reaching its conclusion that the £10,000 was not ordinary income, but rather a personal gift, the High Court emphasised a number of elements to be considered in determining the characteristics of the receipt: • The character of the £10,000 should be assessed as a receipt in the hands of the taxpayer. • The receipt must be a product of the relevant activity to be ordinary income; if it is a product of friendship or other personal characteristics, then it is a personal gift. • The fact that Scott was fully remunerated for his services separately from the payment supported the case that the £10,000 was a personal gift. • The fact that Scott did not expect the gift also supported the case that the £10,000 was a personal gift. • The personal relationship prior to the payment, as well as the fact that the donor made other gifts at the same time, also supported the argument that the £10,000 was a personal gift. • The motives of the donor do not normally determine whether the character of the receipt is ordinary income, although it might be one of the factors to consider in deciding whether the receipt is ordinary income.
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6: IncoMe froM personal serVices anD eMploYMent [6.100] 147
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[6.100] The characteristics of a personal gift established in Scott v FCT (1966) 117 CLR 514 emphasise the importance of the personal relationship of the parties in distinguishing between receipts that are a product of personal services or a personal gift. In addition, where the payment is made by an entity with which the taxpayer has an employment or commercial connection, it is important to ascertain whether any service provided is separately and fully paid for. Ultimately, whether a voluntary payment is ordinary income or not will depend on whether it has sufficient nexus to the service provided. If there is sufficient nexus it will be ordinary income, but if there is not, then the voluntary payment will be a personal gift. As the case law shows, there are a number of factors that help in borderline cases to determine whether the nexus is strong enough to make a voluntary payment ordinary income. However, it must be stressed that these factors are not determinative and only assist to make this decision. The more important of these factors are: • whether the gift was expected. Expected receipts are more likely to be ordinary income: Scott v FCT (1966) 117 CLR 514; • whether the gift consists of a lump- sum or regular payments. If it consists of regular payments, then it is more likely to be ordinary income: FCT v Blake (1984) 15 ATR 1006; • the motive of the donor. If the donor intends the gift to be a reward for services, the gift is more likely to be ordinary income: Scott v FCT; • whether the recipient has already been remunerated for his or her services. If so, this makes the voluntary payment less likely to be ordinary income: Scott v FCT; Hayes v FCT (1956) 96 CLR 47; and • whether there was a personal relationship between the donor and recipient. The existence of a pre- existing personal relationship will make the voluntary payment less likely to be ordinary income: Scott v FCT; Hayes v FCT.
Case study 6.5: Characteristics of a gift In Hayes v FCT (1956) 96 CLR 47, Hayes was the supervising and general accountant for Mr Richardson’s meat and smallgoods business. Mr Richardson’s business was taken over by a company of which Hayes was a director, secretary and shareholder. Initially, Richardson did not have a controlling interest in the company but after several years gained control of the entity. Richardson persuaded Hayes to sell his shares to him but Hayes remained a director and secretary. The company became quite successful and was incorporated as a public company in which Richardson was allotted a considerable number of shares and he transferred 12,000 of these to Hayes. The Commissioner argued that the
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148 [6.100] PRINCIPLES OF TAXATION LAW 2020
value of these shares was ordinary income or assessable under s 26(e) of ITAA 1936 (now s 15-2 of ITAA 1997): see [6.190]. The High Court concluded that the value of the shares transferred to Hayes was a personal gift and not ordinary income. In reaching its decision, the Court noted that Hayes and Richardson had developed a personal relationship, and that for the value of the shares to be ordinary income they must be seen in the hands of the recipient as a reward from employment or other services. In this case, Hayes had been fully paid for his services and therefore the shares were not additional reward for his work. This, together with the personal relationship, was sufficient for the Court to find that the value of the shares was a personal gift and not ordinary income, or statutory income under s 26(e) of ITAA 1936.
Example 6.3: Voluntary payments from employer
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Kim is employed in the family business, which is a medium- sized accounting firm. Both her parents are partners in the five-partner firm that operates the business. Kim has been an employee for the last three years. During the current tax year, Kim received several amounts in addition to her normal wage which was equivalent to other employees with similar experience and similar qualifications. One evening during discussions over the dinner table, Kim’s father asked her whether she had any good ideas on how to improve the client base of the firm. Kim had been thinking about this for some time and she prepared a two-page document outlining her ideas which her father presented to the other partners. One of Kim’s ideas was adopted and proved moderately successful in attracting new clients. At the end of the financial year, Kim was surprised to receive an envelope with a letter thanking her for her ideas and a cheque for $2,000. Characterising the $2,000 as ordinary income under s 6-5 of ITAA 1997 or as a non-assessable gift requires consideration of the elements used in Scott v FCT. First, it is important to view the receipt in Kim’s hands and give less importance to the motive of the partners for making the payment. In this example, there is a strong case to argue that the payment was a product of Kim’s suggestions to the partners and therefore is assessable as ordinary income. However, as she is fully remunerated for her work and there is a family relationship, this would support the argument that the $2,000 is a personal gift. On balance, the stronger case is that the receipt is a product of her extra effort, and the personal relationship appears to be weaker than that in Scott v FCT.
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6: IncoMe froM personal serVices anD eMploYMent [6.110] 149
An alternative method of analysis, as used in FCT v Harris (see Case Study [6.2]), is to ask what else gave rise to this income? Using this approach, it would be difficult to argue that the $2,000 was received for her personal qualities just because Kim’s parents are partners of the firm, as they do not hold a majority. During the year Kim also announced her engagement and at her engagement party she was handed an envelope by her mother. The envelope contained a card of congratulations signed by all the partners and a cheque for $3,000 drawn on the firm’s account. Kim also received a very generous gift directly from her parents. In this case, it may be contended that Kim would not have received the cheque for $3,000 if she had not been an employee. However, that is not the test of whether the amount is a personal gift or shows a nexus with her employment. This receipt is more clearly a personal gift as it is in recognition of her engagement and is therefore paid for personal qualities and is not connected to her position as an employee of the firm.
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Prizes and chance winnings [6.110] An important characteristic of ordinary income is that it is earned as a result of personal services. Windfall gains in the form of chance winnings or prizes, which primarily depend on luck, are therefore not ordinary income, although they may in some cases be income from business: see [8.60]–[8.80]. For example, winnings from gambling will be a windfall gain unless the gambler is in the business of gambling: Babka v FCT (1989) 20 ATR 1251. For prizes to be classified as ordinary income, they would have to be earned as a result of a business activity or the degree of personal services and skill would have to outweigh the element of chance. For example, an employee’s winnings from a football tipping competition organised and run by her employer are clearly not ordinary income as they depend on chance and have no connection with employment. Similarly, the winnings of a casual participant in a television game show are not normally ordinary income as the element of chance is generally far greater than any skill required: Case 37 (1966) 13 CTBR (NS) 235; Ruling IT 167. It is a question of degree as to whether the level of personal services is sufficient to turn a prize into ordinary income and, as with all questions of degree, the difficulty is to determine the level of personal service that is necessary to change the character of the receipt: Kelly v FCT (1985) 16 ATR 478.
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Case study 6.6: Professional sportsperson’s prize In Kelly v FCT (1985) 16 ATR 478, the taxpayer played football at the highest level in the Western Australia competition and he was paid a fixed amount for each match played. In 1978, he won a prestigious award for the “best and fairest player”, known as the Sandover Medal. Prior to the announcement of the winner of the medal, a local television station publicly broadcast that it would pay $20,000 to the winner. The Commissioner assessed Kelly on the $20,000 prize on the basis that, although unexpected, the prize directly related to his skill and performance as a professional footballer.
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Franklyn J held in the Supreme Court of Western Australia that the $20,000 was ordinary income. This was because the amount was directly related to Kelly’s employment as a footballer, even though it was unexpected and paid by an unrelated third party. First, Kelly was eligible because he was a member of the football club and, second, he was awarded the prize because of his skills and abilities. [6.120] Given the increased profile of professional sporting people since the decision in Kelly v FCT (1985) 16 ATR 478, it is most likely that all winnings and prizes relating to their sporting activities will be ordinary income. However, the distinction between a non-assessable prize and a prize that is related to personal service is more difficult when the activity is not associated with employment or professional activities. Some of the factors used to make this distinction are: • the degree of professionalism; • whether the reward is for services rather than for personal qualities; • whether the reward is paid before or after service; and • whether the reward is related to the taxpayer’s contract.
Example 6.4: Prizes of a non-professional As a young girl, Marlene had always loved dancing and she has received training in a wide range of dancing styles. Over the years she has participated in a number of local dancing competitions and she has collected quite an array of cups and trophies. At present, Marlene is employed as a full-time lawyer and she has not danced in any competitions for the past six years. During the current tax year, Marlene decided to get back into dancing and entered a local talent competition which she won and received a cash prize of $200.
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The receipt of $200 raises the issue of whether this payment is ordinary income as a reward for personal services and her skill in the performance or whether it is a non-assessable prize that primarily depended upon luck. Marlene is clearly not a professional dancer and she has voluntarily entered the competition, rather than being engaged to dance by the co-ordinators. In addition, there is a significant element of chance as to whether Marlene will win the prize. Considering all these factors, the $200 receipt is not ordinary income but is a non-assessable prize.
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Later in the year Marlene responded to an advertisement to participate in a television dancing competition. There were 5,000 applicants and only 50 would be selected after the auditions and Marlene was one of the lucky few. On being selected, Marlene was required to sign a contract with the television company agreeing to quite stringent rules restricting what information could be disclosed to the public, what media outlets she could talk to, where and when she had to appear and what was required of her if she reached the final 10 and if she won the competition. Marlene was very successful and she reached the final 10, which required her to commit four days per week to the television production and, as a result, she took unpaid leave from her employment. During the final weeks of the competition, a local newspaper offered a $10,000 prize to the contestant that could record the fastest tapping in a tap dance routine. Marlene won the $10,000, but she did not go on to win the final competition. Considering the factors listed above, there is a stronger case that the $10,000 is ordinary income compared to the $200 prize. In this situation, Marlene is required to sign a contract which indicates that she is adopting a degree of professionalism. The prize was only available to those contestants that had reached the final stages of the competition and it was not paid for personal qualities but for the demonstration of a particular skill.
Non-cash benefits [6.130] The general definition of “ordinary income” discussed at [5.60] identifies one of the prerequisites of ordinary income as being cash or convertible to cash. Conversely, receipts that are not convertible to cash are not ordinary income: Tennant v Smith [1892] AC 150; Payne v FCT (1996) 32 ATR 516; FCT v Cooke and Sherden (1980) 10 ATR 696. This characteristic of ordinary income is particularly relevant in relation to receipts from personal services, as payments in kind (eg, a free holiday) are quite common in employment and service arrangements. An example of the application of this characteristic of income can be seen in Payne v FCT, where the Federal Court considered whether benefits received from a customer loyalty program were, among other things, ordinary income.
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152 [6.140] PRINCIPLES OF TAXATION LAW 2020 Customer loyalty programs typically accumulate points that can be redeemed as free travel, free accommodation, discounts on purchases or other similar rewards. Two issues arise in relation to taxation from these loyalty programs: first, whether the rewards are cash or convertible to cash and, second, whether the benefit is connected with personal service. Case study 6.7: Frequent flyer points In Payne v FCT (1996) 32 ATR 516, Janet Payne travelled regularly as a result of her employment with a large accounting firm. The flights were paid for by her employer as she was travelling for business purposes. On one of these trips Payne was offered a brochure which invited her to join the airline’s Frequent Flyer Club. She duly completed the application form and paid the $95.00 membership fee. Over the next two years, Payne accumulated sufficient points to purchase airline tickets for her parents to fly from England to Australia. The bulk of these points were accumulated through travel that was paid for by her employer, although a small percentage was from private travel (3.2%).
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Foster J of the Federal Court held that the free flights earned by Payne as a result of frequent flyer points generated through work travel were not ordinary income. The primary reason for this conclusion was that the tickets were not money or monies worth as they could only be used by the program member or his or her nominee. They could not be sold or in any way converted into money. The decision by Foster J in this case went on to consider whether these benefits were assessable under s 26(e) of ITAA 1936 (now s 15-2 of ITAA 1997): see Case Study [6.16]. Benefits that are not cash or cash convertible cannot be ordinary income and are not assessable under s 6-5 of ITAA 1997, but they may be assessable under s 15-2 (see [6.190]–[6.240]) or subject to FBT: see Chapter 7. However, if the benefit is convertible to money through sale or via some other means, then the question of the benefit’s assessability as ordinary income will rest with whether the benefit shows a nexus with personal service: see [6.30].
Capital receipt or personal service [6.140] Capital receipts are not ordinary income under general principles: see [5.40]. As a result, it is necessary to consider whether receipts from personal services and employment are capital or not. The distinction between a receipt that is a reward for services (and is therefore ordinary income) and a receipt that is capital in nature is primarily concerned with whether the taxpayer has
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given up a valuable right. It follows that where the payment is for giving up a capital right, then the payment is most likely capital in nature and not ordinary income. Conversely, if nothing substantial of a capital nature is given up then, as discussed at [6.30ff], it is necessary to consider whether the payment shows a nexus with any service, in which case it will be ordinary income: Brent v FCT (1971) 125 CLR 418. In the case of a restraint of trade, there may be a distinction between the treatment of valuable rights depending on whether those rights are relinquished on commencement, during or at the ending of an employment contract: see [6.160]–[6.170]. For example, if a professional sportsperson has included in her contract a clause that prevents her from playing with any other club during the term of the contract, then any payment received as a result of this agreement is an incident of the playing contract and is therefore ordinary income. Clearly, no valuable right is given up in this instance as the sportsperson is being paid to play for one club to the exclusion of the other.
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Case study 6.8: Payment for service of giving up valuable rights In Brent v FCT (1971) 125 CLR 418, Mrs Brent was the wife of the infamous criminal Ronald Biggs, who was one of the gang responsible for the UK “Great Train Robbery”. Brent was arrested in Melbourne where she had been living with Biggs following his escape from a UK gaol. After her arrest, Brent was approached by a number of newspapers with offers to publish her life’s story, and she eventually signed an agreement with The Daily Telegraph. The agreement gave the UK newspaper exclusive rights to the publication of Brent’s story. It required her to be available for interviews by newspaper staff who would then write her story for publication. The taxpayer claimed the payments were not ordinary income but that she was being paid for giving up the capital rights to her story as she signed over the exclusive rights to the newspaper. The High Court held that Brent’s earnings from this agreement were ordinary income. Brent was essentially paid for her services of telling her story and she did not give up or dispose of any property. Her secret knowledge was not property as it was not acquired through the conduct of a business and did not relate to anything to which copyright could be attached. Brent’s story was about her life and she did not write the story nor did she possess any copyright that she could assign to The Daily Telegraph. Consequently, the Court held that nothing of a capital nature was given up and therefore the payments were for the service of telling her story. The High Court also placed little importance on the so- called “exclusive rights” clause as this could not restrict any other author from collecting information on Brent and publishing its own version of her life’s story.
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Changes to entitlements [6.150] Payments for changes to entitlements under employment and service contracts may give rise to capital receipts for the giving up of valuable capital rights and therefore not fall into the category of ordinary income: Bennett v FCT (1947) 75 CLR 480. This follows the principle that compensation takes the form of what it replaces in that compensation for the loss of capital rights will be a capital receipt: see [10.20]. If no capital right is given up, as in FCT v Brent (1971) 125 CLR 418, then the receipt is more likely to be ordinary income unless it is a personal gift. Case study 6.9: Relinquishing employment rights
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In Bennett v FCT (1947) 75 CLR 480, the taxpayer was employed as the managing director of a company which he affectively controlled. His original contract was terminated and he was re-appointed with the same remuneration but he relinquished certain rights that he previously held, including absolute control of the company. To compensate for the loss of these rights, the company agreed to pay Bennett three payments over a two-year period. The High Court held that the payments were not for loss of income, but were capital in nature for the removal of those rights that Bennett possessed under the original agreement. Williams J applied the compensation principle finding that because the payments were not for the loss of income, they were capital payments for giving up the right to control the company. The nature of payments for changes to existing entitlements under an employment contract was also considered by the Administrative Appeals Tribunal in AAT Case 7,752 (1992) 23 ATR 1057. In this case, employees of Shell Company Aust Ltd had their entitlements to rostered days off removed without the employees’ knowledge and it was concluded that compensation paid for the loss of these valuable rights was of a capital nature.
Receipts for entering a restrictive covenant [6.160] A restrictive covenant or restraint of trade may be formed at the time of entering a contract, during the contract’s operation or after the completion of the service. For example, it is common for professional sportspeople to sign restrictive covenants on entering new contracts which may limit their rights to be interviewed by the media or appear on designated television shows. Similarly, professional actors and movie stars may enter agreements on the
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completion of a production to not perform in another production for a given length of time. Another example would be an employment contract entered into whereby an accounting firm requires an employee to sign a restrictive covenant preventing the employee from registering as a tax agent. Characterising receipts from entering a restrictive covenant as capital or ordinary income will depend on whether the payment is connected with the current employment agreement or whether it is a separate agreement to give up valuable rights. However, where the restrictive covenant is commonly used as part of the normal employment contract, it will be ordinary income as it is generally viewed as a payment for future services. Although the decision in Higgs v Olivier [1952] Ch 311 found the restrictive covenant to be capital, the comments in this case and in FCT v Woite (1982) 13 ATR 579 would suggest that restrictive covenant payments made as part of an ongoing contract are more likely to be income. [6.170] Payments made at the termination of a service agreement that restricts the activities of the taxpayer are seen as capital as they do not arise out of the employment or service contract and do not show a nexus with the earning activity: Higgs v Olivier [1952] Ch 311; Hepples v FCT (1991) 22 ATR 465. Case study 6.10: Restrictive covenant –capital
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In Higgs v Olivier [1952] Ch 311, the famous actor Sir Laurence Olivier was paid £15,000 for agreeing to not appear in or direct any film for a period of 18 months after he appeared in the film “Henry V”. The English Court of Appeal held that the receipt of £15,000 was not received as a result of his vocation as an actor and therefore was not assessable. The Court held that as the agreement to pay the £15,000 was separate to his contract to perform in the film, and was made after the completion of the film, it was not payment for his performance as an actor but for his giving up the right to earn income which was capital in nature.
Case study 6.11: Restrictive covenant –genuine capital payment In Hepples v FCT (1991) 22 ATR 465, the taxpayer was paid $40,000 on his retirement for agreeing not to disclose the secrets of his employer. Although this decision was mainly concerned with CGT, the High Court had no difficulty in finding that this receipt was not a substitute for income and was a capital payment for entering the restrictive covenant on termination of employment.
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156 [6.170] PRINCIPLES OF TAXATION LAW 2020 Capital receipts may also arise out of a restrictive covenant agreed to at the time of entering a contract, and the characterisation of these receipts will again be based on whether the payment is for giving up a valuable right or for services provided: FCT v Woite (1982) 13 ATR 579; Reuter v FCT (1993) 27 ATR 256. Case study 6.12: Restrictive covenant –ordinary income The taxpayer in Reuter v FCT (1993) 27 ATR 256 was involved in the very famous takeover of John Fairfax Ltd. As part of the arrangements in relation to the takeover, the taxpayer was paid $8 million to agree that he would not, without prior approval, claim the success fee (normal payment for a successful takeover) for the takeover against Bond Media. Hill J in the Federal Court looked at the substance of the agreement, rather than its form, and held that the receipt of $8 million was closely connected to the services provided by the taxpayer to Rothwells Ltd and was therefore ordinary income.
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Case study 6.13: Restrictive covenant on entering a contract In FCT v Woite (1982) 13 ATR 579, the taxpayer was a footballer who played for a South Australian team. Woite received $10,000 for entering an agreement with the North Melbourne Football Club to not play football with any Victorian club other than North Melbourne (Australian Rules Football did not have a national competition at this time). The contract did not require Woite to play for North Melbourne unless he decided to play football in the Victorian league, which he never did. The Supreme Court of South Australia held that the $10,000 was capital in nature and was not ordinary income from his profession as a footballer. Woite was contracted to the South Australian club and the payment from the North Melbourne club was not a payment for service, but a capital payment to give up the right to play for a club other than North Melbourne. It is interesting to note, although not part of the decision, that Mitchell J implied that it was highly likely that the $10,000 could be ordinary income if Woite had followed the signing of the restraint of trade by signing with the North Melbourne Club and had subsequently played football for them.
Example 6.5: Restraint of trade payments Luke is a famous basketball player and he has been contracted to play for his club for the last five years. Currently, Luke is in negotiations with his club to renew his contract for an additional 12 months and one of the
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clauses in the contract states that he may only do media appearances with TVX, a media company that has a substantial interest in the club. Due to the inclusion of media restrictions, Luke’s agent is able to have the annual playing fee increased by $50,000. Luke signs the new contract, but halfway through the season he has a serious dispute with the club’s management as he is not being picked to play on a regular basis. Following threats of legal action by both parties, the club agrees to end Luke’s contract for no cost to Luke and also pays him $100,000 for agreeing not to disclose the reasons for the dispute with the club.
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There may be an argument that the $50,000 is payment for giving up the right to speak to any media Luke wishes, but it may also simply be part of his employment contract which requires a range of conditions. The comments in Higgs v Olivier [1952] Ch 311 and FCT v Woite (1982) 13 ATR 579 would suggest that restrictive covenant payments made as part of an ongoing contract are more likely to be income. This is not unlike an employment contract that requires certain restrictions of an employee, such as signing a secrecy agreement. In contrast, the payment of $100,000 is on termination of the contract and imposes a specific restraint on Luke and, as it is not a payment related to his playing duties, it is more likely to be capital, as in Hepples v FCT (1991) 22 ATR 465.
Receipts that are of a capital nature are not assessable under s 6-5(1) of ITAA 1997, but they may be statutory income under other provisions such as the CGT provisions: see Chapter 11. It is important to distinguish receipts that are ordinary income and those that are subject to CGT, as the method of determining the liability to tax differs between these two forms of income.
Sign-on fees [6.180] Sign-on payments enticing the party to enter the contract are quite common in professional sporting contracts and some higher level professional employment contracts. These receipts raise the issue of whether they are a capital payment for giving up some valuable right or whether they are ordinary income in the form of payments for future services. Case study 6.14: Sign-on fees –capital in nature In Jarrold v Boustead (1963) 41 TC 701, an amateur rugby player was paid a £3,000 sign-on fee to give up his amateur status and turn professional. At this time in UK, there were some advantages in being an amateur
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and there was a chance that he could become an international player at amateur level. The Court of Appeal held that this receipt was capital in nature as it was a payment for giving up the right to play amateur football, rather than a payment for future services. The view expressed by the Commissioner in Ruling TR 1999/17 is that where a sign-on fee is a normal part of the practices of attracting sportspeople and employees into a new contract, the payment is less likely to be capital and more likely to be ordinary income as a one-off payment for future services: Pickford v FCT (1998) 40 ATR 1078. Case study 6.15: Sign-on fees –ordinary income In Pickford v FCT (1998) 40 ATR 1078, the taxpayer was offered a salary package to take up employment with another firm, and this package included a one-off payment of $20,000 as compensation for given-up share options in an employee share scheme with his current employer. The Administrative Appeals Tribunal held that the $20,000 was ordinary income because it was an incident of the taxpayer’s income- earning activities and employment.
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There is very little direct Australian case authority on this issue, which could suggest that it is well settled that it is difficult to make a strong case that these receipts are not an incident of an income-earning activity. Income from personal services may be assessable as ordinary income or statutory income. However, regardless of whether an amount is likely to be ordinary income, it is still necessary to consider whether any statutory provisions specifically apply to the receipt. The discussion at [6.190]–[6.390] covers the most important statutory provisions that apply to receipts from employment and services.
Section 15-2: Statutory income from services and employment Introduction [6.190] Section 15-2 of ITAA 1997 (previously s 26(e) of ITAA 1936) deems certain gains arising from employment and services to be assessable as
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statutory income. For the most part, s 15-2 has the same operation as its predecessor. However, there is one major difference: s 26(e) did not have a “contrary intention”. This meant that gains that were ordinary income and covered by s 26(e) were taxed under s 26(e). However, the current s 15-2 does have a contrary intention in s 15-2(3)(d), which means that if a gain is ordinary income, it will not be covered by s 15-2: see [3.80].
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Specifically, s 15-2 covers gains from employment and services if they are not ordinary income or a fringe benefit (see Chapter 7) and if they fulfil all three of the requirements discussed at [6.200]–[6.220]. The application of s 15-2 is wider than ordinary income in two ways: • For employment and service gains to be ordinary income, they need to be cash or cash convertible. On the other hand, s 15-2 covers gains that are cash, cash convertible and non-cash convertible. • For employment and service gains to be ordinary income, there needs to be a nexus between the gain and the services required: see [6.30]. For these gains to be assessable under s 15-2, there must also be a nexus between the gain and the services. However, case law indicates that the nexus test is easier to satisfy under s 15-2 than it is for ordinary income. For example, in Smith v FCT (1987) 19 ATR 274 (see Case Study [6.17]), Brennan J found no reason that s 26(e) of ITAA 1936 (the predecessor of s 15-2) should be limited to benefits that are income in ordinary concepts, with the result that s 15-2 could potentially include capital benefits. Section 15- 2 potentially only applies to gains from employment or the provision of services. However, this could include services provided by a business taxpayer and also amounts received from providing services under an independent contract for services. Section 15-2 could therefore apply to gains made by a business from providing engineering or accounting services. Conversely, s 15-2 will not apply to gains made from holding property or from business operations that do not involve the supply of services. For instance, in FCT v Cooke and Sherden (see [5.60]), the taxpayer ran a business selling soft drinks “door to door” and subsequently received a gift from the soft drink manufacturer. In this case, the Court held that such a gift was not assessable under the predecessor of s 15-2 because the income was sourced from a business selling goods rather than from providing a service of selling goods.
First requirement [6.200] The first requirement for a gain to be assessable under s 15-2 of ITAA 1997 is that there is an “allowance, gratuity, compensation, benefit, bonus or premium”. These words are very wide and will cover a range of benefits received by the taxpayer. This includes receipts that are cash, cash convertible or non-cash convertible.
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160 [6.200] PRINCIPLES OF TAXATION LAW 2020 Some examples of receipts that meet the first requirement are: • a cash payment for services, which is a “benefit” and so would fulfil this requirement; and • an employer giving an employee a free television or giving the employee use of a car for personal purposes. Note also that this first requirement: • is not confined to receipts that the taxpayer is entitled to receive, but can also include gifts (gratuities) that have been received by the taxpayer; and • will also be satisfied when the taxpayer receives something from an entity to which he or she has not directly provided a service. For instance, free hotel accommodation received by an employee of an accounting firm from one of the firm’s clients would satisfy this first requirement.
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An example of an item that satisfies the first requirement is an “allowance”. An allowance is a predetermined amount given to a taxpayer for a specific purpose where the taxpayer does not have to return any of the unspent amount. This is in contrast to a “reimbursement”, where a taxpayer only receives what he or she has spent. For example, a taxpayer who receives $150 from her employer for travel purposes, but ends up only spending $60 of it and is allowed to keep the rest, is in receipt of an allowance. On the other hand, a taxpayer who is reimbursed only her actual travel expenditure would not be in receipt of an allowance, but rather a reimbursement. While allowances will satisfy the first requirement of s 15-2, whether or not a reimbursement is captured by s 15-2 is contentious, although it is of little practical importance as, either way, it will be tax neutral. For example, where an employee purchases paper for their work’s photocopier for $50 and then is reimbursed $50, it may be argued that this is effectively not the employee’s expense but the employer’s expense and the employee is simply carrying out the purchase for the employer. If this is the case, then the employee has no benefit and no assessable income or equivalent deduction. Conversely, if s 15-2 makes the $50 assessable, then the employee will also be entitled to a deduction (s 8-1 of ITAA 1997) for the $50 expense incurred, which is again tax neutral. Reimbursements are also not usually ordinary income, but they may be subject to FBT: see Chapter 7. Although allowances will generally fulfil the three requirements of s 15-2, they also will usually constitute ordinary income (see [5.70]) in which case they will be assessable as ordinary income under s 6-5 rather than s 15-2. This is because of the contra-intention contained in s 15-2(3)(d) which removes the application of s 15-2 if the amount is also ordinary income.
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Second requirement [6.210] The second requirement for a gain to be assessable under s 15-2 of ITAA 1997 is that the allowance, benefit, etc is “provided to you” (ie, the taxpayer). Usually, this requirement will be relatively simple for the taxpayer to fulfil. For example, if a taxpayer has received cash, property or a benefit, like free accommodation, it will have been “provided” to the taxpayer and this second requirement will have been satisfied. Therefore, it is only in some very limited circumstances that it will be unclear whether this requirement has been met. Case study 6.16: Free ticket due to frequent flyer points earned from work-related travel not assessable In Payne v FCT (1996) 32 ATR 516, the taxpayer worked for KPMG and undertook considerable work- related travel. Payne signed up for the Qantas Frequent Flyer program and accumulated a large number of points due to her work-related travel. These points were converted to free airline tickets.
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The Court examined whether receipt of the free tickets was assessable under s 26(e) of ITAA 1936, the predecessor of s 15-2 of ITAA 1997. The Federal Court (single judge) held that the free tickets were not assessable under s 26(e). One of the reasons for this was that the equivalent of the second requirement of s 15-2 had not been met, because the benefit was due to a “crystallising of contractual entitlements” under the Frequent Flyer program agreement.
Third requirement [6.220] The third requirement for a gain to be assessable under s 15-2 of ITAA 1997 is that what has been received by the taxpayer is “in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by the taxpayer”. This requirement will be satisfied when there is a sufficient nexus between the receipt and services provided. Earlier cases, such as Scott v FCT (1966) 117 CLR 514, FCT v Dixon (1952) 86 CLR 540 and Hayes v FCT (1956) 96 CLR 47, found that the nexus test under s 15-2’s predecessor was identical to the nexus test for determining whether a receipt is ordinary income. However, more recent case law, such as Smith v FCT (1987) 19 ATR 274, has seen courts take a different approach by indicating that the nexus test in s 15-2 is easier to meet than the nexus test for ordinary
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162 [6.220] PRINCIPLES OF TAXATION LAW 2020 income. Despite this, there still is a nexus requirement for this third requirement of s 15-2. Courts have also explicitly stated that, in general, it is much easier to meet s 15- 2’s nexus test where the taxpayer was legally entitled to the receipt compared to when the taxpayer has received a gift: Smith v FCT (1987) 19 ATR 274; FCT v Holmes (1995) 31 ATR 71. Nevertheless, it is still possible for gifts to pass the nexus requirements of s 15-2 under certain factual scenarios.
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Case study 6.17: Employee receipt from employer as reward for studying assessable In Smith v FCT (1987) 19 ATR 274, Westpac introduced a scheme to encourage its employees to undertake study that it considered related to banking. Under this scheme, the employer would give the employees a certain dollar amount upon successful completion of every subject of an approved degree and an extra amount upon successful completion of that approved degree. At the time there were no tertiary fees so, in effect, the employees who received this money could use it for personal purposes. Smith was an employee who undertook approved study and received money under this scheme. The issue was whether the amount received under the scheme was assessable under the predecessor to s 15-2, s 26(e) of ITAA 1936. The High Court held that the taxpayer’s receipt was assessable. Specifically, the Court addressed the nexus issue and said that there was a sufficient nexus with employment in this case. This was due to a combination of factors, the most important being that the scheme existed to increase employee productivity by encouraging them to be more highly educated. In addition, it was also an important fact that Smith was eligible for the scheme by being employed by the donor of the gift. The Court did not consider whether the gain would have been assessable as ordinary income, although it did state that it is easier for service-related gains to be assessable under s 15-2’s predecessor than to constitute ordinary income.
Case study 6.18: Receipt of free tickets due to frequent flyer points lacks sufficient nexus As discussed in Case Study [6.16], Payne v FCT (1996) 32 ATR 516 involved a taxpayer who acquired frequent flyer points through work-related travel and used them to acquire free Qantas tickets. The Federal Court held that
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this amount was not assessable under s 15-2’s predecessor (s 26(e) of ITAA 1936) for two reasons. First, the second requirement of s 26(e) was not satisfied: see [6.210]. Second, the Court backed up its conclusion with another, more convincing reason. It said that this third requirement of s 15-2’s predecessor was not satisfied because there was an inadequate nexus between the receipt of the free ticket and the services provided by the employee in her capacity as a KPMG employee. It was true that, had the taxpayer not provided services for KPMG, and thus not done the amount of work-related travel, she would not have earned enough points for a free ticket. However, the Court stated that such facts were not enough to satisfy the nexus requirements of s 15-2’s predecessor, even if its nexus test was more lenient than required for a gain to be ordinary income. The Court said that, on the facts, the free tickets were not a reward for the taxpayer’s services to KPMG, but rather a reward for flying with Qantas.
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Case study 6.19: Receipt of reward money for helping to prevent was assessable In FCT v Holmes (1995) 31 ATR 71, the taxpayer was an employee on a shipping vessel which happened to be near a leaking oil tanker. The leaking oil tanker was heading towards the shore; this meant that there was a risk of the oil tanker losing most of its cargo and causing an environmental disaster. The taxpayer and some of his co-workers were able to use the vessel they were on to tow the oil tanker out of danger. As a result of his effort, the taxpayer received a payment of $23,381 “salvage reward”. The entitlement to this reward was based on a principle in the law of Admiralty (laws relating to ocean vessels) that an owner of salvaged property must pay those that saved the salvaged property. The taxpayer would not have received the reward had the efforts of towing the oil tanker to safety been unsuccessful. The Full Federal Court held that the reward money was assessable under the predecessor of s 15-2. It stated that there was clearly a nexus between the effort of the taxpayer in saving the oil tanker and the reward money. The Court stated that the fact that the taxpayer would not have received the money had the salvage been unsuccessful only strengthened the case for there being a nexus between the reward money and the services performed. In this case, the Court did not need to consider whether the reward constituted ordinary income, because the gain was assessable under
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s 15-2’s predecessor. The predecessor of s 15-2 considered in this case, unlike the current s 15-2, did not exclude amounts that were also ordinary income. If this case were decided today, the Court would first consider if the gain was ordinary income, and then only if it decided that there was a chance that it was not ordinary income, would the Court then proceed to apply s 15-2.
Can compensation receipts be assessable under s 15-2? [6.230] Compensation paid to an employee takes on the form of what the employee is being compensated for: see [10.20]. This means that compensation for loss of salary is ordinary income and compensation paid for loss of the actual job or some of the rights related to that job is generally capital. Could some compensation payments that are not ordinary income be assessable under s 15-2 of ITAA 1997? This issue was considered in the following two cases.
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Case study 6.20: Receipt of compensation payment mandated under legislation not assessable under predecessor of s 15-2 In FCT v Inkster (1989) 20 ATR 1516, the taxpayer received compensation from his ex-employer due to health problems resulting from asbestos exposure that had occurred during their previous employment relationship. This compensation payment was for the taxpayer’s loss of earning ability rather than for his loss of earnings. Furthermore, the payment was mandated and calculated under legislation that applied at the time. The Court held that the compensation was not assessable under the predecessor of s 15-2 (s 26(e) of ITAA 1936). The Court stated that this was because the compensation payment was a mandatory payment made by the ex- employer to compensate the taxpayer for their loss of earning ability. The Court said that in contrast, if the compensation payment had been a discretionary payment that was paid to the taxpayer as a reward for his services, then the payment would have fallen under s 15-2’s predecessor. However, it should be noted that a discretionary reward for services would be very likely to constitute ordinary income, and so would not be covered by s 15-2 due to it excluding amounts that are ordinary income (s 15-2(3)(d)). It is not totally clear how the Court would have treated a discretionary payment between the parties to compensate the taxpayer for his loss
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of earning capacity; however, the Court did appear to imply that such a payment would not be assessable under s 15-2’s predecessor. It is also unclear how the Court would have treated a mandated payment that was for compensation for loss of earnings rather than loss of earning capacity. However, such a payment would constitute ordinary income (see [10.80]) and so the current s 15-2 could not apply to it due to s 15-2(3)(d).
Case study 6.21: Tribunal finds that receipt of compensation payment for loss of fortnightly rostered day off assessable under predecessor of s 15-2 In AAT Case 7752 (1992) 23 ATR 1057, the taxpayer was compensated by his employer for losing the right to have a day off every fortnight. The employer had unilaterally terminated the taxpayer’s right to have a fortnightly day off and had compensated him with three months’ salary paid over three instalments. The Tribunal held that, while not being ordinary income, this payment was assessable under the predecessor of s 15- 2, as the taxpayer’s employment was the cause of the payment. However, because this is an AAT Case, it is not a binding precedent on future Court decisions.
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Given the scarcity of Court decisions on the issue, it is unclear to what extent (if any) s 15-2 will cover compensation payments paid to employees.
Section 15-2’s relationship with other tax provisions [6.240] As discussed at [6.90], s 15-2 of ITAA 1997 will not apply to gains that are ordinary income, and it is wider than ordinary income in that it has a more lenient nexus test and also applies to non-cash convertible items. Section 23L(1) of ITAA 1936 also states that if a gain is a fringe benefit, it will not be assessable for income tax purposes. This means that gains that are fringe benefits will not be assessable as ordinary income or under any income tax provisions, including s 15-2, and may instead be subject to FBT (which is not income tax). The precise definition of “fringe benefits” and details about the operation of FBT are discussed in Chapter 7. Note that, in general, most non-cash benefits provided by an employer to an employee are fringe benefits. In some limited circumstances, cash payments by an employer to an employee would also be regarded as a fringe benefit.
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Example 6.6: Examples of the application of s 15-2
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Because s 15-2 of ITAA 1997 only applies to gains that are not ordinary income and not fringe benefits, this leaves it with limited application. Some examples of where s 15-2 might still operate are: • the receipt of non-cash convertible items as a reward for volunteer work. In such an instance, the gains would not be ordinary income as they are non-cash convertible and they would not be fringe benefits because they have not been provided by an employer to an employee; • third-party payments for employment or services that are not cash convertible, for example, the receipt of a free non-transferrable holiday by an employee lawyer from a client of the law firm. Such receipts would not be assessable as ordinary income because they are not cash convertible. Furthermore, they would not be regarded as fringe benefits because they are not provided by an employer to an employee (if the employer has arranged for the third party to make this contribution to the employee, then it would be regarded as a fringe benefit and would be taxed under the fringe benefits regime: see Chapter 7); and • third-party payments that are cash or cash convertible and have some nexus with employment or services, but do not have a strong enough nexus to constitute ordinary income. These would not be ordinary income due to their insufficient nexus with the services. Furthermore, they would not be fringe benefits as they are not provided by an employer to an employee.
Section 15-3: Return-to-work payments [6.250] Payments made to a taxpayer as an inducement to return to work or provide services will be assessable as statutory income under s 15-3 of ITAA 1997. Section 15-3 does not have a contrary intention, so it will potentially apply to payments that are also ordinary income. Example 6.7: Return-to-work payment Nadia works as a lawyer for a big law firm. She quits because she is unhappy with the management of the firm. The firm would like to re- employ Nadia and offers her a one-off payment of $20,000 on top of her salary if she agrees to be re-employed by the firm.
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If Nadia agreed to this and received the $20,000, this money would be assessable under s 15-3.
Payments upon termination of employment [6.260] The principle that compensation payments take on the character of what is being compensated for is discussed at [10.20]. However, the compensation principle does not apply to payments connected with the termination of employment. In other words, where there is a payment connected to the termination of employment that falls under one of the termination provisions of the legislation, it does not matter whether the payment is compensation for income or capital, as legislation dictates how such payments are taxed. Depending on the precise nature of the termination payment, it may be statutory income (such as an employment termination payment (ETP)) or non- assessable income (such as genuine redundancy payments that are below a certain threshold). The main termination payments include: • ETPs: see [6.270] (for calculations on how ETP’s are taxed, see [6.370]); • genuine redundancy payments and early retirement scheme payments: see [6.320]; and • payments for unused annual and long service leave: see [6.390].
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Employment termination payment – Div 82 [6.270] In general, an ETP is a payment given by an employer to the employee upon termination. Payments can potentially be ETPs whether they are made voluntarily, under industrial relations laws, under contractual obligations or for some other reason. Payments can also be ETPs whether they are a result of the employee resigning or the employer dismissing the employee, although some redundancy payments are not regarded as ETPs: see [6.340]–[6.380]. There are two broad sub-types of ETPs: 1. Life benefit termination payment: an ETP paid to the ex-employee for his or her termination of employment. 2. Death benefit termination payment: a payment made after an employee has died. This payment is usually (although not necessarily) made to a relative of the former employee. [6.280] Specifically, under s 82-130 of ITAA 1997, a receipt is an ETP when it is a payment made in consequence of termination of employment. In other
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168 [6.290] PRINCIPLES OF TAXATION LAW 2020 words, for a payment to be an ETP, it must be shown that the following three requirements have been satisfied: 1. there was a payment “in consequence” of the employment termination: see [6.290]; 2. there was in fact a genuine termination of employment: see [6.310]; and 3. the payment did not fall into one of the exclusions below. The following are specifically excluded from the definition of an ETP (ss 82-130 and 82-135): • superannuation payments (superannuation is subject to its own taxation regime); • pensions and annuities (pensions and annuities are usually taxable as ordinary income, although annuities are also subject to statutory provisions that usually reduce the tax payable on them: see [9.120]); • genuine redundancy payments or early retirement scheme payments, but only to the extent they are not above the relevant threshold (see [6.380]); and • a restraint of trade payment that is capital in nature: see [6.140]–[6.180].
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The following payments are examples of ETPs: • An employer voluntarily makes a payment to an employee upon retirement (a life benefit termination payment). • An employer makes a payment (required by an industrial award) as a result of dismissing an employee for his or her unsatisfactory work (a life benefit termination payment). • An employer wrongly sacks an employee. The employee receives compensation in a successful unfair dismissal claim (a life benefit termination payment). • As a result of an employee’s death, the employer makes a payment to the employee’s spouse (a death benefit termination payment).
When is the payment “in consequence” of termination of employment? [6.290] For a payment to be regarded as an ETP, it must be paid “in consequence” of termination of employment. At first glance this would appear to mean that the payment must be due to the employment relationship ending. However, causation is never a simple matter. For example, what is the cause of the payment to an employee of 10 years who resigns and is given a termination payment of $12,000 based on the number of years of service in accordance with the relevant industrial award? The $12,000 is the result of several factors:
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• the termination of employment; • the fact that the employee worked for that employer for 10 years; and • the terms of the relevant industrial award. Termination of employment is one of the causes of the payment, but it is not the only cause and probably not even the dominant cause. Case law on the words “in consequence of termination of employment” shows that termination of employment need only be one of the causes for the payment, and it need not be the dominant cause for the payment to be an ETP: Reseck v FCT (1975) 5 ATR 538; McIntosh v FCT (1979) 20 ATR 13.
Case study 6.22: Payment in consequence of termination of employment In Reseck v FCT (1975) 5 ATR 538, a construction worker worked on one construction site between 25 November 1969 and 24 September 1971 and on a second site between 27 September 1971 and 11 February 1972. Both of these jobs were for the same employer. At the end of each of the two work periods, Reseck received a severance payment, even though the gap between the first and second period of employment was just a weekend: see [6.310].
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For technical reasons, the Court had to accept that both terminations were genuine. The main issue for the Court was whether the payments were “in consequence” of termination of employment. The legislation being considered at the time had the requirement that the payment be in “in consequence” of termination of employment, which is the same as is required by the current ETP provisions. Two out of three judges in the Full Federal Court (Gibbs and Stephens JJ) decided that the payments were in consequence of termination of employment. Although the language of these two judges was different, they were in fact saying substantially the same thing. Gibbs J stated that “in consequence” of termination means that the payment was a result of termination of employment. His Honour also stressed that the termination need not be the only or even dominant cause of the payment. Here, the payments were a result of a number of factors, including the fact that the employee’s performance had been satisfactory, the industrial agreements and the employment terminations. However, the payments were still “in consequence” of termination of employment because the terminations were one of the causes of the payments. Stephens J stated that for the payment to be “in consequence of” termination of employment, it must “follow on” from the termination. Like Gibbs J, His Honour emphasised that the termination need not be the dominant cause of the payment.
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Case study 6.23: Conversion of pension entitlement to lump sum “in consequence” of termination In McIntosh v FCT (1979) 20 ATR 13, the taxpayer had worked for a bank for many years. In those days compulsory superannuation was still a few decades away so most workers did not have superannuation accounts. However, the employer promised a private pension to some of its employees who had met the requirement of a minimum length of service. Under the terms of this entitlement, a retiring employee could convert part of the pension to a lump sum. McIntosh retired and was entitled to the bank pension and chose to convert half of it to a lump sum. The legislation at the time, like the current ETP provisions, applied where the payment was “in consequence” of termination of employment. Under the laws of the time, if the payment was “in consequence of termination of employment” the taxpayer would have had to pay some tax on the lump sum. If it was not, then the payment would have been tax free. The taxpayer argued that the payment was not in consequence of termination of employment because it was in consequence of the taxpayer’s decision to convert his pension to a lump sum. All three judges of the Full Federal Court (Brennan, Toohey and Lockhart JJ) disagreed and decided that the lump-sum payment was “in consequence” of termination of employment. As in Reseck v FCT (1975) 5 ATR 538, the Court emphasised that retirement need not be the dominant cause of the receipt in order for the receipt to be considered to be “in consequence” of retirement. Brennan and Toohey JJ referred to Reseck v FCT and stated that for a payment to be “in consequence” of retirement there must be some connection between the retirement and the payment, although retirement need not be the dominant cause. All three judges stated that, while it was true that one of the causes of the payment was the taxpayer’s election to convert the pension to a lump sum, the payment was still “in consequence” of retirement. This was because if the taxpayer had not retired, the taxpayer would not have been able to receive the lump sum.
Case study 6.24: Damages for unfair dismissal payment “in consequence” of termination of employment In Le Grand v FCT (2002) 51 ATR 139, the taxpayer worked as managing director with the Business Council of Australia (BCA). BCA terminated his employment and the taxpayer claimed that he had been wrongfully dismissed. He sued BCA for loss of wages, loss of reputation and some other related grounds, including the loss of opportunity to earn money
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elsewhere. The case was settled without going to court and the taxpayer was given nearly $550,000 in compensation. Goldberg J of the Federal Court held that this payment was “in consequence” of termination of employment. This was because there was sufficient connection between the compensation payment and the taxpayer’s termination. Like many of the judges in the previous cases, Goldberg J stated that for a payment to be “in consequence” of the termination of employment, the termination need not be the dominant cause of the payment. [6.300] These cases (at [6.290]) clearly illustrate the point that termination of employment need not be the only reason a payment is received for the payment to be considered “in consequence” of termination of employment. However, just because a payment is given shortly after retirement does not automatically mean that it is “in consequence of termination of employment”. In other words, although termination of employment does not have to be the only or a dominant cause of the payment, it still has to be one of the causes. The fact that employment termination and the payment happen at similar times is not enough to show causation between the payment and retirement, per Brennan J in McIntosh v FCT (1979) 20 ATR 13.
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Example 6.8: Post retirement payment not “in consequence” of retirement Three months before her retirement, Linda brings a new client to the firm, which has a large impact on the firm’s profitability. The firm voluntarily gives her a substantial bonus because of this and ends up paying it to her one month after her retirement. Linda would have received this bonus even if she had continued to work for the firm. Although the payment did occur shortly after her retirement, it would not be regarded as “in consequence” of her retirement and so would not be an ETP because the payment was for introducing the new client, not because of her retirement.
Case study 6.25: Payment due to tax minimisation scheme not “in consequence” of employment termination In Freeman v FCT (1983) 14 ATR 457, the taxpayers worked for Company A, which provided engineering consulting services. The taxpayers were also shareholders and directors of Company A. The taxpayers wanted the business transferred from Company A to Company B, as Company B
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would be run through an entity that would allow for less tax to be paid. This meant that the taxpayers would then be employed by Company B, rather than Company A. To facilitate this transaction, the taxpayers lent money to Company B. Company B used this money to pay Company A for the purchase of the engineering business and Company A then paid the taxpayers certain sums of money. In other words, the money trail followed a circle and ended up where it started. It went from the taxpayers to Company B to Company A and then to the taxpayers. The taxpayers claimed that the money they received from Company A should be concessionally taxed as it was paid “in consequence” of termination of employment. The Full Federal Court unanimously held the payment was not “in consequence of” their employment ending. The Court stated that this was partially due to the fact that the payments from Company A were made almost 12 months after the taxpayers had ceased working for Company A. The Court also appeared to be highly influenced by the fact that the whole scenario was a very contrived arrangement to reduce the amount of tax payable, rather than a genuine redundancy payment for termination of employment.
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Note: This case should not be interpreted as meaning that a payment made 12 months after retirement cannot be “in consequence” of employment terminating, although it does indicate that, all other things being constant, the longer the time lag between retirement and payment, the less likely the payment will be “in consequence” of employment terminating.
When is there a genuine termination? [6.310] “Termination” is defined as including cessation of employment due to retirement, as well as cessation of employment due to the taxpayer’s death: s 80-10 of ITAA 1997. In most cases, it will be clear whether there is a termination of employment. For example, where a taxpayer receives a payment upon his or her redundancy, there will have been a termination of employment. Where a worker dies and his or her spouse receives a payment, there will have been a termination of employment. However, in a limited number of cases, it might be unclear whether there has been a genuine termination. Case study 6.26: Fixed-term position made permanent not regarded as “termination” In Grealy v FCT (1989) 20 ATR 403, a university lecturer was on a fixed- term contract. Before this contract ended, it was terminated and the
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lecturer was given a permanent position by the same employer. The Court held that there had not been a “termination” of employment. Case study 6.27: Termination and re-employment a few days later may not be genuine In the case of Reseck v FCT (1975) 5 ATR 538, discussed in Case Study [6.18], a construction worker had his job terminated on Friday and was re- employed the following Monday by the same employer, but on a different construction site. For certain legal reasons, the Court had to accept that the termination was genuine. All the Court was asked to do was to decide whether the payment was “in consequence” of a termination. The Court decided that it was. However, Gibbs J did indicate that he was sceptical that there was a genuine termination, but acknowledged that, for legal reasons, he had to accept that there was a genuine termination.
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Genuine redundancy payments and early retirement scheme payments – Div 83 [6.320] To the extent that genuine redundancy payments and early retirement scheme payments do not exceed the relevant threshold, they are excluded from being ETPs and are tax free: s 83-170 of ITAA 1997. However, to the extent that they are over the relevant threshold, they will be regarded as forming part of an ETP and will be taxed as such.
What is a genuine redundancy payment? [6.330] Under s 83-175 of ITAA 1997, a genuine redundancy payment is a payment made to an employee due to his or her position being genuinely made redundant. However, this is limited to the extent that the payment exceeds the amount that could be reasonably expected to be received if that employee had voluntarily terminated his or her employment. Example 6.9: Redundancy payment Jane works for a bank. Jane was paid a genuine redundancy payout of $30,000. To the extent the $30,000 is under the relevant threshold (see [6.360]), it will be tax free.
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What is an early retirement scheme payment? [6.340] Under s 83-180 of ITAA 1997, an early retirement scheme is a scheme that satisfies all of the following conditions: • The scheme is open to all of the employer’s employees who are in the group that the Commissioner states are entitled to participate in the scheme. • The employer’s purpose in having the scheme is to reorganise the operations in that workplace. • The Commissioner has approved the scheme as an early retirement scheme. However, only the portion of the payment that exceeds the amount that could be reasonably expected to have been received if that employee had voluntarily terminated his or her employment is regarded as an early retirement scheme payment. Example 6.10: Early retirement scheme payment
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Neil works as a production line worker for a clothing manufacturer. The clothing manufacturer closes part of its operations due to shifting production offshore. A likely scenario would be that: • the Commissioner in writing states that this is an early retirement scheme; and • all the production line workers on that production line are considered to be a group that should be eligible for the scheme; and • the purpose of the scheme is to reorganise the workplace in question. Subsequent to the Commissioner’s written approval, the employer offers all employees on that production line $25,000 if they take a redundancy package. This would be an early retirement scheme. To the extent that the $25,000 would be under the relevant threshold (see [6.360]), it will be tax free.
Further conditions for redundancy payments and early retirement scheme payments [6.350] Sections 83-175 and 83-180 of ITAA 1997 require that, for payments to be considered redundancy payments and early retirement scheme payments, as well as fulfilling the above conditions:
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• the employee must be dismissed before he or she reaches the age of 65; • the payment must represent what would be payable under a normal commercial arrangement; and • there must be no arrangement at the time of dismissal that the employee be re-employed by the employer.
Threshold [6.360] Redundancy payments and early retirement scheme payments are not ETPs and are tax free to the extent they are below the relevant threshold: s 83-170 of ITAA 1997. To the extent they are above the relevant threshold, they will usually fall into the definition of ETPs and are taxed accordingly. The formula for determining the relevant threshold for any given taxpayer is: Base amount + (Service amount × Year / s of service)
The base amount and service amount are indexed every year. For the 2018– 2019 financial year, the amounts are $10,638 for the base amount and $5,320 for the service amount. Example 6.11: Taxation of redundancy payments
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Katie has worked for her employer for 11 years. She is made redundant and receives a payment of $90,000 on top of any annual and long service leave entitlements. Had she not been made redundant and resigned voluntarily, she would have been paid $10,000 under the relevant workplace policies (on top of any annual and long service leave entitlements). This means that, of the $90,000:
• $10,000 is not a redundancy payment because it would have been paid had Katie voluntarily resigned. It will be taxed as an ETP.
• The remaining $80,000 ($90,000 –$10,000) is a genuine redundancy payment. The relevant threshold for Katie would be $10,638 + ($5,320 × 11) = $69,158. This means of the $80,000 genuine redundancy payment $69,158 would be tax free and the remaining portion of the redundancy payment of $10,842 ($80,000 –$69,158), would be taxable as an ETP. Therefore, the total amount taxable as an ETP would be $22,842 ($10,000 + $10,842).
Calculation of tax payable on ETP [6.370] If there is an ETP, the next step is to calculate the amount of income tax payable on the ETP. The amount of tax payable will depend on whether
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176 [6.370] PRINCIPLES OF TAXATION LAW 2020 the ETP is a life benefit termination payment or a death benefit termination payment. The difference is that a life benefit termination payment is an ETP given to a living taxpayer whose job has been terminated, whereas a death benefit termination payment is an ETP given to someone due to the death of another person (usually a relative): see [6.270]. For example, if a taxpayer resigns and receives a payout from her former employer of $30,000, it will be classified as a life benefit termination payment. An example of a death benefit termination payment would be where a taxpayer dies and the deceased’s employer pays his spouse $100,000 because of his death. Where the ETP is taxed at concessional rates the concession is facilitated by a tax rebate (offset) which effectively lowers the rate of tax. This rebate is used to reduce the final tax liability for the employee. An important effect of applying the concession through a tax rebate is that the total amount (less any tax-free amount) will still be included in assessable income which can influence other tax components such as the Medicare Surcharge. An ETP will be taxed as follows: • Tax- free component: ss 82- 10(1), 82- 65(1) and 82- 70(1) of ITAA 1997. The tax-free component will include the following amounts (s 82-140): 1 The portion of the ETP that is attributable to pre- 1 July 1983 employment: s 82-155. For example, if the taxpayer has worked for his employer from July 1980 to July 2010, it might be reasonable to assume that 10% of an ETP is due to his pre- 1 July 1983 employment and is tax free. This is because, of his 30 years of employment, three are due to the pre-1 July 1983 period. Copyright © 2019. Thomson Reuters. All rights reserved.
2
The portion of an ETP that is due to a taxpayer’s invalidity, referred to in the legislation as an “invalidity segment”: s 82-150. For example, if a taxpayer becomes permanently disabled due to a work injury, an ETP received as a result will be tax free. Specifically, the portion of an ETP that constitutes an “invalidity segment” is one: (a) that is paid to a taxpayer due to the taxpayer being unable to work because of his or her ill-health; (b) where the taxpayer’s inability to work occurred before the age of 65; and (c) where two medical doctors certify that the taxpayer is unlikely to ever be able to be employed for the position that he or she is reasonably qualified to work.
Under s 82-150(2), the legislation puts a limit as to what portion of the ETP can constitute an invalidity segment. This cap is based on how many years of employment income the taxpayer has lost due to his or her invalidity.
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• Taxable component: Any portion of the ETP that is not a tax- free component will be a taxable component: s 82-145. How the taxable component is taxed depends on whether the ETP is a life benefit termination payment or a death benefit termination payment. The taxable component of a life benefit termination payment will be taxed at the rates shown in Table 6.1: s 82-10. TABLE 6.1 Taxable component of life benefit termination payment ETP taxable component amount
Taxpayer is at preservation age or older: see Table 18.2
Taxpayer is below preservation age: see Table 18.2
0 = threshold
Taxed at normal marginal tax rates but capped at a rate of 15% plus 2% Medicare levy
Taxed at normal marginal tax rates but capped at a rate of 30% plus 2% Medicare levy
Amounts over the threshold
Taxed at 45% plus 2% Medicare levy
Taxed at 45% plus 2% Medicare levy
The threshold applied in Table 6.1 will be the lower of the following two amounts (s 82-10(4)): • $210,000: This figure is indexed annually and is correct for the 2019– 2020 financial year.
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• A $180,000 “whole-of-income cap” which is reduced by any non-ETP taxable income of the taxpayer. This figure is fixed by legislation and not annually indexed. Furthermore, this amount cannot be reduced below zero. However, this threshold is unaffected by and is inapplicable to any of the following excluded amounts (s 82-10(6)): – Genuine redundancy payments: see [6.330]. This includes payments that are not strictly speaking genuine redundancy payments because the taxpayer is 65 or over, but would have been genuine redundancy payments had the taxpayer been under 65. Note that this particular exclusion applies to the full genuine redundancy payment, not only the part which is under the threshold discussed in [6.360]. – Early retirement scheme payments: see [6.340]. This includes payments that are not strictly speaking early retirement scheme payments because the taxpayer is 65 or over, but would have been early retirement payments had the taxpayer been under 65. Note that this exclusion applies to the full early retirement scheme payment, not only the part which is under the threshold discussed in [6.360]. – An amount that includes an invalidity segment: see the earlier discussion in this paragraph. This includes payments that are not
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178 [6.370] PRINCIPLES OF TAXATION LAW 2020 strictly speaking invalidity segments because the taxpayer is 65 or over, but would have been an invalidity segment had the taxpayer been under 65. – Compensation received due to employment disputes relating to personal injury, harassment, discrimination or unfair dismissal to the extent that such amount exceeds what the employee would have received had they voluntarily resigned in the absence of such a dispute. – Death benefit payments: see the earlier discussion in this paragraph. However, note that if the taxpayer receives an ETP that has both excluded and non- excluded components, the taxpayer is deemed to have received the excluded component first (s 82-10(7)) and considered only against the $210,000 cap. Also, because both non-excluded and excluded amounts have been received, it is necessary to determine whether the $210,000 or the $180,000 caps apply to the non-excluded ETPs. Therefore, the $210,000 cap is first reduced by any excluded amount that has already been applied against this cap (s 82-10(4)). An important effect of these rules is that the total amount of an ETP payment that is capped at the lower rate (15% or 30%, depending on age, plus Medicare levy) will not exceed $210,000: see Example 6.16. Example 6.12: ETP calculation
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Nick aged 53 (under preservation age) resigns from his work and receives a payment of $50,000. He has already earned $160,000 in salary and investment income for the financial year. The full $50,000 is regarded as an ETP. Although the $50,000 is less than the $210,000 threshold, the $180,000 “whole-of-income cap” must be reduced by the $160,000 taxable income (from salary and investment income) that Nick has received, meaning that the cap is in effect only $20,000 ($180,000 –$160,000). Since this $20,000 cap is less than the $210,000 threshold, the $20,000 cap is the one that applies. This means that the first $20,000 of Nick’s ETP will be capped at the tax rate in Table 6.1 at 30% plus Medicare levy (as Nick is under preservation age). The remaining $30,000 will be taxed at 45% plus Medicare.
Example 6.13: ETP calculation Nathan is 51 (under preservation age) and made redundant from his employment in a bank where he has been working for 11 years. He receives a redundancy payment of $159,158 in the current year on top of his annual and long service leave entitlements. Had he resigned voluntarily, he would have received only $30,000 (on top of his annual
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and long service leave entitlements), leaving the rest of the payment as a genuine redundancy payment under s 83-175. For the financial year so far, Nathan received a salary of $250,000 and did not have any deductions. Nathan’s termination payment can be viewed as consisting of the following amounts:
• $30,000 is an ETP as he would have received this amount if he resigned and was not made redundant.
• $129,158 ($159,158 –$30,000) balance is a genuine redundancy payment and not an ETP. As he has been working in this job for 11 years, $69,158 ($10,638 + ($5,320 × 11)) of this is tax free (see [6.360]). The remaining $60,000 ($129,158 − $69,158) is taxable as an ETP, though it is still regarded as a genuine redundancy payment.
The total amount regarded as an ETP is therefore $90,000 ($30,000 + $60,000).
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The $60,000 portion of the ETP is an excluded amount due to it being a genuine redundancy payment. Consequently, it is deemed to have been received first (s 83-10(7)). As it is an excluded amount, the “whole-of- income cap” does not apply to it, and only the $210,000 threshold will be relevant. As the $60,000 is less than the $210,000 threshold, the amount of tax on the $60,000 is capped at 30% plus Medicare levy because Nathan is under his preservation age (as, below the preservation age): see Table 6.1. In addition, the $30,000 portion of the ETP will potentially be subject to both thresholds. First, the $180,000 “whole-of-income cap” is reduced (but not below zero) by the $250,000 salary he received for the financial year, meaning that this cap becomes zero. Second, the $210,000 threshold will be reduced by the $60,000 portion of the ETP payment (genuine redundancy excluded amount that is not tax free) reducing it to $150,000. Since the “whole-of-income cap” amount of zero is the lower of the two, it will be the applicable threshold. This means that the whole $30,000 amount will have breached this threshold and so will be taxed at the rate of 45% plus Medicare levy: see Table 6.1.
Example 6.14: ETP calculation Amelia works for a major department store and is 61 years of age (above preservation age). She resigns and receives a payout of $178,000, and she has $5,000 of salary income for the financial year. The full $178,000 is regarded as an ETP.
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The $180,000 “whole- of- income cap” is reduced to $175,000 as Amelia has earned other income ($5,000) for the financial year. As the $175,000 “whole-of-income cap” is lower than the $210,000 threshold, the $175,000 threshold will apply. This means that the first $175,000 of Amelia’s ETP is capped at 15% plus Medicare levy (as, she is over the preservation age). The remaining $3,000 is taxed at the rate of 45% plus Medicare levy: see Table 6.1.
Example 6.15: ETP calculation William is 48 (under preservation age) and works for a car importer. He loses his job and initially receives $65,000 from his employer for ceasing employment (this did not qualify as a genuine redundancy termination payment). This $65,000 is on top of his annual and long service leave entitlements. He then sues his employer for unfair dismissal, is successful, and so receives damages of an additional $100,000. William has received other taxable income for the financial year (his salary) of $150,000. The full $165,000 ($65,000 + $100,000) is considered an ETP.
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The $100,000 is excluded from the $180,000 “whole-of-income cap” as it is compensation for unfair dismissal. Consequently, it is deemed to have been received first (s 83-10(7)), and only needs to be applied against the $210,000 threshold. As the $100,000 is below the $210,000 threshold it would be capped at 30% plus Medicare levy: see Table 6.1. The $65,000 portion of the ETP will be offset against the lower of the two thresholds. First, the “whole-of-income cap” is reduced from $180,000 to $30,000 due to the non- ETP taxable income of $150,000. Second, the $210,000 threshold is reduced by $100,000 to $110,000 due to the $100,000 portion of the ETP. As the $30,000 is the lower of these two amounts, this is the threshold that would be applicable to the $65,000 portion of the ETP. This means that $30,000 of the $65,000 is capped at 30% plus Medicare levy, whereas the remaining $35,000 would be taxed at the top tax rate: see Table 6.1.
Example 6.16: Redundancy payment Mia is 66 (above preservation age) and works for an electronic parts distributor. Due to illness, she becomes unable to work and resigns. Her work pays her $60,000 which is what she would have received had she resigned under any situation (this $60,000 is on top of her annual and long service leave entitlements), and an additional $160,000 as an invalidity
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payment. Before her illness Mia had earned taxable income of $70,000 (her salary) for the financial year. Although the full $220,000 ($160,000 + $60,000) is regarded as an ETP, the $160,000 invalidity payment is excluded from the “whole-of-income cap”. This is despite the fact that none of the invalidity payment is tax-free due to Mia being 66 years old (over 65). The $160,000 excluded portion of the ETP is dealt with first as it is deemed to have been received first (s 83-10(7)) and only needs to be tested against the $210,000 threshold. As the $160,000 is below the $210,000 threshold, it is capped at the rate of 15% plus Medicare levy: see Table 6.1. The remaining $60,000 is potentially subject to the two thresholds. First, the “whole-of-income cap” is reduced from $180,000 to $110,000 due to the $70,000 salary. Second, the $210,000 threshold is reduced due to the $160,000 portion of the ETP being offset against it. This will mean that the $210,000 threshold is reduced by the $160,000 to $50,000. As $50,000 is the lesser of these two thresholds, it will be the relevant amount. Consequently, $50,000 of the $60,000 will be capped at 15% plus Medicare levy, and the remaining $10,000 will be taxed at 45% plus Medicare: see Table 6.1.
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[6.380] Taxation of the taxable component of a death benefit termination payment depends on whether the recipient of the payment is a “dependent” of the deceased. Under s 302-195 of ITAA 1997, the recipient will be a dependent if he or she is: • the deceased’s spouse or ex-spouse (spouse will also include de facto and same-sex partners in some circumstances); • the deceased’s child who is under 18; • a person who had an “interdependency relationship” with the deceased. This means someone who the deceased lived with and had a close personal relationship with. Furthermore, for someone to show he or she had a “interdependency relationship” with the deceased, it is also required that at least one of the parties involved provided financial support and at least one of the parties involved provided domestic support; or • anyone else dependent on the deceased before he or she died (this would cover financial dependence). The taxable component of a death benefit termination payment is taxed at the rates shown in Table 6.2: ss 82-65 and 82-70. The $210,000 threshold in Table 6.2 is indexed annually and is correct for the 2019–2020 financial year.
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182 [6.390] PRINCIPLES OF TAXATION LAW 2020 TABLE 6.2 Taxable component of death benefit termination payment ETP taxable component amount
Recipient is a dependent
Recipient is not a dependent
$0–$210,000
Not taxed, except for 2% Medicare levy where applicable
Taxed at normal marginal tax rates but capped at a rate of 30% plus 2% Medicare levy
$210,000+
Taxed at 45% plus 2% Medicare levy
Taxed at 45% plus 2% Medicare levy
Payments for unused annual and long service leave – Div 83 [6.390] When an employee has his or her employment terminated, it is normal for the employee to receive a lump- sum payment for any annual (holiday) leave and long service leave owing to the employee. These receipts are assessable as statutory income under s 83-10 of ITAA 1997 for the annual leave payments and s 83-80 for the long service leave payments. In many cases, these provisions provide no tax concession as the annual leave and long service leave payments are taxed at normal marginal tax rates. However, under some limited circumstances, a concession in the form of the payments being capped at the rate of 30% (plus Medicare levy) will apply. Under s 83- 15 of ITAA 1997 (for annual leave) and s 83-85 of ITAA 1997 (for long service leave), this will be the case when:
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• the payment was due to annual leave or long service leave accrued due to services performed before 18 August 1993; or • the payment was in connection with a payment that consists of a genuine redundancy payment or early retirement scheme payment, or an invalidity segment of an ETP. Also, only 5% of any leave accrued prior to 16 August 1978 is subject to tax (s 83-80). Example 6.17: Annual and long service leave payment Jack has worked for his current employee since January 2000 and he resigns voluntarily. Under the relevant industrial award, he is entitled to receive $10,000. Furthermore, he receives $12,000 in annual and long service leave owing to him. The $10,000 will be assessable as a life benefit termination payment (a type of ETP) and the $12,000 in leave entitlements will be assessable at normal marginal tax rates.
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Example 6.18: Genuine redundancy and annual leave payment Jill has worked for her current employee for three years and is made redundant. She receives a genuine redundancy payment of $6,000, as well as an ETP of $10,000. She also receives a $9,000 payment for annual leave that is owed to her: • The $6,000 will be tax free because it is below the maximum tax free amount of $25,999 ($10,399 + ($5,200 × 3)). • The $10,000 will be taxed as a life benefit termination payment (ETP). • The $9,000 will be subject to normal marginal tax rates, but will be capped at the rate of 30% (plus Medicare levy) because it was paid in connection with a genuine redundancy payment.
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Questions [6.400] 6.1 During the current tax year, Erin received the following amounts: • Salary and wages income of $98,000. • $4,200 interest from a bank term deposit of $50,000. • $500 per week for 50 weeks of the year from a rental property she owns. • Winnings of $10,000 on the poker machines. • $500 from selling eggs that her chickens laid to friends. • A holiday bonus of $1,000 from her employer. • A watch worth $200 from a happy client. What is Erin’s ordinary income for the current tax year? 6.2 Jane and Sally are employed school teachers who have a very wide general knowledge. Both decide to enter a television quiz program called “Lease of the Decade”. Under the rules, contestants receive $100 for each appearance, but if questions are answered correctly, they receive substantial cash prizes and other prizes, such as household items and holiday packages. The holiday packages cannot be transferred or redeemed, but the organisers of the program allow them to be converted into alternative venues and accommodation. Jane and Sally go on the show but Jane is eliminated in the first contest and receives her $100. Sally, however, makes 10 appearances. She
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184 [6.400] PRINCIPLES OF TAXATION LAW 2020 wins cash prizes of $50,000, household appliances worth $20,000 and a trip to Europe with her family valued at $30,000. Discuss the assessability of these prizes. 6.3 Hilary is a well-known mountain climber. The Daily Terror newspaper offers her $10,000 for her life story, if she will write it. Without the assistance of a ghost writer, she writes a story and assigns all her right, title and interest in the copyright for $10,000 to the Daily Terror. The story is published and she is paid. She has never written a story before. She also sells the manuscript to the Mitchell Library for $5,000 and several photographs that she took while mountain climbing for which she receives $2,000. Discuss whether or not the three payments are income from personal services. Would your answer differ if she wrote the story for her own satisfaction and only decided to sell it later? 6.4 George is manager of Newcastle Steel Ltd. His contract is for 10 years. In the third year, George enters into a restrictive covenant which provides that during the remainder of his contract he must not reveal to another party the confidential information of his employer. It further provides that he must not work for a competitor during the remainder of the employment agreement. Consideration for entering into the agreement is $40,000. Is this capital or income in George’s hands?
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6.5 A well-known television personality was paid a lump sum of $400,000 to encourage her to join a new television network. She accepted the offer and received an annual salary of $100,000 in addition to the lump- sum payment. Discuss whether both the $400,000 and the $100,000 receipts are assessable income. 6.6 Consider the following situations and discuss whether or not they are income in ordinary concepts: • A cash prize for being the best student in income tax law received by a student who also receives a Youth Allowance from the government. • A gratuity (not being superannuation) received by a widow from her husband’s former employer in recognition of her husband’s services. • An honorarium received by a student for acting as honorary secretary of a small country town football club. • A bonus received by an employee for a suggestion adopted by the management. 6.7 Jane teaches company law at a regional university. For many years she has had a passionate interest in amateur theatricals. She has performed with several local groups. On 30 December Arthur asked
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6: IncoMe froM personal serVices anD eMploYMent [6.400] 185
Jane if she would be interested in performing in the next production of the group with which he performs. Jane, who has several weeks free from performing, eagerly agrees. Jane has only worked with this group once before, six years ago. After the last performance, Charles, the producer of the play, handed Jane an envelope which she assumes contains a thank-you card for performing in the play. Jane opened the envelope late the next morning and discovered that, in addition to a thank-you card, there is a cheque for $49.28 for participating in the production. Jane has never before been paid for appearing in any of the 60 productions in which she has been involved. Jane endorsed the cheque to her landlord as part-payment of her rent. Advise Jane of her income tax liability with respect to $49.28. 6.8 Frederick has been out of work for the past five years, and he has been using the Findjobs Ltd employment agency for the past 12 months to find employment. In April of this year a new case manager, Albert, was given the task of finding Frederick a job. In a matter of 10 days Albert had Frederick a permanent job. In gratitude, Frederick bought a $1,000 gold watch (it was a very good job he landed) and gave it to Albert as a mark of his appreciation. Advise Albert as to whether this gift is assessable income. 6.9 Nadia is an accountant in a large accounting firm. She is on a three- year contract, which still has two years to go. Her official job title is “Manager” and under her contract she is entitled to her own private office. • Nadia is offered $6,000 if she changes her job title to “Senior Accountant”, with no change in pay or length of the contract. She is also offered $4,000 by her employer if she agrees to give up her private office. She agrees to this. • Advise Nadia as to her income tax liability with respect to the $6,000 and $4,000 payments. 6.10 Dan is made redundant from his job that he has been working for four years and receives $50,000 as a genuine redundancy termination payment. Before the redundancy, Dan had earned $120,000 for the tax year. Advise Dan as to the tax implication of receiving the $120,000. 6.11 Bev is dismissed from her job and receives a $80,000 redundancy amount (not a genuine redundancy termination payment). She then sues her ex-employer for unfair dismissal and settles for $140,000. As the dismissal was early on in the tax year, she had only received $20,000 in salary for the year. Advise Bev as to the tax implications of the receipts of the $80,000 and $140,000 amounts.
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7 Fringe benefits tax
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Key points...................................................................................................... [7.00] Introduction.................................................................................................. [7.10] Definition of fringe benefit........................................................................... [7.20] Benefit .................................................................................................... [7.30] Provided during the year of tax............................................................. [7.40] Employer, associate or third-party arranger......................................... [7.50] Employee or associate........................................................................... [7.60] In respect of the employment of the employee................................... [7.70] Exclusions...................................................................................................... [7.80] Categories of fringe benefits....................................................................... [7.90] Car fringe benefits –Div 2.................................................................... [7.100]
Exempt benefits....................................................................................... [7.110] Taxable value........................................................................................... [7.120] Debt waiver fringe benefits –Div 3..................................................... [7.150] Taxable value........................................................................................... [7.160] Loan fringe benefits –Div 4................................................................. [7.170] Exempt benefits....................................................................................... [7.180] Taxable value........................................................................................... [7.190] Expense payment fringe benefits –Div 5........................................... [7.200] Exempt benefits....................................................................................... [7.210] Taxable value........................................................................................... [7.220] Meal entertainment fringe benefits –Div 9A...................................... [7.230] Taxable value........................................................................................... [7.240] Property fringe benefits –Div 11......................................................... [7.250] Exempt benefits....................................................................................... [7.260] Taxable value........................................................................................... [7.270] Residual fringe benefits –Div 12......................................................... [7.280] Exempt benefits....................................................................................... [7.290] Taxable value........................................................................................... [7.300] Exempt fringe benefits............................................................................... [7.310] Minor benefits –s 58P.......................................................................... [7.320] Work-related items –s 58X.................................................................. [7.330]
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188 [7.00] PRINCIPLES OF TAXATION LAW 2020 Membership fees and subscriptions –s 58Y...................................... [7.340] Single-trip taxi travel–s 58Z................................................................ [7.350] Reductions in taxable value....................................................................... [7.360] In-house fringe benefits....................................................................... [7.370] Recipient’s contribution....................................................................... [7.380] Otherwise deductible rule.................................................................... [7.390] Type of fringe benefit................................................................................. [7.400] Fringe benefits taxable amount................................................................. [7.410] FBT liability................................................................................................. [7.420] Interaction with income tax....................................................................... [7.430] Employer.............................................................................................. [7.430] Employee.............................................................................................. [7.440] Interaction with GST.................................................................................. [7.450] Questions..................................................................................................... [7.460]
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Key points [7.00] • Fringe benefits tax is a different type of tax as it is imposed on the provision of fringe benefits, rather than the derivation of income. • Liability for fringe benefits tax is imposed on employers, not employees. • A “fringe benefit” arises where an employer provides an employee with a benefit, directly or indirectly, and the benefit is provided due to the employment relationship. • There are 13 categories of fringe benefits, and the calculation of the fringe benefits tax liability arising in relation to a particular fringe benefit will depend on its category. • A number of benefits do not attract fringe benefits tax because they are either excluded from the definition of “fringe benefit” or specifically made exempt by the fringe benefits tax legislation. • Fringe benefits tax paid by an employer and the cost of providing a fringe benefit are generally deductible to the employer for income tax purposes. • The receipt of fringe benefits by an employee is either exempt or non- assessable, non-exempt income to the employee.
Introduction [7.10] The introduction of a fringe benefits tax (FBT) was announced by then Treasurer, the Hon Paul Keating, on 19 September 1985 and came into effect on 1 July 1986. FBT was introduced to tax the provision of fringe benefits
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(ie, benefits other than salary) by employers to employees. At the time it was estimated that almost 20% of the total remuneration of senior white-collar employees comprised benefits other than salary: Reform of the Australian Tax System, Draft White Paper (AGPS, Canberra, 1985) at 96. The introduction of s 26(e) of ITAA 1936 (now s 15-2 of ITAA 1997) (see [6.190]–[6.240]) was inadequate in capturing all non- cash benefits provided by employers to employees within the tax system. In particular, the section did not capture benefits provided to associates of employees (eg, spouses) and included in the employee’s assessable income “the value to the taxpayer” of the benefit, which is a subjective assessment. As will be seen, the FBT regime has a very wide scope and captures all benefits provided in an employment context. It is through the exclusions (see [7.80]) that some employment benefits, such as salary, are subject to income tax in the employee’s hands. There are also a number of exemptions that exclude certain employment benefits from tax altogether. FBT is a different type of tax in that it is a tax that is imposed on the provision of fringe benefits, rather than the derivation of income. As discussed in Chapter 3, separate legislation is required for the imposition of different taxes. The provisions regarding FBT are contained in the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA) and the Fringe Benefits Tax Act 1986 (Cth).
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A key difference between income tax and FBT is the taxpayer. FBT is imposed on the employer, not the employee: s 66(1) of FBTAA. As such, tax is imposed on the provision of fringe benefits, not on the receipt of them. The imposition of FBT on the employer rather than the employee reduces the administrative burden as there are far fewer employers than employees. A second difference between the FBT system and the income tax system is the tax year. Unlike the income tax year, which is from 1 July to 30 June, the FBT year is from 1 April to 31 March: see definition of “year of tax” in s 136(1) of FBTAA. The very first FBT year was a transitional year of only nine months for the period 1 July 1986 to 31 March 1987. The different FBT year spreads the tax compliance burden to a different time in the year, ensuring that taxpayers and tax agents are able to meet their income tax and FBT obligations in a timely manner. The FBT legislation adopts a largely prescriptive and methodical approach to determining the FBT consequences of a transaction. For example, the legislation specifies what constitutes a fringe benefit, whether or not it is subject to FBT, the value of the fringe benefit for FBT purposes and the method of calculating the FBT liability. This step-by-step approach should be adopted when determining the FBT consequences of a transaction. Figure 7.1 provides an overall guide to dealing with the tax consequences arising on the provision of fringe benefits.
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190 [7.10] PRINCIPLES OF TAXATION LAW 2020
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Figure 7.1: Overall FBT guide
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Definition of fringe benefit [7.20] The term “fringe benefit” is defined in s 136(1) of FBTAA and is central to the imposition of FBT. The first part of the definition provides that a fringe benefit exists, where there is: • a benefit: see [7.30]; • provided during the year of tax: see [7.40]; • by an employer, associate or third-party arranger: see [7.50]; • to an employee or an associate: see [7.60]; • in respect of the employment of the employee: see [7.70]. This very broad definition of “fringe benefit” essentially captures all benefits provided by an employer to an employee, whether or not the benefits are convertible to money. Importantly, the definition then excludes a number of specific employment benefits (such as salary) from being “fringe benefits”: see [7.80]. Note that FBT only applies to benefits received in an employment context. Any benefits provided in the context of other working arrangements, such as where independent contractors are engaged or partners in a partnership, will fall outside the scope of FBT.
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Benefit [7.30] The term “benefit” is defined in s 136(1) of FBTAA and includes any right, privilege, service or facility provided under an arrangement in relation to the performance of work. This definition is very wide and is likely to capture most benefits provided by an employer to an employee, whether of a monetary or non-monetary nature. As we will see at [7.90], the legislation identifies a number of specific categories of fringe benefits (such as private use of an employer- provided car and loans) but there is an important final category, residual benefits (see [7.280]), which captures any benefits that do not fall within the specific categories and ensures the broad scope of the term “benefit”. Section 6 of FBTAA confirms this by providing that the specific categories of fringe benefits do not limit the generality of the expression “benefit”. While the scope of the term “benefit” is certainly broad, it is not unlimited. In Slade Bloodstock Pty Ltd v FCT (2007) 68 ATR 911 (see Case Study [7.4]), the Full Federal Court suggested that, where an employee makes a loan to an employer, the repayment of the loan by the employer to the employee, in whole or in part, is unlikely to constitute a “benefit” (to the employee) under
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192 [7.40] PRINCIPLES OF TAXATION LAW 2020 the definition of “benefit” in s 136(1) which includes a right, benefit, privilege, service or facility that is provided under an arrangement for, or in relation to, the lending of money.
Provided during the year of tax [7.40] FBT is imposed annually and tax is imposed on fringe benefits provided during, or in reference to, a particular FBT year –that is, 1 April to 31 March. The term “provide” is defined in s 136(1) of FBTAA. In relation to benefits, it includes “allow, confer, give, grant or perform” and, in relation to property, the disposal of a beneficial interest in or legal ownership of the property. This definition is generally consistent with the common meaning of the term. A benefit may also be deemed to be provided, where the benefit is prohibited but the prohibition is not consistently enforced: s 148(3). For example, where an employee is prohibited from using an employer-provided car for private purposes but the employer “turns a blind eye”, the private use of the car is a fringe benefit (see [7.100]) deemed to be provided by the employer per s 148(3). Section 148(4) further specifies that a benefit that is received or obtained by an employee in respect of employment is deemed to be “provided”. This ensures that fringe benefits that are supplied to an employee by a party other than the employer (see [7.55]–[7.58]) are nonetheless “provided” by the employer.
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Case study 7.1: Meaning of “provide” In Westpac Banking Corporation v FCT (1996) 34 ATR 143, Hill J considered the meaning of “provide” in an FBT context. The taxpayer usually charged its customers a loan establishment fee when entering into a loan arrangement. However, the fee was waived in the case of loans made to employees. The taxpayer argued that the definition required a positive act for a benefit to be “provided”. The non-imposition of a fee could not be said to be a benefit “provided” by the taxpayer. The Federal Court accepted the Commissioner’s argument that the taxpayer had “provided” its employees with a benefit –that is, the review and assessment of the employee’s loan application for no fee.
Employer, associate or third-party arranger [7.50] “Employer” is defined in s 136(1) of FBTAA as a person who pays, or is liable to pay, “salary or wages”. “Salary and wages” is discussed at [7.85]. Section 137 ensures that the FBT legislation applies in situations where there is a clear employment relationship, but the employee is remunerated with
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non-cash benefits instead of salary or wages. In other words, an employer cannot escape being an “employer” under the FBT legislation by not paying an employee salary and wages but providing non-cash benefits instead. The definition includes current, former and future employers, but excludes the Commonwealth or an authority of the Commonwealth. A “future employer” is a person who will become a current employer, while a “former employer” is a person who has been a current employer: s 136(1). The scope of past and future employment relationships is discussed further at [7.60] in the context of the definition of “employee”. [7.55] It is important to note that a benefit does not have to be provided by an employer to an employee directly to qualify as a fringe benefit. Benefits provided by an associate of the employer may also qualify as a fringe benefit provided by the employer. The definition of “associate” in s 136(1) refers to s 318 of ITAA 1936 and s 159 of FBTAA.
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Where the employer is a “natural person”, the employer’s associates include: • relatives; • a partner of the employer and their spouse or child; • a partnership in which the employer is or was a partner; • trustees of trusts where the employer or the employer’s associates may be a beneficiary; and • companies formally or informally controlled by the employer (formal control refers to a majority voting power in the company while informal control refers to situations where the directors of a company usually act in accordance with the employer’s directions). “Relative” is defined in s 995-1 of ITAA 1997 as a person’s spouse or that person’s parent, grandparent, sibling, uncle, aunt, nephew, niece, lineal descendant or adopted child of that person or that person’s spouse. The spouse of any of these people is also a relative. “Spouse” is defined in s 995-1 to include de facto and same sex relationships. Where the employer is a “company”, its associates include:
• a partner (and their spouse or child if the partner is a natural person); • a partnership in which the employer is or was a partner; • companies which formally or informally control the employer; • companies which are formally or informally controlled by the employer; and
• sister companies (ie, companies with the same parent company). Section 159 specifies when authorities of the Commonwealth, a State or Territory are associates.
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Example 7.1: Fringe benefits from associates Company A and Company B are part of the same wholly-owned group, that is, they are owned by the same parent company. Jack is an employee of Company A. Under the terms of his employment contract, he is entitled to a 25% discount on goods purchased from Company B. The provision of the goods at a discount by Company B qualifies as a fringe benefit provided by Jack’s employer (Company A) to Jack, as Company B is an associate of Company A under s 318 of ITAA 1936.
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[7.58] Fringe benefits can also be provided by an employer to an employee indirectly through third- party arrangements. Although the benefit is provided to the employee by a third party, it qualifies as a fringe benefit from the employer to the employee where the third party does so under an arrangement with the employer. Note that the employer must “participate in or facilitate the provision or receipt of the benefit” for the benefit to qualify as a fringe benefit: see para (ea) of the definition of “fringe benefit” in s 136(1) of FBTAA. Paragraph (ea) was introduced following Payne v FCT (1996) 32 ATR 516: see Case Studies [6.16] and [6.18]. In Ruling TR 1999/6, the Commissioner confirms that frequent flyer points earned by an employee for work-related travel do not constitute a fringe benefit as they have not been provided by an employer, associate of the employer or a third-party arranger. The frequent flyer points do not arise out of an arrangement entered into by the employer with the airline, but are due to a private arrangement between the employee and the airline. Example 7.2: Fringe benefits from a third party Big Bank waives the home loan application fees for all university employees and provides them with a discount of 0.5% on the home loan rate it offers all other customers. It waives the application fee as it considers university employees “low risk” and it provides the discounted home loan rate due to an arrangement with the university whereby, in return, the university agreed to deal exclusively with Big Bank. The waiver of loan application fees does not qualify as a fringe benefit as it does not arise through an arrangement between Big Bank and the university but is a unilateral action by Big Bank. The provision of the discounted home loan rate qualifies as a fringe benefit provided by the university to its employees as it arises under an arrangement between Big Bank and the university and has therefore been facilitated by the university.
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Example 7.3: Fringe benefits from third party under arrangement Jack is an employee of Company A. Under the terms of his employment contract, he is entitled to a discount for goods purchased from various retailers, such as Coles and Woolworths, pursuant to agreements in place between Company A and those retailers. The provision of goods at a discount by Coles and Woolworths qualifies as a fringe benefit provided by Jack’s employer (Company A) to Jack as the discount has been provided pursuant to an arrangement between Company A and the retailers. As mentioned at [7.40], s 148(4) ensures that fringe benefits that are supplied by an associate of the employer or a third party are nonetheless “provided” by the employer for the purposes of the FBT legislation. In this chapter, any reference to the provision of fringe benefits by an employer is intended to also include the provision of fringe benefits by associates of the employer or third- party arrangers.
Employee or associate
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[7.60] An “employee” is someone who receives salary and wages and includes current, former and future employees: s 136(1) of FBTAA. The term “salary and wages” is discussed at [7.85]. A “future employee” is a person who will become a current employee, while a “former employee” is a person who has been a current employee: s 136(1). The extension of the definition of “employee” to cover former and future employees ensures that benefits provided prior to the commencement of employment (eg, sign-on bonuses) or provided to former employees as a result of the former employment relationship (eg, low interest loans) are captured by the FBT legislation. In Ruling MT 2016, the ATO confirms that a person will only qualify as a future employee if it can be said that the person will (not may) become an employee at the time the benefit is provided. [7.65] A fringe benefit can also arise where the benefit is not provided to an employee directly, but to an associate of an employee. This aspect of FBT overcomes a limitation of s 15-2 of ITAA 1997 (previously s 26(e) of ITAA 1936), which only captures the provision of benefits to an employee directly. The meaning of “associate” was discussed at [7.55]. A person will also be deemed to be an “associate” of the employee, where a benefit is provided to the person due to an arrangement between the employer and the employee: s 148(2). For example, where a benefit is provided to a friend of an employee, the friend is not an “associate” of the employee under the definition of “associate”, but is deemed to be an associate per s 148(2) of FBTAA.
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Example 7.4: Provision of fringe benefits to associates Simon is an employee of Company A. Under the terms of his employment agreement, he and his wife are entitled to one free interstate trip per year. The provision of the free trip to Simon’s wife qualifies as a fringe benefit as it is provided by Simon’s employer, Company A, to his associate –his wife. The term “recipient” is used in this chapter to refer to an employee or an associate of an employee. Note that in order to constitute a fringe benefit, the benefit provided must relate to a particular employee: Essenbourne Pty Ltd v FCT (2002) 51 ATR 629; FCT v Indooroopilly Children Services (Qld) Pty Ltd (2007) 158 FCR 325.
In respect of the employment of the employee
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[7.70] Finally, and most importantly, the benefit must be provided in respect of the employee’s employment to qualify as a fringe benefit. As well as the exclusions and exemptions, this is one of the key features of the FBT regime, which ensures that only targeted benefits are subject to FBT. The definition of “in respect of” in s 136(1) of FBTAA specifies that, to qualify as a fringe benefit, the benefit must be provided “by reason of, by virtue of, or for or in relation directly or indirectly to, that employment”. While most benefits provided by an employer to an employee would generally be provided in respect of employment, this is not necessarily always the case and the scope of this nexus requirement has been the subject of judicial consideration. In J & G Knowles & Associates Pty Ltd v FCT (2000) 44 ATR 22, the Full Federal Court said: The words “in respect of” have no fixed meaning. They are capable of having a very wide meaning denoting a relationship or connection between 2 things or subject matters. However, the words must, as with any other statutory expression, be given a meaning that depends on the context in which the words are found … [W]hat is required is a sufficient link for the purposes of the particular legislation. It cannot be said that any causal relationship between the benefit and the employment is a sufficient link so as to result in a taxable transaction.
Their Honours proceeded to suggest that, for the benefit to constitute a fringe benefit, there must be a “sufficient and material relationship” between the employment and the provision of the benefit. Case study 7.2: “In respect of the employment” In J & G Knowles & Associates Pty Ltd v FCT (2000) 44 ATR 22, the taxpayer, a company, was the trustee of a unit trust. The units in the unit trust
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were held by the family trusts of the four directors of the company. The company permitted the directors to write cheques for personal expenses on the company’s cheque account and the amounts were treated as loans to the directors’ family trusts. The directors were employees of the company for FBT purposes. The question arose as to whether the loans were provided to the directors in their capacity as directors and therefore in respect of their employment (making the loans fringe benefits), or whether the loans were provided because the directors were the beneficiaries of family trusts (in which case the loans would not be fringe benefits). The facts pointed in both directions. The directors drew upon the trust’s assets as these assets were ultimately held and applied for their benefit, but it was only because of their position as directors of the company that they were permitted to do so. The Court remitted the matter to the AAT to re-examine the facts, but with the benefit of the guidance on the nexus requirement mentioned above. The AAT found that the loans were not made to the directors in their capacity as directors but because they were the “ultimate owners of the business and its assets” and, as such, the loans were not fringe benefits: Re J & G Knowles (2000) 45 ATR 1101.
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Case study 7.3: Loan to company directors and shareholders not “in respect of employment” In Starrim Pty Ltd v FCT (2000) 44 ATR 487, the taxpayer was a company owned by a husband and wife who were the only shareholders and directors of the company. The company lent the husband and wife money to purchase a block of land. The block of land was the site of a business which had just been purchased by the company and it was therefore in the company’s interests for the transaction to take place. Lindgren J concurred with the AAT’s conclusion that the taxpayer had made the loan because the husband and wife were the purchasers of the property and not in respect of their employment.
Case study 7.4: Repayments of loans not fringe benefits In Slade Bloodstock Pty Ltd v FCT (2007) 68 ATR 911, the taxpayer company provided loans to Mr and Mrs Slade, who were its sole shareholders. The Slades made a series of loans to the taxpayer on the basis that the taxpayer would repay any amounts owing at call and that the taxpayer would direct the payments to any parties nominated by the Slades. The loans represented the taxpayer’s only source of working capital and, over
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time, the taxpayer paid a number of the Slades’ private expenses such as children’s school fees or private credit card balances. These payments were set off against the amounts owing to the Slades. The Commissioner assessed the taxpayer for FBT on the basis that the payments of the Slades’ private expenses (ie, the loan repayments) constituted fringe benefits. At issue was whether the payments had been made “in respect of the employment of an employee”. The Slades accepted that through their actions they were employees of the company, but contended that the payments were made as a consequence of their being creditors of the company and not because of the employment relationship. The AAT found in favour of the taxpayer but a single judge of the Federal Court, Heerey J, found in favour of the Commissioner. By the time the case reached the Full Federal Court, the Commissioner had conceded that the payments were not in respect of the Slades’ employment as “there was no material relationship” between the employment and the payments. In doing so, the Commissioner accepted that the repayment of a loan owed by an employer to an employee is not a benefit that is provided in respect of employment, at least where there is a binding obligation to repay the loan under the loan agreement and the obligation is imposed without reference to the employment of the lender. In such cases, the repayments are a product or incident of the creditor/debtor relationship. The Full Federal Court noted that this position is consistent with the policy of the FBT legislation, which is to capture benefits that would have been income if provided as cash to the employee. [7.75] The scope of the requirement that the benefit be provided in respect of the employment of the employee is potentially widened by s 148(1) of FBTAA, which states that a benefit is provided in respect of the employment of the employee regardless of whether the benefit: • is also provided in respect of another matter or thing; • relates to past, current or future employment; • is surplus to the needs or wants of the recipient; • is also provided to another person; • is offset by any inconvenience or disadvantage; • is provided or used in connection with the employment; • is in the nature of income; and • is a reward for services rendered or to be rendered by the employee. In Rulings MT 2016 and MT 2019, the ATO suggests that s 148(1) should not be read as broadening the scope of FBT beyond the targeted benefits. In Ruling MT 2016, the ATO states:
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7: FrinGe Benefits tax [7.75] 199 Sub-section 148(1) seeks to anticipate arguments that might otherwise be put so as to narrow the defined meaning of “fringe benefit”. The subsection is based in part on experiences of difficulties with the practical application of para 26(e) of the Income Tax Assessment Act 1936 [now section 15-2 of ITAA 1997]. Sub-section 148(1) does not remove in any circumstances, the fundamental requirement that, before there can be a tax liability, the benefit under consideration has to be provided in respect of the employment of the employee.
In Ruling MT 2019, the ATO suggests that a benefit provided to an employee who is also a shareholder will not constitute a fringe benefit if it is provided to the person solely because they are a shareholder. This is despite the fact that s 148(1) deems the benefit to be provided in respect of employment.
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Despite the ATO’s guidance, the application of s 148(1) remains uncertain. In FCT v Slade Bloodstock Pty Ltd (2007) 68 ATR 911 (see Case Study [7.4]), Heerey J found that payments by an employer to its employees, which were loan repayments arising out of the debtor/creditor relationship, were nonetheless fringe benefits due to the operation of s 148(1). By the time the case reached the Full Federal Court, however, the ATO conceded that the payments were not fringe benefits. Therefore, the operation of s 148(1) was not fully considered by the Full Federal Court. It is particularly important to ascertain whether a benefit is provided “in respect of employment”, where there is another relationship between the employer and the employee since that other relationship may be the reason for the provision of the benefit. Essentially, for a benefit to be in respect of the employee’s employment, the benefit must be provided to the person because he or she is an employee and not for some other reason. The ATO’s Fringe Benefits Tax: Guide for Employers (NAT 1054) suggests (at s 1.1) that a useful question to ask when determining whether a fringe benefit is provided “in respect of employment” is whether the person would have received the benefit if he or she were not an employee. Where there is an employment relationship as well as a family relationship, it is necessary to consider whether the benefits are provided in an ordinary family setting and would have been a normal incidence of family relationships.
Example 7.5: Benefit not provided in respect of employment Kim works in the family business owned by his parents, which imports furniture from overseas. For his birthday, Kim’s parents gave him an expensive piece of furniture from the shop. Although Kim is an employee who has received a benefit from his employer, the benefit does not qualify as a fringe benefit as Kim did not receive the benefit in respect of his employment. The benefit was
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received by him due to the private, family relationship between him and his employer. Source: Adapted from Example 2 (1.1 What is a fringe benefit?) in the ATO’s Fringe Benefits Tax: Guide for Employers (NAT 1054).
Example 7.6: Benefit not provided in respect of employment Nora is an employee of Company X. She also owns shares in Company X, which she purchased because all shareholders are entitled to a 10% discount on goods sold by Company X. Nora purchases goods from Company X at a 10% discount. Although Nora is an employee who has received a benefit from her employer, the benefit does not qualify as a fringe benefit as Nora did not receive the benefit in respect of her employment. Rather, the benefit was received by her in her capacity as a shareholder.
Example 7.7: Benefit provided in respect of employment
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Janet is an electrician. She is employed under the terms of a particular industrial award. The award requires Janet’s employer to reimburse her for all travel expenses. Janet’s employer reimburses her for her travel expenses in accordance with the terms of the award. Although the employer provided the reimbursement due to the terms of the award, the reimbursement of the travel expenses is a benefit received in respect of Janet’s employment. The reimbursement would not have been made if Janet was not an employee. Source: Adapted from Example 1 (1.1 What is a fringe benefit?) in the ATO’s Fringe Benefits Tax: Guide for Employers (NAT 1054) (original document).
Exclusions [7.80] The definition of “fringe benefit” in s 136(1) of FBTAA specifically excludes certain items from being a fringe benefit, including: • salary or wages (as defined by reference to Sch 1 of the Taxation Administration Act 1953 (Cth), in particular, s 12-35 of that Schedule); • superannuation contributions; • payments from superannuation funds;
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• benefits under an employee share scheme; and • payments on termination of employment. These items are excluded from the definition of “fringe benefit” as they are dealt with under the income tax system. [7.85] “Salary or wages” comprises payments (including commissions, bonuses or allowances) to employees, company directors and office holders; Commonwealth education or training payments; and compensation, sickness or accident payments. These amounts are subject to the PAYG withholding provisions in Sch 1 of the Taxation Administration Act 1953.
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It has been said that the definition of “salary and wages” is “deliberately wide” (Hill J in Roads & Traffic Authority of NSW v FCT (1993) 26 ATR 76 at 82) and a wide approach was adopted by the majority of the Full High Court in Murdoch v Commr of Pay-roll Tax (Vic) (1980) 143 CLR 629. Essentially, “salary and wages” comprise all amounts paid as a reward for services rendered by an employee: FCT v J Walter Thompson (Australia) Pty Ltd (1944) 69 CLR 227. The description of the payment is not determinative, and it is necessary to look at the substance of the payment to determine its character: Roads and Traffic Authority of New South Wales v FCT (1993) 26 ATR 76; Ruling TR 92/15. One issue that often arises in an FBT context is whether a payment to an employee constitutes an allowance (which is “salary and wages”) or a reimbursement (which is not “salary and wages”). The term “reimburse” is defined in s 136(1) of FBTAA as “any act having the effect or result, direct or indirect, of a reimbursement”. The scope of the term “reimburse” was considered by Hill J in Roads & Traffic Authority of NSW v FCT (1993) 26 ATR 76. His Honour said that “the concept of reimbursement requires that the payment in question be made by reference to actual cost … [T]here would need to be some correspondence between the payment and the expenditure incurred”. As a general rule, an amount will constitute an allowance, where it is a predetermined amount to cover an estimated expense, while a reimbursement is a payment made in respect of the taxpayer’s actual expenditure: Roads and Traffic Authority of New South Wales v FCT (1993) 26 ATR 76; Ruling TR 92/15. Example 7.8: Allowance versus reimbursement Zhou and Beatrice are both employed by the same company. Under the terms of his employment agreement, Zhou receives $500 per month to cover the costs of entertaining clients. Under an industrial award, Zhou also receives $50 per fortnight to cover his medical insurance premiums. Zhou is required to provide a letter from the health fund certifying that he is a member of the health fund, but is not required to provide any further evidence in relation to the payments.
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Under the terms of her employment agreement, Beatrice is entitled to a payment for her medical insurance premiums up to a limit of $500 per year. In order to claim the payment, Beatrice is required to provide the employer with her insurance premium statements verifying the actual amount incurred by her in relation to the premiums. The payments made to Zhou for entertaining clients and his medical insurance premiums are allowances. He receives the amounts regardless of his actual expenditure. The payments made to Beatrice are reimbursements –that is, she is compensated for the actual amount of her medical insurance and cannot make a claim for payment without documentary evidence. The upper limit of $500 per year does not alter the character of the payment as it is based on the precise accounting of actual expenditure. Source: Adapted from the Example in Ruling TR 92/15. Allowances are classified as “salary and wages” and are excluded from the definition of “fringe benefit”; on the other hand, reimbursements are not excluded from the definition of “fringe benefit”.
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Categories of fringe benefits [7.90] There are 13 categories of fringe benefits in the legislation, and it is important to determine the appropriate category a fringe benefit falls into as the FBT consequences arising differ between each category. Each category of fringe benefit is dealt with by a separate Division in the FBTAA. Each Division describes when the fringe benefit arises, any exemptions applicable to that particular category of fringe benefit and the taxable value of the fringe benefit. Remember that the benefit must constitute a “fringe benefit” as discussed at [7.20]. In particular, the benefit must be attributable to the employment relationship. The following categories of fringe benefits are discussed in detail in this chapter: • car fringe benefits: see [7.100]; • debt waiver fringe benefits: see [7.150]; • loan fringe benefits: see [7.170]; • expense payment fringe benefits: see [7.200]; • meal entertainment fringe benefits: see [7.230]; • property fringe benefits: see [7.250]; and • residual fringe benefits: see [7.280].
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The other categories of fringe benefits in the legislation which are less common and are not discussed in further detail in this chapter are: • housing fringe benefits: Div 6; • living-away-from-home allowance fringe benefits: Div 7; • airline transport fringe benefits: Div 8; • board fringe benefits: Div 9; • tax-exempt body entertainment fringe benefits: Div 10; and • car parking fringe benefits: Div 10A.
Car fringe benefits – Div 2
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[7.100] One of the most common types of fringe benefits provided by employers to employees is a car fringe benefit. A car fringe benefit arises where an employer provides a car for an employee’s private use: s 7(1) of FBTAA. A “car” is defined in s 136(1) (by reference to s 995-1 of ITAA 1997) as a motor vehicle designed to carry a load of less than 1 tonne or fewer than nine passengers. “Motor vehicle” is defined as any motor-powered road vehicle, including a four-wheel drive vehicle. “Private use” is defined in s 136(1) as any use of a car by an employee or associate that is not exclusively in the course of producing assessable income. As a general rule, travel between home and work is not considered to be in the course of producing assessable income and would constitute private use: see [12.390]; Ruling MT 2027. It is important to note that it does not matter whether the employee actually uses the car for private purposes; a fringe benefit arises as long as the car is available for private use: s 7(1). This is relevant where the statutory formula method (see [7.130]) is used to calculate the taxable value of the car as the formula refers to the number of days the car was provided as a fringe benefit. For example, a car fringe benefit will arise where the car is garaged at or near the residence of an employee or an associate of the employee: s 7(2). In AAT Case 9824 (1994) 29 ATR 1246, the AAT found that a car that was used solely in a business run from a home was a car fringe benefit under s 7(2) as the car was garaged at the home. In Determination TD 94/16, the Commissioner suggests that a car fringe benefit will arise even where the employee is overseas if the car is garaged at or near the employee’s home during this time. There is an exception in s 7(2A) for ambulances, fire fighting vehicles and police cars that are garaged at the employee’s home. A car fringe benefit will also arise where an employee or an associate of the employee has custody and control over the car and it is not being used for employment purposes at the time: s 7(3). Finally, a car fringe benefit can still arise where the employer prohibits the private use of a car if the prohibition is not strictly enforced: s 7(4). In Determination TD 94/16, the Commissioner
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204 [7.110] PRINCIPLES OF TAXATION LAW 2020 suggests that the prohibition against private use must be made in clear and unequivocal terms and a general instruction or understanding between the employer and employee would be insufficient. The prohibition should be enforced through disciplinary measures and consistent enforcement such as checks of odometer readings. Example 7.9: Car available for private use John is provided with a car by his employer. John leaves the car in an airport car park while travelling overseas for work purposes. The car cannot be left at the employer’s premises as there are no car parking facilities available there. The airport car park is not in the vicinity of John’s residence. If John retains the keys to the car while he is overseas, a car fringe benefit will arise as he has custody and control over the car. However, if John’s employer removes control and custody of the car from John (eg, by taking the car keys) and enforces a prohibition on the private use of the car by John or his associates, a car fringe benefit will not arise. Source: Adapted from the Example in Determination TD 94/16.
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Exempt benefits [7.110] A car fringe benefit will be an exempt benefit, where the car provided by an employer to an employee is only used for work-related travel and any private use by the employee or an associate of the employee is minor, infrequent and irregular: s 8(2) of FBTAA. Note that, to be exempt, the car must be a taxi, panel van, utility truck or other road vehicle not designed for the principal purpose of carrying passengers: s 8(2)(a). A car fringe benefit will also be exempt where the benefit arises in relation to an unregistered car: s 8(3). Any fringe benefits that may arise in relation to the provision of a car fringe benefit are treated as exempt benefits under s 53. For example, payments for fuel or repairs by the employer could be considered expense payment fringe benefits, but are exempt due to the operation of s 53.
Taxable value [7.120] There are two methods prescribed by the FBTAA for calculating the taxable value of a car fringe benefit: • statutory formula method (s 9): see [7.130]; and • cost basis (s 10): see [7.140].
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The statutory formula method applies automatically unless an employer elects to use the cost basis: s 10(1). An employer can choose either method for each car that gives rise to a car fringe benefit. An employer’s election to use the cost basis is automatically disregarded if the statutory formula method results in a lower taxable value: s 10(5). [7.130] Statutory formula method (s 9 of FBTAA). The taxable value of a car fringe benefit under this method is the amount calculated in accordance with the following formula: Base value 0.2 × × of the car
Number of days during that year of tax Amount on whiichthe car fringebenefits if any ) ( were provided by the provider − of the Number of daays recipient’s inthat year of tax payment
Broadly, the base value of the car will be either its cost (if the car was purchased by the provider) or the leased car value at the earliest time the provider started to hold the car (if the car is leased). In either case, the amount is reduced by one-third if the relevant FBT year commences at least four years after the provider first started holding the car: s 9(2)(a).
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In Taxation Ruling TR 2011/3, the ATO suggests that, in addition to the purchase price, the “cost” of a car would include any other amounts that are directly attributable to the acquisition or delivery of the car. For example, dealer delivery charges would be included in the “cost” of a car, but insurance costs and extended car warranties would not be included in “cost”. The recipient’s payment includes amounts paid directly by the employee to the employer in relation to the car and amounts paid by the employee to a third party, such as petrol costs, for which the employee was not reimbursed by the employer. Example 7.10: Taxable value of car fringe benefit –statutory formula method Raj is a troubleshooter for his employer. He visits the company’s various premises to deal with any problems that may arise. He is provided with a car for his work travel. The contract for the provision of the car was entered into on 1 January 2019. Raj is permitted to take the car home at the end of the day and there is no restriction on his use of the car for non- work purposes. The car was originally leased by Raj’s employer on 1 July
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2013. The leased car value at that time was $45,000. For the current FBT year, the following expenses were incurred by the company in relation to the car: Petrol and oil
$3,000
Repairs and maintenance
$500
Registration
$1,000
Insurance
$900
Lease payments
$6,000
Raj is required to contribute $50 per month towards the car expenses. He has determined that the total kilometres travelled by the car for the year 1 April 2019 to 31 March 2020 is 50,000 km (30,000 km related to business travel). Note that the payment of the car expenses does not give rise to a separate fringe benefit: s 53 of FBTAA. Statutory formula method: Taxable value = 0.2 × $30, 000 ×
366 − $600 = $5, 400; 366
where:
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Base value = leased car value = $45,000, which is reduced by one-third as the car has been held by Raj’s employer for more than four years. Number of days in the FBT year when the car is provided as a fringe benefit. There is no restriction on Raj’s private use of the car and he takes the car home at the end of the day, which is deemed private use under s 7(2). As such, it appears that the car fringe benefit was provided for the entire FBT year. Number of days in the FBT year. As it is a leap year, the total number of days is 366. Recipient’s contribution = $50 × 12 = $600. [7.140] Cost basis (s 10 of FBTAA). The taxable value of a car fringe benefit using the cost basis is determined as follows: Taxable value = [C × (100% − BP)] − R
where: C is the operating cost of the car during the holding period; BP is the business use percentage of the car during the holding period; and R is the amount of the recipient’s payment (if any).
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The operating cost of the car consists of any expenses relating to the car incurred by the provider or any other person during the holding period. Examples of such expenses include repairs and maintenance, registration and insurance attributable to the holding period. Where the car is owned by the provider, an amount for deemed depreciation and deemed interest is also included in operating cost (s 11 of FBTAA describes how deemed depreciation and interest are calculated). Where the car is leased by the provider, the leasing costs attributable to the holding period are included in operating cost: s 10(3)(a)(v). The “business use percentage” is the percentage of the business kilometres travelled by the car out of the total kilometres travelled by the car during the holding period. Business kilometres refers to the number of kilometres on a “business journey”, which is defined in s 136(1) as any use of the car other than private use by an employee or associate. The cost basis may provide a lower taxable value than the statutory formula method, where the business use percentage of the car during the year is high. However, log book records and odometer records must be maintained when using the operating cost method, which increases the compliance burden: ss 10A and 10B.
Example 7.11: Taxable value of car fringe benefit Assume the same facts as Example 7.10 and that Raj has maintained the necessary log book and odometer records. Cost basis:
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Taxable value = (C ) $11, 400 × (100% − (BP ) 60% ) − (R ) $600 = $3, 960;
where: C = operating cost = $3,000 + $500 + $1,000 + $900 + $6,000 = $11,400; BP = business use percentage = (30,000/50,000) × 100% = 60%; R = recipient’s contribution = $50 × 12 = $600. Comparing Examples 7.10 and 7.11, Raj’s employer should use the cost basis to determine the taxable value of the car fringe benefit since it results in a lower taxable value.
Debt waiver fringe benefits – Div 3 [7.150] A debt waiver fringe benefit arises where an employee (or associate) owes an amount to an employer and the employee (or associate) is released from his or her obligation to repay all or some of that amount: s 14 of FBTAA.
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208 [7.160] PRINCIPLES OF TAXATION LAW 2020 The debt must be waived due to the employment relationship and not for some other reason (eg, because it is irrecoverable) to constitute a debt waiver fringe benefit.
Taxable value [7.160] The taxable value of a debt waiver fringe benefit is the amount of the loan that no longer needs to be repaid: s 15 of FBTAA. Example 7.12: Debt waiver fringe benefit Due to unexpected personal misfortune, Miles was forced to borrow $30,000 from his employer on 1 September. On 1 January, his employer informed him that he was only required to repay $20,000 of the loan. The debt was waived because the employer values Miles as an employee and wants to reward him for his loyalty. A debt waiver fringe benefit arises as Miles has been released from his obligation to repay an amount that is owed to his employer and the waiver was due to the employment relationship. The taxable value of the debt waiver fringe benefit is $10,000, being the amount that Miles no longer has to repay.
Loan fringe benefits – Div 4
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[7.170] A loan fringe benefit arises in each year when an employer provides an employee (or associate) with a loan: s 16 of FBTAA.
Exempt benefits [7.180] A loan fringe benefit will be an exempt benefit where the loan is provided by a person who provides loans to the general public in the ordinary course of his or her business, and the loan to the employee is provided at an interest rate at least equal to the interest rate prevailing at that time on similar loans to the public (eg, a home loan to a bank employee at standard commercial terms): s 17(1) and (2) of FBTAA. A loan fringe benefit will also be an exempt benefit where the loan is essentially an advance to the employee so that the employee can meet expenses that are reasonably expected to be incurred by the employee in the next six months in the course of performing his or her duties of employment: s 17(3) of FBTAA.
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Finally, a loan fringe benefit will also be exempt where the loan is provided to enable the employee to pay a rental bond, security deposit in respect of gas, electricity or telephone services or any similar amount. The employee must be required to repay the loan amount within 12 months, and the loan must be provided in conjunction with certain other fringe benefits to be exempt: s 17(4) of FBTAA.
Taxable value [7.190] The taxable value of a loan fringe benefit is determined as follows (s 18 of FBTAA): Loan amount × [Statutory interest rate − Actual interest rate ] ×
No of days loan provided during the year T year No of days in FBT
The statutory interest rate is published by the ATO at the start of each FBT year. For the FBT year commencing on 1 April 2019, the applicable statutory interest rate is 5.37% per annum: Determination TD 2019/6. Essentially, the fringe benefit represented by the taxable value is the interest “saved” by the employee in obtaining a loan through the employer, rather than at commercial market rates. Where the loan is provided at an interest rate which is equal to or higher than the statutory interest rate, no FBT liability arises as the taxable value is nil.
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Where the loan is provided for only a portion of the FBT year, it is necessary to adjust the taxable value for the loan period. Example 7.13: Loan fringe benefit Company Z provides its employee, Robyn, with a loan of $10,000 on 1 December 2019 at no interest. Robyn has not repaid any amount of the loan at 31 March 2020. A loan fringe benefit arises as Company Z has provided one of its employees with a loan. The taxable value of the loan fringe benefit = $10, 000 × [5.37% − 0%] ×
122 = $179 366
Therefore, Robyn has “saved” $179 in interest by obtaining a loan from her employer rather than at commercial rates.
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Expense payment fringe benefits – Div 5 [7.200] An expense payment fringe benefit arises, where: • an employer pays an expense incurred by the employee; or • an employer reimburses an employee for expenditure incurred by the employee: s 20 of FBTAA. To constitute an expense payment fringe benefit, the expense must be “incurred” by the employee. Broadly, an expense is incurred by an employee when the employee is definitely committed to the expense. Some other category of fringe benefit (eg, residual fringe benefits) may arise where an employer pays an expense which is not incurred by the employee. Example 7.14: Expense incurred by employee Stefan’s employer pays for his mobile phone bills. His employer also pays for him to go to a physiotherapist once a month as Stefan often works long hours in front of his computer. Stefan would not otherwise go to the physiotherapist.
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The payment of Stefan’s mobile phone bills by his employer is an expense payment fringe benefit as Stefan’s employer has paid an expense incurred by Stefan (he is definitely committed to the expense). The payment of the physiotherapist’s cost is not an expense payment fringe benefit as Stefan has not incurred the expense. However, it may constitute a residual fringe benefit. Where an employer pays an amount to an employee in relation to expenditure incurred by the employee, it is necessary to consider whether the payment is a “reimbursement” or an “allowance”. The distinction gives rise to very different tax consequences. “Reimbursements” are treated as expense payment fringe benefits and taxed to the employer under the FBT regime, while “allowances” constitute “salary and wages” (see [7.85]) and are taxed to the employee under the income tax.
Exempt benefits [7.210] An employer can make a “no-private-use declaration” in respect of all of the employer’s expense payment fringe benefits, which means that the employer will only pay or reimburse so much of an expense as would result in a taxable value of nil (reductions in taxable value are discussed at [7.360]). An expense payment fringe benefit covered by such a declaration is an exempt benefit: s 20A of FBTAA. Certain accommodation expense payment benefits where the employee is required to live away from his or her usual place of residence due to employment
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reasons and certain car expense payment benefits are also treated as exempt benefits: ss 21 and 22 of FBTAA.
Taxable value [7.220] The taxable value of an expense payment fringe benefit depends on whether the fringe benefit is an in-house expense payment fringe benefit or an external expense payment fringe benefit. An expense payment fringe benefit is an in-house expense payment fringe benefit, where the expense relates to goods or services provided by the employer or an associate of the employer to outsiders in the ordinary course of their business: definition of “in-house expense payment fringe benefit” in s 136(1) of FBTAA. For example, an employee purchases a laptop computer from their employer who is a computer retailer. The employer reimburses the employee for the cost of the computer. The reimbursement is an expense payment fringe benefit, which is an in-house expense payment fringe benefit since it relates to property that is sold by the employer in the ordinary course of its business.
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An expense payment fringe benefit is an external expense payment fringe benefit if it is not an in-house expense payment fringe benefit: definition of “external expense payment fringe benefit” in s 136(1). An employer reimburses an employee for the employee’s children’s school fees. The reimbursement is an external expense payment fringe benefit (assuming the employer is not the school). Broadly, the taxable value of an in-house expense payment fringe benefit is the taxable value of the fringe benefit as if it was a property or residual fringe benefit (ie, assume the employer did not reimburse the employee but provided the property or services directly): s 22A. The taxable value of an external expense payment fringe benefit is the amount of the expense or reimbursement incurred by the employer: s 23. Example 7.15: Expense payment fringe benefit Joe pays his telephone bill of $200 for which he is later reimbursed by his employer, an accounting firm. The employer also pays $3,000 in fees directly to the university for a further study course he is undertaking. There are two expense payment fringe benefits arising as Joe’s employer has reimbursed him for the telephone bill and paid for his university fees. Both expenses were incurred by Joe as he is definitely committed to them.
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212 [7.230] PRINCIPLES OF TAXATION LAW 2020
Both expenses are external expense payment fringe benefits as the benefits are not provided by Joe’s employer in the ordinary course of its business. The taxable values of both benefits are $200 and $3,000, respectively, being the amount paid by the employer in relation to them. Depending on the facts, the “otherwise deductible” rule (see [7.390]) may apply to reduce the taxable value of both fringe benefits under s 24 of FBTAA.
Meal entertainment fringe benefits – Div 9A [7.230] Meal entertainment fringe benefits can be captured by a number of categories, such as expense payment fringe benefits, property fringe benefits and, of course, meal entertainment fringe benefits. Generally, the most specific category is the relevant category for a fringe benefit. However, in the case of meal entertainment, an employer can elect for Div 9A of FBTAA to apply to the provision of meal entertainment fringe benefits for a particular FBT year, in which case the relevant fringe benefits will be taxed under this Division and not another: ss 37AA and 37AF. A meal entertainment fringe benefit arises where an employer provides its employees with: • entertainment by way of food or drink;
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• accommodation or travel in connection with entertainment by way of food or drink; or • a reimbursement of expenses incurred by an employee in relation to the above. A meal entertainment fringe benefit arises regardless of whether or not the meal entertainment relates to business purposes. Determining whether food or drink is provided as “entertainment” will be a question of fact. In Ruling TR 97/17, the ATO suggests that the following factors are relevant in answering that question: • why the food or drink is provided: the ATO suggests that food or drink provided as refreshment (eg, morning tea for employees) will not be entertainment, but food or drink provided in a social situation (eg, lunch at a restaurant) will be classified as entertainment; • what type of food or drink is provided: for example, morning or afternoon tea, sandwiches or light meals are unlikely to constitute entertainment, while a three-course meal will constitute entertainment; • when the food or drink is provided: food or drink provided during work hours, during overtime or while an employee is travelling for work purposes is less likely to be entertainment; and
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• where the food or drink is provided: food or drink provided at the employer’s premises is less likely to be entertainment but food or drink provided at a hotel, restaurant or café is more likely to be classified as entertainment. Although no single factor is determinative, the ATO suggests that the first two factors will be the most important in determining whether food or drink is provided as entertainment.
Taxable value
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[7.240] There are two methods for calculating the taxable value of meal entertainment fringe benefits: • 50/50 split method; and • 12-week register method. The 50/50 split method will apply automatically unless the employer elects for the 12-week register method to apply: s 37B of FBTAA. Under the 50/50 split method, the taxable value of meal entertainment fringe benefits is half of the expenses incurred by the employer during the FBT year in providing meal entertainment: s 37BA. Alternatively, the employer can elect to calculate the taxable value of meal entertainment fringe benefits under the 12-week register method: s 37CA. In this case, the employer must maintain a register of all meal entertainment expenditure over a representative 12-week period and determine the percentage of that expenditure which relates to the provision of meal entertainment as fringe benefits (ie, meal entertainment provided to employees or their associates and not to others, such as clients): s 37CB. The percentage of total meal entertainment expenditure which constitutes meal entertainment fringe benefits (ie, meal entertainment provided to employees and their associates) is known as the “register percentage”: s 37CB. The 12-week period chosen should be representative of the first FBT year in which the register method is to be used for the register to be valid: s 37CC. The register is valid for the FBT year in which it is first used and the four FBT years following that year: s 37CD. Where the 12-week period spans more than one FBT year, the register can only be used for the first time in the FBT year in which the 12-week period ends: s 37CD(2). A register ceases to be valid for a particular FBT year, where the total meal entertainment expenditure in that year exceeds the total meal entertainment expenditure in the year the register was first used by more than 20%: s 37CD(3). The taxable value of meal entertainment fringe benefits under the register method is calculated using the following formula (s 37CB): Total meal entertainment expenditure incurred in the FBT ye ear × Register percentage
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Example 7.16: Meal entertainment fringe benefit Company A incurred $5,000 in expenditure on meal entertainment for the year. Assume Company A elects to apply Div 9A and treat the expenses as meal entertainment fringe benefits. Company A has maintained a register of all meal entertainment expenditure for a period of 12 weeks, in accordance with the above requirements. The register information indicates that 70% of the meal entertainment expenditure was on clients (ie, not fringe benefits) while 30% related to employees and their associates (ie, fringe benefits). Therefore, Company A’s register percentage is 30%. Under the 50/50 split method, the taxable value of the meal entertainment fringe benefits is $2,500, being half the expenditure on providing meal entertainment. Alternatively, if Company A elected to use the 12-week register method, the taxable value of the meal entertainment fringe benefits is $1,500, being $5,000 × 30%. Therefore, in this case, it would be better for Company A to elect to use the register method in calculating its FBT liability in relation to the provision of meal entertainment fringe benefits. The register method will generally provide a lower taxable value (and therefore a lower fringe benefits tax liability), where less than 50% of meal entertainment expenditure is provided as fringe benefits (ie, to employees and their associates).
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Property fringe benefits – Div 11 [7.250] A property fringe benefit arises where an employer provides an employee (or associate) with property: s 40 of FBTAA. Note that a fringe benefit only arises where the employer gives the employee the property, not just the use of the property. The use of property may be captured by another category such as residual benefits. “Property” is defined in s 136(1) as tangible and intangible property. “Tangible property” is defined to mean goods, and the definition specifies that this includes animals, fish, gas and electricity. “Intangible property” is defined as real property (ie, land and buildings), a chose in action (ie, a right to sue) and any other kind of property that is not tangible property. However, rights arising under a contract of insurance or a lease or licence in respect of real or tangible property are specifically excluded.
Exempt benefits [7.260] A property fringe benefit will be an exempt benefit where the property is provided to a current employee and the property is provided to and
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consumed by the employee on a working day and on the business premises of the employer or a related company: s 41 of FBTAA. For example, biscuits or fruits provided to employees to be consumed on work premises would be exempt property fringe benefits.
Taxable value [7.270] The taxable value of a property fringe benefit depends on whether the property fringe benefit is an in-house property fringe benefit or an external property fringe benefit. Broadly, a property fringe benefit is an in-house property fringe benefit, where the property is provided by the employer or an associate of the employer to outsiders in the ordinary course of their business: s 136(1) of FBTAA. A property fringe benefit is an external property fringe benefit if it is not an in- house property fringe benefit: s 136(1). The taxable value of an in-house property fringe benefit is determined under s 42 and is broadly as follows:
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1. Where the property is manufactured, produced, processed or treated by the provider and: (a) is sold in the ordinary course of business to manufacturers, wholesalers or retailers –the taxable value is the lowest price at which the property was sold; or (b) is sold in the ordinary course of business to members of the public –the taxable value is equal to 75% of the lowest price at which property was sold to a member of the public; or (c) in any other case –the taxable value is 75% of the amount that could reasonably be paid to acquire the property from the provider in an arm’s length transaction. 2. Where (1) does not apply and the property is acquired by the provider, the taxable value is the lesser of: (a) the cost of the property if acquired in an arm’s length transaction; or (b) the amount that could reasonably be paid to acquire the property from the provider in an arm’s length transaction. 3. In any other case, the taxable value is 75% of the amount that could reasonably be paid to acquire the property from the provider in an arm’s length transaction. The determination of the taxable value of in-house property fringe benefits essentially depends on whether the employer is a manufacturer or reseller and whether the employer operates in the wholesale or retail market. Employers can still provide employees with in-house property fringe benefits without incurring FBT, where the employee pays the wholesale price of the property.
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216 [7.270] PRINCIPLES OF TAXATION LAW 2020 As we will see at [7.380], the taxable value of a fringe benefit is reduced by the amount of the recipient’s contribution, if any. Both employers and employees benefit in this case as the employer does not incur FBT, and the employee pays the wholesale, rather than retail, price of the goods. Example 7.17: In-house property fringe benefit Ratna works at a second-hand computer shop. Her employer provided her with a computer which cost the employer $1,000 to acquire and is for sale to the public for $1,500. The provision of the computer is an in-house property fringe benefit as Ratna’s employer provides computers to outsiders in the ordinary course of its business. The taxable value of the fringe benefit is the lesser of: • the cost of the property –$1,000; or • the amount that could reasonably be paid to acquire the property from Ratna’s employer –$1,500. Therefore, the taxable value is $1,000.
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Note that if Ratna paid her employer $1,000 for the computer, the taxable value would be nil as the recipient’s contribution is deducted from taxable value: see [7.380]. Both the employer and Ratna benefit in this situation as the employer does not incur FBT and Ratna has paid $1,000, rather than the retail price of $1,500, to acquire the computer. Broadly, the taxable value of an external property fringe benefit is the cost to the employer, or expenditure incurred by the employer to provide the property: s 43. Where the employer can acquire the property for less than the employee could (eg, due to the employer’s purchasing power or because it can purchase the property at wholesale prices) and the employee reimburses the employer for the cost of acquiring the property, a win-win situation arises since the employer has no FBT liability and the employee has acquired the property for less than the retail price. Example 7.18: External property fringe benefit Following on from Example 7.17, Ratna’s employer also gave her a brand new plasma television, which was acquired from a television wholesaler for $2,000. The provision of the plasma television is an external property fringe benefit since Ratna’s employer does not provide plasma televisions to outsiders as part of its business.
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The taxable value of the fringe benefit is the cost to Ratna’s employer in acquiring the property, which is $2,000. If Ratna paid her employer $2,000 for the television, the taxable value is reduced to nil as the recipient’s contribution is deducted from taxable value: see [7.380]. Both the employer and Ratna benefit in this situation as the employer does not incur FBT and Ratna has paid the wholesale price of $2,000 for the television, rather than the retail price which is likely to be higher.
Residual fringe benefits – Div 12 [7.280] The last category of fringe benefits is residual fringe benefits, which is a catch-all category to capture any benefits that do not fall into any of the other categories of fringe benefits: s 45 of FBTAA. Examples of residual benefits include the provision of services for free or at a discount; the provision of caravans at work sites for the accommodation of employees (Roads and Traffic Authority of NSW v FCT (1993) 26 ATR 76) and waivers of loan establishment fees: Westpac Banking Corporation v FCT (1996) 34 ATR 143. Note that a residual benefit can arise in conjunction with another fringe benefit, but not if the benefit is fully captured by another category: Westpac Banking Corporation v FCT (1996) 34 ATR 143.
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Case study 7.5: Residual fringe benefits Following on from Case Study [7.1], in Westpac Banking Corporation v FCT (1996) 34 ATR 143, the taxpayer sought to argue that the waiver of the loan establishment fee was not a residual benefit as the waiver was integrally related to the making of the loan to the employee, and therefore there was only one benefit –that is, the making of the loan. As such, the fringe benefits tax consequences were to be determined solely in accordance with Div 4 regarding loan fringe benefits. Hill J found that Div 4 was not an exclusive code for all benefits relating to loans. In this case, there were two separate benefits –the loan that is dealt with under Div 4 and the fee waiver that is captured as a residual fringe benefit.
Exempt benefits [7.290] As the scope of residual fringe benefits is unlimited, there are a number of residual benefits that are made exempt in s 47 of FBTAA. For example, “business operation facilities”, such as toilets, bathroom facilities, food or drink vending machines, tea-or coffee-making facilities, water dispensers and other
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218 [7.300] PRINCIPLES OF TAXATION LAW 2020 such amenities, are exempt benefits under s 47(4). Recreational or child care facilities located on the employer’s premises are exempt under s 47(2). Ruling TR 2000/4 discusses the meaning of “business premises” in the context of the s 47(2) exemption. Section 47(3) also provides an important exemption for any private use of property located on the employer’s premises, where the property is wholly or principally in connection with the operation of the business. This exempts from FBT private phone calls or personal printing at the employer’s premises.
Taxable value [7.300] Similar to property fringe benefits (see [7.270]), the taxable value of a residual fringe benefit depends on whether the residual fringe benefit is an in-house residual fringe benefit or an external residual fringe benefit. Broadly, the taxable value of an in-house residual fringe benefit under ss 48 and 49 of FBTAA is: • 75% of the lowest price at which an identical benefit is sold to a member of the public under an arm’s length transaction; or • in any other case, 75% of the amount that could reasonably be paid to acquire the property from the provider in an arm’s length transaction. The taxable value of an external residual fringe benefit is, broadly, the cost to the employer or expenditure incurred by the employer in providing the benefit: ss 50 and 51.
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Example 7.19: In-house residual fringe benefit Imogen works at a second-hand computer shop. She has had problems with her computer and her employer services her computer for free. The employer would normally charge customers $60 for the service. The servicing of the computer would constitute an in- house residual fringe benefit as the benefit does not fall within any of the other categories of fringe benefits and as Imogen’s employer services computers in the ordinary course of its business. The taxable value of the fringe benefit is 75% of the lowest price charged to members of the public in an arm’s length transaction, which would be 75% × $60 = $45.
Example 7.20: External residual fringe benefit Following on from Example 7.19, Imogen’s employer also gave her two tickets to an upcoming classical music concert by an international artist. The tickets cost $250 each.
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The provision of the tickets would constitute an external residual fringe benefit as they do not fall within any of the other categories of fringe benefits and Imogen’s employer does not provide concert tickets in the ordinary course of its business. Note that the payment for the tickets does not constitute an expense payment fringe benefit as Imogen has not “incurred” the expense. The taxable value of the fringe benefit is the expenditure incurred by Imogen’s employer in providing the benefit, which is $500.
Exempt fringe benefits
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[7.310] There are a number of benefits that are exempt from FBT. No FBT liability arises in relation to an exempt fringe benefit. The exemptions can apply to a particular category of fringe benefit or fall within Div 13 of FBTAA, which covers “miscellaneous exempt benefits”. The category-based exemptions were discussed under the relevant categories at [7.100]–[7.300]. There are a number of exempt benefits in Div 13, such as: • reimbursements for the costs of travelling to an interview or selection test in connection with an application for employment with a new employer, or a promotion or transfer with an existing employer (s 58A); • various job relocation expenses (ss 58AA, 58B, 58C, 58D, 58E and 58F); • certain medical benefits (ss 58K, 58L and 58M); and • the cost of providing newspapers and periodicals to employees for business purposes: s 58H. The following common exemptions are discussed in detail: • minor benefits: see [7.320]; • work-related items: see [7.330]; • membership fees and subscriptions: see [7.340]; and • single-trip taxi travel: see [7.350].
Minor benefits – s 58P [7.320] Broadly, a benefit will be exempt as a minor benefit, where the notional taxable value of the benefit is less than $300. “Notional taxable value” is defined in s 136(1). It is the taxable value of the fringe benefit as determined for each category of fringe benefit taking into account any reduction for recipient’s contribution but not any reduction of taxable value due to the application of the otherwise deductible rule (see [7.360]). In the case of a car fringe benefit,
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220 [7.320] PRINCIPLES OF TAXATION LAW 2020 the notional taxable value is the taxable value determined as if the car benefit was a residual benefit. The $300 limit is applied to each benefit and is not a cumulative exemption. However, to be treated as a minor benefit, the frequency and regularity of the minor benefit (and similar or connected benefits) must be taken into consideration, and it must be concluded that it would be unreasonable to treat the minor benefit as a fringe benefit: s 58P(f) of FBTAA; Ruling TR 2007/12. The exemption does not apply to in-house fringe benefits which are subject to a $1,000 reduction in taxable value for each employee: see [7.370]. The exemption is also not available for meal entertainment fringe benefits if the employer uses the 50/50 split method (see [7.240]) to calculate the taxable value of the meal entertainment: s 37BA; Ruling TR 2007/12. Example 7.21: Infrequent but regular benefits qualify as minor benefits Joe provides each of his employees with a bottle of wine every Christmas. The cost of each bottle is less than $300 and satisfies the taxable value limit for minor benefits. The gifts are provided infrequently (once a year) but regularly (every Christmas). There are no similar or connected benefits. Upon evaluation of these criteria, it can be concluded that the provision of the bottle of wine is a minor benefit as it would be unreasonable to treat it as a fringe benefit. Source: Adapted from Example 1 in Ruling TR 2007/12.
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Example 7.22 Infrequent but regular benefits qualify as minor benefits Each year Nicholas provides all of his employees and their families with an end of financial year dinner at a local restaurant. The total value of the fringe benefit for each employee is less than $300. The benefit is provided infrequently (once a year) but regularly (every year). As the total value of the benefit and all connected benefits is less than $300, and taking into account the other factors, it can be concluded that the provision of the fringe benefit is a minor benefit as it would be unreasonable to treat it as a fringe benefit. Source: Adapted from Example 2 in Ruling TR 2007/12.
Example 7.23 Frequent and regular benefits not treated as minor benefits Big Firm provides its employees with a fine dining meal voucher whenever they have to work late. The value of each voucher is less than $300.
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However, employees generally work late at least once a month. Although each benefit is less than $300, it would not be reasonable to treat the meal vouchers as a minor benefit, taking into consideration the frequency and regularity with which they are provided and the fact that their cumulative value for each employee is likely to exceed $300.
Work-related items – s 58X [7.330] The following work-related items are treated as exempt fringe benefits: • a portable electronic device; • an item of computer software; • an item of protective clothing; • a briefcase; and • a tool of trade: s 58X(2) of FBTAA.
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These items will only be eligible for the exemption, where they are primarily for use in the employee’s employment. In ATO ID 2008/127, the ATO suggests that the provision of a laptop computer to an employee who regularly visits clients is primarily for use in the employee’s employment. Further, the exemption is limited to one item of each type per employee per FBT year unless the item is a replacement item: s 58X(3) and (4) of FBTAA. The limitation does not apply if the work-related item is a “portable electronic device” and the employer is a “small business entity”. In this context, a “small business entity” is a sole trader, partnership, company or trust that operates a business for all or part of the income year and has an aggregated turnover of less than $10 million. Broadly, “aggregated turnover” is the entity’s turnover plus the annual turnover of any business that is connected or affiliated to the entity. Note that employees are not entitled to depreciation deductions (see Chapter 14) in relation to these items. The legislation does not specify what is a “portable electronic device”, and in ATO ID 2008/133, the ATO suggests that it should therefore take on its ordinary meaning. The ATO further suggests that a portable electronic device would be one which is: • easily portable and designed for use away from an office environment; • small and light; • able to operate without an external power supply; and • designed as a complete unit. This includes mobile phones, laptop computers, GPS navigation receivers, personal digital assistants and so on.
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Membership fees and subscriptions– s 58Y [7.340] The following benefits are exempt benefits whether paid for directly by the employer or by way of a reimbursement: • subscription to a trade or professional journal; • entitlement to use a corporate credit card; and • entitlement to use an airport lounge membership.
Single-trip taxi travel – s 58Z [7.350] The provision of a single taxi trip beginning or ending at the employee’s place of work is an exempt benefit. ATO guidance indicates that the exemption is limited to travel undertaken in a vehicle that is licensed to operate as a taxi by the relevant State or Territory and does not extend to travel undertaken in a ride-sourcing vehicle or other vehicle for hire that does not hold a taxi license.
Reductions in taxable value [7.360] Having determined the taxable value of a fringe benefit, it is then necessary to determine whether the taxable value can be reduced because:
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• it is an in-house fringe benefit: see [7.370]; • there is a recipient’s contribution: see [7.380]; or • the otherwise deductible rule applies: see [7.390]. All of these reductions can apply individually or in conjunction with the others.
In-house fringe benefits [7.370] Under s 62 of FBTAA, the taxable value of all in-house (expense, property or residual) fringe benefits for each particular employee is reduced by $1,000. Where the taxable value of all in-house fringe benefits to a particular employee is less than $1,000, the taxable value is reduced to nil, and there is effectively no FBT payable on the provision of the in-house fringe benefits to that employee. Note that the reduction relates to the particular employee and cannot be done on an aggregate basis. Example 7.24: Reduction in taxable value for in-house property fringe benefits Company Y provides its employees Leonie and James with in-house property fringe benefits. The taxable value of Leonie’s in-house fringe
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benefits is $2,000 and the taxable value of James’ in-house fringe benefits is $300. Applying s 62 of FBTAA, the taxable value of Leonie’s in-house fringe benefits is reduced to $1,000 and the taxable value of James’ in-house fringe benefits is reduced to nil. The reduction relates to the particular employee and cannot be done on an aggregate basis. The unutilised $700 exemption in relation to James cannot be applied to reduce Leonie’s liability.
Recipient’s contribution [7.380] The definition of “taxable value” for most fringe benefits reduces the taxable value of the fringe benefit by the amount of the recipient’s contribution (if any). Of the categories of fringe benefits discussed in detail at [7.100]–[7.300], this step is not required for car fringe benefits, debt waiver fringe benefits and loan fringe benefits, as it is either not applicable or has been incorporated into the determination of taxable value at first instance. Where the fringe benefit is an expense payment fringe benefit that arises because of a reimbursement, the amount of the employee’s expenditure is not considered the recipient’s contribution: ss 22A(4) and 23 (as the employee has been reimbursed for the expense). In all other cases, reduce the taxable value by the amount of the recipient’s contribution (if any).
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Example 7.25: Reducing taxable value for recipient’s contribution Belinda is a lawyer at a small law firm specialising in conveyancing. She recently purchased her first home for $500,000. The firm provided her with conveyancing services at a 50% discount. The standard fee for conveyancing services on properties similar to Belinda’s would be $2,000. The provision of conveyancing services constitutes an in-house residual fringe benefit as the services are provided to outsiders in the ordinary course of the employer’s business. The taxable value of the fringe benefit is 75% of the lowest price charged to customers, which would be 75% × $2,000 = $1,500. The services were provided to Belinda at a 50% discount, which means that she paid $1,000 towards the conveyancing fees. The taxable value is therefore reduced for recipient’s contribution to $500. (Note: The taxable value may be further reduced to nil by applying the $1,000 reduction for in-house benefits, depending on whether Belinda received any other in-house benefits during the FBT year: s 62 of FBTAA.)
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224 [7.390] PRINCIPLES OF TAXATION LAW 2020
Otherwise deductible rule [7.390] Most categories of fringe benefits also include the “otherwise deductible rule” to reduce the taxable value of a fringe benefit. Of the categories of fringe benefits discussed in detail at [7.100]–[7.300], the otherwise deductible rule is not applicable to car fringe benefits and debt waiver fringe benefits. Under the otherwise deductible rule, the taxable value of a fringe benefit is reduced by the amount which would have been deductible to the employee had the employee incurred an expense directly rather than received a fringe benefit. It is important to note that the otherwise deductible rule only applies in relation to the employee and not associates of the employee (ie, the expense must have been deductible to the employee). It is also important to note that the expense must give rise to a one-time-only deduction to the employee for the otherwise deductible rule to apply. An expense which would be deductible to the employee over a number of years (eg, depreciation) would not qualify as an otherwise deductible expense. In such cases, it may be preferable for the employee to incur the expense themselves as the amount is excluded from the employee’s income (as deductions), albeit over a period of years, rather than receive a benefit that is fully taxable to the employer under FBT.
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Example 7.26: Otherwise deductible rule On 1 April 2019, Ali received a loan of $20,000 from his employer at an interest rate of 2.37%. Ali used $10,000 to purchase shares, $5,000 to pay his personal credit card debt and the remaining $5,000 to purchase shares in his wife’s name. The $20,000 provided by the employer to Ali is a loan fringe benefit. The taxable value of the benefit is $20,000 × (5.37% –2.37%) = $600. The loan is provided for the entire FBT year, so there is no need to adjust for the loan period. The $600 represents interest that Ali has “saved” by obtaining a loan from his employer, rather than at commercial rates. The relevant question when applying the otherwise deductible rule is whether Ali would have been entitled to a deduction for some or all of the $600 had he incurred the interest expense directly by obtaining a loan at commercial interest rates instead of receiving the fringe benefit. Half of the loan amount was used to purchase shares and, as discussed in Chapter 12, interest incurred in acquiring an income-producing asset is deductible for tax purposes. Therefore, the interest expense which relates to that portion of the loan (50% × $600 = $300) would have been “otherwise deductible”.
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Interest relating to the portion of the loan used to pay the credit card debt would not be deductible as it is a private expense. The interest relating to the purchase of shares in the wife’s name is also not otherwise deductible as the interest expense is not deductible to Ali, but to his wife. Therefore, the taxable value of the loan fringe benefit is reduced from $600 to $300 by applying the otherwise deductible rule.
Example 7.27: Otherwise deductible rule Under the terms of his employment agreement, Jerry’s employer has agreed to pay his tax agent’s fees of $550 for the preparation of Jerry’s personal income tax return. The payment of the tax agent’s fees by the employer constitutes an external expense payment fringe benefit. The taxable value of the fringe benefit is the amount of the expense, being $550. The cost of managing one’s tax affairs is deductible under s 25-5 of ITAA 1997: see Chapter 13. Therefore, if Jerry had paid the tax agent’s fees himself, he would have been entitled to a deduction for the fees. Applying the otherwise deductible rule, the taxable value of the expense payment fringe benefit would be reduced to nil as the $550 would have been fully deductible had it been incurred by Jerry.
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Example 7.28: Otherwise deductible rule Under the terms of her employment agreement, Jade’s employer has agreed to pay her home phone bills totalling $2,200 for the year. Only 20% of her calls were for work purposes. The payment of the phone bills by the employer constitutes an expense payment fringe benefit. The taxable value of the fringe benefit is the amount of the expense, being $2,200. Twenty per cent of Jade’s calls are for work purposes and it is likely that, had she paid the phone bills herself, she would have been entitled to a deduction for 20% of the cost, being $440 (see Chapter 12). Therefore, applying the otherwise deductible rule, the taxable value of the expense payment fringe benefit would be reduced by $440 to $1,760.
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226 [7.390] PRINCIPLES OF TAXATION LAW 2020 Where a benefit is provided to an employee and their associate jointly, the otherwise deductible rule is to be applied on a proportionate basis. The otherwise deductible rule for loan fringe benefits, expense payment fringe benefits, property fringe benefits and residual fringe benefits was amended by Sch 4 of the Tax Laws Amendment (2008 Measures No 5) Act 2008 (Cth) to ensure that the rule operated as such. The amendments were necessary due to s 138(3), which deems a benefit jointly provided to an employee and their associate to be provided solely to the employee. In National Australia Bank v FCT (1993) 26 ATR 503, the Federal Court held that the taxable value of a loan fringe benefit provided to an employee and his spouse was reduced to nil under the otherwise deductible rule. This was due to the operation of s 138(3), which deemed the benefit to be provided solely to the employee. The following examples from Sch 4 of Tax Laws Amendment (2008 Measures No 5) Act 2008 illustrate the application of the law following the amendments. Example 7.29: Benefit provided to employee and associate
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Francisca and her husband Peter receive a joint interest- free loan of $50,000 from Peter’s employer. Assume that the taxable value of the loan fringe benefit is $10,000. Francisca and Peter use the loan to purchase $50,000 of shares which they will hold jointly with a 50% interest each. Francisca and Peter return 50% of the dividends derived from the shares as assessable income in each of their income tax returns. Under the previous law (and as a result of the NAB case), the otherwise deductible rule would apply to reduce the taxable value of the loan fringe benefit ($10,000) (ie, in respect of both Francisca and Peter’s share of the benefit) to nil and consequently the employer would have no FBT liability. As a result of new paragraph 19(1)(i) and new subsection 19(5), the notional deduction of $10,000 is reduced by Peter’s percentage of interest in the shares –that is, 50% so that the taxable value of the loan fringe benefit of $10,000 is reduced by $5,000. The employer has an FBT liability on $5,000, which reflects the share of the loan fringe benefit that was provided to Francisca. Source: Adapted from Example 4.2 in Explanatory Memorandum to Tax Laws Amendment (2008 Measures No 5) Act 2008.
Example 7.30: Benefit provided to employee and associate Assume Francisca and Peter only use 50% of the $50,000 loan for acquiring shares. They use the other 50% ($25,000) for a private overseas holiday. The taxable value of the loan fringe benefit that relates to that
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part of the loan used for private purposes ($5,000) is not deductible to either Francisca or Peter, so the otherwise deductible rule does not apply to reduce that part of the loan fringe benefit. The taxable value of the loan fringe benefit that arises on the part of the loan that is used for acquiring shares can be reduced by Peter’s share of the benefit (ie, $2,500). The employer can reduce the taxable value of the loan fringe benefit ($10,000) by $2,500. The taxable value of the loan fringe benefit provided to Francisca and Peter that will be subject to FBT is therefore $7,500 ($10,000 –$2,500) which represents the portion of the loan used for the private holiday and the portion for Francisca’s ownership of the shares. Source: Adapted from Example 4.3 in Explanatory Memorandum to Tax Laws Amendment (2008 Measures No 5) Act 2008.
Type of fringe benefit [7.400] Having determined the taxable value of each fringe benefit, it is then necessary to determine whether the fringe benefit is a Type 1 fringe benefit or a Type 2 fringe benefit.
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A Type 1 fringe benefit exists where the employer is entitled to input tax credits (ie, a refund of GST paid) in relation to the provision of a fringe benefit: ss 5C(3) and 149A of FBTAA. See Chapter 25 for when a taxpayer is entitled to input tax credits. A Type 2 fringe benefit is any fringe benefit which is not a Type 1 fringe benefit: s 5C(4). For example, where an employer did not pay GST in relation to the provision of the fringe benefit, the fringe benefit will be a Type 2 fringe benefit as the employer is not entitled to input tax credits in relation to that fringe benefit. Debt waiver fringe benefits and loan fringe benefits are always Type 2 fringe benefits as GST is not applicable to them. The separation of fringe benefits into two types is necessary following the introduction of the GST on 1 July 2000. As we will see in Chapter 25, GST is borne by private consumers and not businesses. Where a fringe benefit is provided by an employer, there is an additional benefit to the employee in the GST that has not been paid –that is, if the employee had acquired the benefit themselves they would have paid an additional 10% in GST, and the GST “saved” is an additional benefit of receiving a fringe benefit. The gross-up mechanism discussed at [7.410] adds the GST that has not been paid back into the FBT base.
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228 [7.410] PRINCIPLES OF TAXATION LAW 2020
Fringe benefits taxable amount [7.410] The next step is to calculate the “fringe benefits taxable amount” as prescribed by s 5B of FBTAA. The fringe benefits taxable amount is calculated by “grossing-up” the taxable value of the fringe benefit by the appropriate rate. As mentioned at [7.400], the “gross-up” takes into account the fact that the employee has received an additional benefit in the form of the “GST saved” on receiving a benefit. The “gross-up” also adds the FBT payable on the fringe benefit back into the tax base. Where an employee receives salary, the tax on the salary is paid by the employee. However, where the employee receives a fringe benefit, the tax on the fringe benefit (FBT) is paid by the employer. As such, the employee has received an additional benefit since tax is paid by the employer rather than the employee.
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Example 7.31: Fringe benefits taxable amount Ivo’s employer provides him with a mobile phone. The provision of the mobile phone is a fringe benefit and the taxable value of the fringe benefit is determined by the method discussed earlier. The taxable value only relates to the provision of the mobile phone. In addition, Ivo has also received a benefit in that he has not had to pay GST on the acquisition of the phone. The “GST saved” is also a benefit to Ivo and FBT is payable on that benefit. Ivo receives a further benefit in that he does not pay income tax on the receipt of these benefits. The “income tax saved” is also a benefit received by Ivo, and FBT is payable on that benefit. The “gross-up” adds the GST saved and the income tax saved by Ivo into the tax base – that is, the amount upon which the FBT liability is ultimately calculated. Many students, and even some tax professionals, often find it difficult to understand the reasoning behind the “gross- up”. It is not essential in determining the FBT consequences to understand the reasoning behind this and the fringe benefits taxable amount can simply be calculated in accordance with the following formulae: For a Type 1 fringe benefit, the fringe benefits taxable amount equals: Total taxable value of all Type 1 fringe benefits ×
FBT rate + GST rate
[1 – FBT rate] × [1+ GST rate] × FBT rate
With the current (ie, for the year ending 31 March 2020) FBT rate of 47% and GST rate of 10%, the fringe benefits taxable amount for Type 1 fringe benefits equals: Total taxable value of all Type 1 fringe benefits × 2.0802
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For a Type 2 fringe benefit, the fringe benefits taxable amount equals: Total taxable value of all Type 2 fringe benefits ×
1 1− FBT rate
With the current (ie, for the year ending 31 March 2020) FBT rate of 47%, the fringe benefits taxable amount for Type 2 fringe benefits equals: Total taxable value of all Type 2 fringe benefits × 1.8868
FBT liability [7.420] The final step is to determine the employer’s FBT liability, which is calculated as: ( Type 1 fringe benefits taxable amount ) + ( Type 2 fringe benefits taxable amount ) × FBT rate
See ss 5B(1A) and 66 of FBTAA. The “FBT rate” is equal to the highest marginal tax rate plus the Medicare levy. For the FBT year ending 31 March 2020, the FBT rate is 47%.
Interaction with income tax
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Employer [7.430] From an employer’s perspective, any FBT liability incurred in relation to the provision of fringe benefits and the cost of providing the fringe benefit are generally deductible as ordinary business expenses under s 8-1 of ITAA 1997: see also Ruling TR 95/24. The FBT liability is generally deductible as an expense incurred in gaining or producing assessable income that is not capital or capital in nature; private or domestic in nature; incurred in gaining or producing exempt or non-assessable non-exempt income; or a denied deduction: see Chapter 12. It should also be noted that the deductibility of the FBT liability for income tax purposes does not impact on an employer’s FBT liability. For example, an employer’s FBT liability is not reduced because the employer chooses not to claim a deduction for the FBT liability: Determination TD 94/42. The cost of providing a fringe benefit is also generally deductible under s 8-1 of ITAA 1997 as an ordinary business expense: see Chapter 12. Broadly, the mechanism for calculating FBT and the fact that both the cost of providing a fringe benefit and FBT are deductible to an employer mean that, from a tax perspective, employers are generally indifferent in respect of providing
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230 [7.430] PRINCIPLES OF TAXATION LAW 2020 employees with salary or fringe benefits. The fact that a benefit is an exempt benefit or that the taxable value of a benefit is reduced for any of the reasons discussed at [7.360]–[7.390] generally does not affect the employer’s entitlement to a deduction for the cost of providing the fringe benefit. There is an important interaction between FBT and the deductibility of expenses which is worth noting. Certain expenses that are generally denied deductions (see [12.240]–[12.260]) are deductible if incurred in the provision of a fringe benefit. For example, entertainment expenses are generally not deductible under s 32-5 of ITAA 1997 but are deductible under s 32-30, where the entertainment expenses are incurred in the provision of a fringe benefit. The amount of the deduction will depend on the treatment of the entertainment expenses for FBT purposes. For example, where the 50/50 split method is used for calculating the taxable value of meal entertainment fringe benefits, only half the meal entertainment expenses will be deductible for income tax purposes as only half the meal entertainment expenses have been treated as a fringe benefit (see also s 51AEA of ITAA 1936).
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Other expenses that are generally not deductible for income tax purposes, but which are deductible when provided as a fringe benefit, include: • higher education contribution payments: s 26-20(2); • a relative’s travel expenses: s 26-30(3); • recreational club expenses: s 26-45(3); and • leisure facility expenses: s 26-50(8). These generally denied deductions are only deductible when provided as a fringe benefit. If the benefit is an “exempt benefit”, a deduction is not allowed as exempt benefits are not “fringe benefits”: see definition of “fringe benefit” in s 136(1). Example 7.32: Denied deductions and exempt fringe benefits Following on from Example 7.22, the cost of the end of financial year dinner is potentially deductible due to s 32-20 of ITAA 1997 as the cost of providing entertainment by way of providing a fringe benefit. However, as discussed in Example 7.22, the provision of the dinner would qualify as a “minor benefit” and thus be an “exempt benefit” under s 58P. Exempt benefits are not fringe benefits per the definition of “fringe benefit” in s 136(1) and therefore, the cost of the dinner is not deductible. Finally, note that any amounts received directly by an employer from an employee in respect of a fringe benefit (recipient’s contribution) may constitute assessable income of the employer.
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Employee [7.440] For an employee, fringe benefits constitute non-assessable, non- exempt income of the employee: s 23L(1) of ITAA 1936; s 15-2 of ITAA 1997. This is the case even where little or no FBT has been paid in relation to the fringe benefit because of a reduction to the taxable value of the fringe benefit. Exempt fringe benefits are treated as exempt income of the employee: s 23L(1A) of ITAA 1936; s 15-2 of ITAA 1997. Where the taxable value of an employee’s fringe benefits exceeds $2,000, the employer is required to report the fringe benefits on the employee’s Payment Summary (subject to certain exceptions), and the employee is required to report these fringe benefits on his or her income tax return. These “reportable fringe benefits” do not affect the employee’s income tax liability, but do affect the calculation of certain amounts, such as the Medicare levy surcharge or Higher Education Loan Program (HELP) repayments.
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Interaction with GST [7.450] As discussed at [7.410], the fact that an employer may be entitled to a refund of GST paid on the acquisition of a fringe benefit, while an employee would generally not be entitled to a refund, is taken into account in determining the FBT liability through the grossing-up mechanism. As such, the cost of a fringe benefit in determining taxable value is the GST-inclusive cost: Ruling TR 2001/2. Where the fringe benefit relates to a reimbursement, s 111-5 of A New Tax System (Goods and Services Tax) Act 1999 (Cth) deems the acquisition to have been made by the employer for GST purposes. This provision enables the employer to obtain GST input tax credits in relation to the acquisition (if entitled) even though the acquisition was actually made by the employee and the employer only reimbursed the employee. As will be seen in Chapter 25, the provision of employee services and the receipt of fringe benefits may be considered a barter transaction that gives rise to GST consequences. However, s 9-75(3) of A New Tax System (Goods and Services Tax) Act 1999 provides that such transactions will not give rise to a GST liability unless the recipient makes a contribution for the benefit. Where the employee makes a contribution towards the benefit, the employer is registered for GST purposes and the benefit is not GST-free or input-taxed, the employer will have to remit one-eleventh of the recipient’s contribution in GST to the ATO in respect of the supply of the fringe benefit.
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232 [7.460] PRINCIPLES OF TAXATION LAW 2020
Questions [7.460] 7.1 Determine whether the following benefits are fringe benefits or exempt fringe benefits and, where applicable, the relevant category of fringe benefit. Provide reasons for your answer: (a) Payment to employee for the estimated cost of the employee’s home phone bill as the employee sometimes has to use the home phone for work purposes.
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(b) Provision of accommodation at the family home to a child who is over 21 and works in the family business. (c) Payment of employee’s superannuation contribution by the employer to a complying superannuation fund. (d) Loan by Company X to one of its directors, Rupert, who is also a shareholder in the company. The company’s rules do not permit loans to directors. (e) Payment of taxi fare by employer for employee to travel home after working late. (f) Flowers sent to a sick employee. The flowers cost $75. (g) Provision of a car for an employee’s private use, including payment of all fuel costs by the employer. (h) Provision of sandwiches at a lunchtime seminar held at the employer’s premises. (i) Provision of an all-expenses-paid holiday to an employee who has had to work every weekend for the last six months. (j) Provision of two laptop computers to an employee who regularly attends clients’ premises. 7.2 Jenny is an employee of the university. She is provided with 10 gift vouchers worth $50 each for use at the local supermarket as a Christmas gift. Advise Jenny and the university of the tax consequences of this transaction. 7.3 Loo is an employee at a large real estate agency. He has negotiated the following benefits with his employer: • Provision of a car for work and personal use. Loo was provided with the car for the period 1 April 2019 to 31 March 2020. The leased car value was $22,000 at 1 April 2019, and the car had only been leased for a year at that time. Loo is required to pay for any petrol costs which he has determined to be $1,300 for the period 1 April 2019 to 31 March 2020. • Provision of the latest model smart phone on 1 April each year as Loo is usually “on the street” and needs a good phone to do his
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7: FrinGe Benefits tax [7.460] 233
job. Loo estimates that he uses the phone 70% for work purposes. The phone was purchased new on 1 April 2019 for $1,100 (including GST). Advise Loo’s employer as to the FBT consequences (including calculation of any FBT liability) arising out of the above information. You may assume that any benefits are Type 1 fringe benefits. 7.4 Jasmine borrowed $15,000 from her employer on 1 February 2020 to pay for her wedding. The loan was provided at an interest rate of 2%. The wedding was on 29 February 2020 and on that day, Jasmine’s employer informed her that she only needed to repay $10,000 of the loan. Advise Jasmine’s employer as to the FBT consequences (including calculation of any FBT liability) arising out of the above information. You may assume that wedding costs are not a deductible expense for tax purposes. You may also assume that any benefits are Type 2 benefits. 7.5 Rita’s employer sells furniture. On 17 January 2020, Rita purchased a table from her employer for $1,000. The table would usually be sold for $3,000 and cost the employer $500 to purchase. The employer decided to give Rita a tablecloth for the table as a “free gift” for the purchase of the table. The tablecloth would usually be sold for $150 and cost the employer $50 to purchase. Rita’s employer also decided to host a “leap year party” on 29 February 2020 for all employees and their partners. In total, there were 20 attendees (10 employees and 10 partners) and the party cost $3,300 (including GST). The party was held at a local Mexican restaurant. Advise Rita’s employer as to the FBT consequences (including calculation of any FBT liability) arising out of the above information. You may assume that any benefits are Type 1 benefits. You may also assume that Rita’s employer has no other meal entertainment expenditure for the year, elects for Div 9A to apply to the provision of meal entertainment fringe benefits and determines the taxable value of meal entertainment fringe benefits using the 50/50 split method.
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8 Income from business
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Key points...................................................................................................... [8.00] Introduction.................................................................................................. [8.10] Step 1: Carrying on a business................................................................... [8.20] Indicators of a business activity............................................................ [8.30]
Gambling.................................................................................................... [8.60] Sportspeople.............................................................................................. [8.80] Investment activities.................................................................................. [8.90] Land sales................................................................................................. [8.100] Sharing economy................................................................................. [8.105] Crowdfunding activities....................................................................... [8.107] Commencement and termination of business................................... [8.110] Step 2: Normal proceeds of a business.................................................... [8.130] Nature of the business –broad or narrow approach?........................ [8.140] Nexus of receipt with business........................................................... [8.150] Non-cash business benefits................................................................. [8.160] Extraordinary and isolated transactions.................................................. [8.170] Introduction.......................................................................................... [8.170]
Transaction forms a business in itself under the principle in FCT v Whitfords Beach.............................................. [8.180]
Principle applied to isolated transactions............................................... [8.180] Principle applied to extraordinary transactions...................................... [8.190] Calculating ordinary income under the principle in FCT v Whitfords Beach............................................................................... [8.200] Two strands of Myer............................................................................ [8.210] First strand of Myer.................................................................................. [8.220] Second strand of Myer............................................................................ [8.260]
Statutory provisions that may apply to extraordinary and isolated transactions................................................................................... [8.265]
Capital gains tax....................................................................................... [8.270] Section 15-10: Bounties and subsidies................................................... [8.280]
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236 [8.00] PRINCIPLES OF TAXATION LAW 2020 Section 15-15: Profit-making undertaking or plan................................. [8.290] Section 25A: Profit from sale of asset acquired with the purpose of resale............................................................... [8.300] Questions..................................................................................................... [8.310]
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Key points [8.00] • Business income is ordinary income under s 6-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). • Whether a business is being carried on or not will be determined by weighing up whether sufficient characteristics of a business are present. • No one of the indicators of a business is decisive in classifying an activity as a business. • Some activities are by nature more likely to be pursued as a hobby or for recreational purposes and are therefore less likely to be classified as a business. • As well as identifying the business, it is also necessary to decide when the business commences and ends as receipts not associated with the operation of the business are not business income. • Receipts that are not the normal proceeds of the business are not assessable as business income but may be assessable under one of the other principles of ordinary income or statutory income. • Non-cash business benefits are deemed to be convertible to cash by s 21A of ITAA 1936 and, provided they are income of the business, they are assessable and valued at an arm’s length value. • One-off transactions undertaken by taxpayers who are not running a continuous business are called isolated transactions. • Transactions undertaken by taxpayers that are running a continuing business but that are not within the scope of that business are called extraordinary transactions. • Isolated and extraordinary transactions usually only generate ordinary income if they fulfil the requirement of one or more of the following three: • the principle in FCT v Whitfords Beach; • the first strand of FCT v Myer Emporium; or • the second strand of FCT v Myer Emporium. • The principle in FCT v Whitfords Beach is likely to be satisfied if the isolated/ extraordinary transaction has sufficient characteristics of a business.
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• The first strand of FCT v Myer Emporium will be satisfied if there is a business/ commercial transaction, a profit- making intention upon entering the transaction and consistency between the way the profit is made and the original intention. • The second strand of FCT v Myer Emporium will be satisfied where a taxpayer sells the right to income but retains ownership of the underlying asset that is the source of the that income. • Profits from isolated and extraordinary transactions will often be taxable under capital gains tax.
Introduction [8.10] Income earned from carrying on a business is ordinary income under s 6-5 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) following the general concepts of income outlined in Chapter 5. This is in contrast to non- business activities, such as hobby or pleasure activities, which do not generate ordinary income and therefore are not assessable under s 6-5. Characterising receipts as ordinary income from a business activity is a two- step process that requires: 1. determine whether the taxpayer is carrying on a business; and
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2. consider whether the particular receipts are in fact the normal proceeds of carrying on that business. This two-step process removes from assessable income activities that are undertaken as a hobby or recreational pursuit and receipts that are not the normal proceeds of the business because they are outside the scope of the business activity. However, receipts that are not the normal proceeds of the business may still be assessable as ordinary or statutory income. This will be the case if they are characterised as ordinary income by one of the other general concepts of income (see [8.170]–[8.300]) or if they are specifically made assessable by the legislation.
Step 1: Carrying on a business [8.20] Disputes relating to whether or not a business is carried on often arise because a taxpayer wishes to take advantage of concessions offered to certain types of businesses, such as farming or the lower tax rates available for some companies (see Chapter 21). Similarly, the taxpayer may wish to use the losses from non-profitable activities, such as share trading, against other taxable income. In contrast, the Commissioner may seek to classify an activity as a business to collect tax on the profits realised, even though the taxpayer is treating it as a hobby.
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238 [8.30] PRINCIPLES OF TAXATION LAW 2020 The term “business” is used throughout the legislation, and the definition in s 995-1(1) of ITAA 1997 “includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee”. This definition is of little assistance as it only adds to the general meaning of “business” by including any profession, trade, etc, and leaves open the question of what is a business in the ordinary meaning of the word. As a result, it is necessary to look at the decided cases to determine the factors that have been used by the courts in making this decision: Ferguson v FCT (1979) 9 ATR 873: see Case Study [8.1]. It is significant that the definition of “business” in s 995-1(1) states that it does not include income from an “occupation as an employee”. This means that in most cases, employment income will not be business income. However, in some cases, an employee contract may not be solely a contract of employment: Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148: see [8.80].
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While income from personal services and business income are both generally assessable under s 6-5 as ordinary income, there are certain consequences that follow depending on how the income is categorised. For instance, gains that are business income can be subject to certain types of deductions that are not available for income that is purely income from personal services: see [8.80]. When considering if a business is being carried on, the courts have made a distinction between activities that are conducted in a commercial-like manner and activities that are pursued as a hobby or recreational activity. As with other characteristics of ordinary income, this distinction is quite clear at the extreme ends of the spectrum. However, it is difficult to identify the point at which a hobby becomes a business, or the point at which activities first undertaken for pleasure show sufficient characteristics of a commercial approach to be later classified as a business.
Indicators of a business activity [8.30] Over the years, the courts have identified a number of characteristics of a business, and the presence, or lack, of these characteristics has been used to classify the activity as a business or a hobby. However, this is a very imprecise process, and it is extremely important to appreciate that the characteristics used by the courts are not necessarily exhaustive and no one characteristic alone is a single indicator of a business. To ascertain whether a business exists, the courts use an accumulative approach of weighing up the characteristics of a business that are present and comparing them to those that are absent. On balance, a decision is then reached as to whether the activity possesses sufficient of the characteristics
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to be classified as a business. This approach involves a question of degree (weighing up the facts toward a possible conclusion) and, like all other questions of degree, it is difficult to draw a precise line between activities that are a business and those that are not. It is also important to recognise that the courts may place varying degrees of importance on particular characteristics for different types of activities. For example, the courts tend to look for a higher level of certainty that a business exists for activities such as gambling: Evans v FCT (1989) 20 ATR 922; Brajkovich v FCT (1989) 20 ATR 1570.
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[8.40] Although it is not possible to create an exhaustive list of the characteristics of a business, the following are the most common factors that have been considered by the courts (Ferguson v FCT (1979) 9 ATR 873: see Case Study [8.1]; FCT v JR Walker (1985) 16 ATR 331: see Case Study [8.2]): • Whether there is a profit-making intent. A profit-making intention is a strong, though not determinative indication that there is a business. In addition, a lack of profit-making intention does not necessarily preclude there being a business, especially if the operation has sufficient other characteristics of a business: Stone v FCT (2005) 59 ATR 50: see Case Study [8.8]. Furthermore, it is not necessary to show the existence of an actual profit to show a profit-making intent. • The scale of activities, including the nature and type of capital and the level of turnover. For example, the larger the business turnover, the more likely it would be held to be a business, but this does not exclude small activities from being held to be a business: FCT v JR Walker (1985) 16 ATR 331: see Case Study [8.2]. • Whether a commercial approach is taken. For example, whether professional advice has been sought before and during the operation, whether markets for produce have been explored and whether the produce is more than that needed for domestic purposes. • System and organisation employed. For example, the degree of planning involved, the amount of time devoted to the activity and whether records are kept. Generally, the courts have been willing to accept that taxpayers may delegate many of the business-like activities to a manager yet still be considered to be running a business: Ferguson v FCT (1979) 9 ATR 873; FCT v JR Walker (1985) 16 ATR 331. • Methods characteristic of the particular line of business. For example, using methods similar to those used in a similar commercial business, such as a dairy farmer using planned breeding programs to increase milk production. • Sustained and frequent activity. For example, occasionally selling pups from your pet dogs is not the same as regularly breeding a particular type of dog and aiming to sell the offspring.
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240 [8.40] PRINCIPLES OF TAXATION LAW 2020 • The type of activity and the type of taxpayer. For example, a business of trading in stamps would have to be much more than the traditional pastime of a hobbyist collecting stamps and occasionally selling some duplicates.
Case study 8.1: Indicators of a business
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In Ferguson v FCT (1979) 9 ATR 873, the taxpayer (Ferguson) planned to purchase rural land on which he intended to establish a full-scale cattle production business for his retirement in two to three years’ time. To begin building up his planned herd of 200 Charolais cattle, Ferguson leased five females for four years and bred them to a stud bull in order to establish his purebred herd. Ferguson also entered into a management agreement with a rural management firm for a period of 10 years for the purpose of managing the leased cattle and their calves. The management agreement required the manager to find suitable grazing for the cattle and to manage their breeding. All resulting offspring became the property of the taxpayer. The taxpayer contended that these activities constituted a business, but the Commissioner argued that this was only preparation for a future business. The Full Federal Court held that Ferguson was carrying on a business, even though it was small and even though it was preliminary to his intended future business. Central to the conclusion reached by the Court was the question of whether the taxpayer was conducting this breeding program in a commercial manner albeit carried out by a manager. In its decision, the Court considered the following factors:
• A purpose of profit-making may be important but not essential. • Repetition and regularity are considerations, but a business could involve a single transaction and every business must commence with a single transaction. • Organisation and a business- like approach with appropriate record keeping, etc, is an indication of a business activity. • Having other sources of income did not preclude this activity from being a business. In other words, the fact that the taxpayer had a full-time job was not inconsistent with him carrying on a business. • The size of the operation and the amount of capital are relevant, but must be looked at in the context of the type of activity. For example, a recreational pursuit may have considerable effort and resources contributed to it and still not be a business. • These activities were more than preparation to begin a future business.
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[8.50] When using these factors to characterise an activity as a business or not, the courts will weigh up the factors present in the context of the type of activity, but there is no single determinative factor that is a reliable indicator of a business. However, the courts may place a relatively higher degree of importance on whether the taxpayer is taking a commercial approach, by conducting the activity in a manner similar to that used in situations that are clearly conducting a business: Thomas v FCT (1972) 3 ATR 165; Ferguson v FCT (1979) 9 ATR 873; FCT v JR Walker (1985) 16 ATR 331.
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Case study 8.2: Small-scale goat-breeding operation a business In FCT v JR Walker (1985) 16 ATR 331, the taxpayer was a real estate agent who was interested in breeding Angora goats. He purchased one female Angora goat for $3,000, and then paid another $2,000 to have the goat impregnated. The breeding process undertaken by the taxpayer involved substantial assistance by a veterinary surgeon called Dr Corbett, who undertook many of the actions and decisions of the goat- breeding operation since the taxpayer lived over 3,000 km away and so could not be directly involved in its everyday running. The breeding eventually led to the birth of four more goats, though the original goat and one of its offspring prematurely died. Although the taxpayer stated that he intended to profit from the breeding operation, in fact it only produced losses. Consequently, after a few years the taxpayer quit the goat- breeding operation. However, while the goat- breeding venture was running, the taxpayer relied upon Dr Corbett for advice, joined the Angora Breeding Society, read that society’s journals and kept detailed books of accounts. Justice Ryan of the Supreme Court of Queensland held that the taxpayer had been running a business rather than a hobby. His Honour applied the criteria outlined in Ferguson v FCT for deciding if there was a business. Specifically, the conclusion that there was a business was partially supported by the fact that the taxpayer had a profit-making intention. It was also supported by the fact that there was repetition and regularity in the breeding activities in that the breeding process was undertaken repeatedly for a number of years. The conclusion was also highly influenced by the fact that the taxpayer conducted the operations in a business-like manner, as evidenced by his keeping of accounts, joining the Angora Breeding Society, reading the relevant journal and generally keeping himself informed about the Angora goat-breeding market. While many of the actions and decisions were deferred to Dr Corbett, this was understandable given the fact that the taxpayer lived some distance from the operation and that Dr Corbett had much more expertise and knowledge on the subject of breeding Angora goats.
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242 [8.50] PRINCIPLES OF TAXATION LAW 2020 The finding in FCT v JR Walker that the taxpayer was running a business was despite the fact that the operation was small even though size was mentioned in Ferguson v FCT as relevant in determining the existence of a business. Therefore, although volume of operations is a factor in deciding whether there is a business, a small operation can still constitute a business if there are sufficient other business-like characteristics. Case study 8.3: A small business or a hobby
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In Thomas v FCT (1972) 3 ATR 165, the taxpayer (Thomas) was a barrister who purchased 7.5 acres (3.04 ha) of land where he constructed a private home and planted several varieties of trees for timber, macadamia nut and avocado production, some of which were irrigated. For the relevant period no income had been produced and some of the trees had been destroyed by fire and there had been some replanting. Thomas contended that he was carrying on a business, but the Commissioner argued that this was a hobby because it was not likely that there would be any significant income and this type of agriculture was not common in this area. The High Court held that there was a business of primary production and that a business may exist even though it is conducted on a small scale and has little or no short-term prospect of making a profit. It was not significant that the taxpayer’s main income was earned from his profession as a barrister or that only a small amount of time was devoted to the farming activity. What was important was that the tree planting was much greater than what would be needed for domestic purposes and the activity was more than a recreational pursuit or hobby. Walsh J was not swayed by evidence that the business was conducted rather inefficiently, and his Honour concluded that it is reasonable to accept that mistakes will be made and the taxpayer did seek technical advice to assist with management decisions. Distinction between a business and hobby in Thomas v FCT centred on the issue of whether the farming undertaken was more than a recreational activity pursued for mainly leisure purposes. Example 8.1: Degree of commercial approach A taxpayer who plants vegetable and fruit trees in his own backyard and uses the produce for his own personal consumption is clearly not conducting a business. This would still be the case even if small amounts of excess produce are sold to neighbours, as this is unlikely to be enough to cross the border between a hobby and business.
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Establishment of a business for income tax purposes requires some degree of commerciality, which would be indicated by production being more than required for domestic consumption and a more systematic and organised approach to the vegetable and fruit production: Ferguson v FCT (1979) 9 ATR 873. Facts such as using land other than the backyard, selling produce on a regular basis at the local markets, seeking professional advice on production techniques, planning production to meet demand and keeping appropriate records would all help to indicate that a commercial approach is being employed. As previously mentioned, there is no exact formula for identifying the dividing line between a business and a recreational activity or hobby. Each case must be considered on its facts and decided in the light of the factors that the courts have considered relevant in the decided cases. Some examples to assist in narrowing the degree of uncertainty in this decision include: • gambling: see [8.60]; • sportspeople’s earnings: see [8.80]; • investment activities: see [8.90]; and • land sales: see [8.100].
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Gambling [8.60] Taxpayers such as professional bookmakers and casino operators are clearly running a business because they take a commercial approach in that they operate on such a large scale that they can reasonably manage the odds of winning and predict their likely profit. On the other hand, an individual who gambles is very unlikely to be considered to be in the business of gambling because such activities are inherently recreational in nature. For instance, a person who regularly bets on horse races or at the casino is normally undertaking a recreational pursuit and is not considered to be in the business of gambling. For an individual to be found to be carrying on a business of gambling, there would need to be a significant level of commercial activity, such as regular and systematic betting, large amounts of money wagered and possibly integration with other business activities like horse racing and horse breeding: Trautwein v FCT (1936) 56 CLR 196; Prince v FCT (1959) 7 AITR 505. Gambling on horse racing is more likely to be a business if the gambler is associated with other related activities, such as owning horses, training horses or operating as a bookmaker: Income Tax ruling IT 2655.
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Case study 8.4: Gambling part of business of horse racing In Trautwein v FCT (1936) 56 CLR 196, the taxpayer had for a number of years been interested in horse racing with a view to making a profit. He devoted a substantial amount of time and money to the sport and established a farm for breeding racehorses. Trautwein raced his own horses as well as others that had been leased to him. The taxpayer was also involved in frequent and systematic betting on horse races wagering large amounts of money and using an agent to place bets and collect winnings. He also regularly attended race meetings throughout the year.
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The High Court held that the taxpayer’s gambling activities were part of his racehorse business, and therefore his earnings were ordinary income. Influential to the Court’s decision was the fact that the taxpayer’s gambling was closely associated and integrated with his horse-racing business. Other factors considered relevant were:
• the size of the bets;
• the systematic and organised approach;
• commitment of substantial amounts of money and time to betting; and
• employment of other people to place bets and collect winnings.
[8.70] In Australia, the courts have generally concluded that gambling does not constitute a business if it is not conducted on a large scale and is not connected to another business: Martin v FCT (1953) 90 CLR 470; Evans v FCT (1989) 20 ATR 922; Brajkovich v FCT (1989) 20 ATR 1570. As a result of the more recent decisions in Martin v FCT and Evans v FCT, it may be suggested that if facts similar to Trautwein v FCT were considered by the courts today, the same conclusion may not be reached. Case study 8.5: Gambling not a business even though associated with horse breeding In Martin v FCT (1953) 90 CLR 470, the taxpayer owned and bred race horses and had previously carried on business as a hotelier and then as a farmer. Over the years, he regularly engaged in betting on horse races in a systematic manner and his accountant kept the records of his expenses and winnings from gambling. The High Court held that the taxpayer was not conducting a business, but pursuing a recreational pastime despite the facts that there were a large number of bets, he employed a system in his betting and he had other interests in horse racing.
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Case study 8.6: Gambling not a business due to lack of systematic approach In Evans v FCT (1989) 20 ATR 922, the taxpayer earned over $800,000 from betting on horse racing over a five-year period. The Federal Court held that Evans was a lucky gambler and was not conducting a business because of the lack of a systematic approach. The Court relied on the fact that he did not place his bets with a bookmaker and he often wagered on long- odds bets.
Case study 8.7: Gambling with no other source of income was not a business
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In Babka v FCT (1989) 20 ATR 1251, on retiring at the age of 51, the taxpayer had commenced spending a large amount of time gambling. The gambling was predominantly concentrated on horse racing, although it included other activities such as card games and casinos. The taxpayer did not have employees or an office. The Commissioner claimed that the taxpayer was in the business of gambling due to the fact that they had no other income, kept detailed records of previous bets and utilised a betting system. Justice Hill of the Federal Court held that Babka was not in the business of gambling. His Honour stated that the fact that a taxpayer devotes a large amount of time to their gambling activities, uses a betting system and keeps detailed betting records does not necessarily mean that they are in the business of gambling.
Sportspeople [8.80] Some sporting activities involve a high degree of professionalism to the extent that participants are fully occupied by their sporting pursuits. Also, there may be significant amounts of money involved, extensive use of managers and agents to negotiate individual contracts and significant involvement of the media and advertising industries. In these circumstances, it is relatively clear that the participants are carrying on a business of earning income or at least earning income from personal services: see [6.30]. In contrast, sporting activities that are undertaken as a recreation pursuit will not constitute the carrying on of a business although there may still be income from personal services: see [6.30]. Identifying the receipts of a professional sportsperson as income from a business or income from personal services (see [6.10]–[6.30]) is important.
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This is because it may influence how they are treated for tax purposes as a team-based professional sports person paid as an employee may have limited tax deductions compared to a professional sports person judged to be operating a business: Stone v FCT (2005) 59 ATR 50; Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148: see Case Studies [8.8] and [8.9]. The tax consequences of a professional sportsperson’s activities constituting a business, or not, include: • Any fees paid by the club that the professional sportsperson is playing for will be ordinary income regardless of whether the taxpayer’s sporting activities are regarded as a business. For example, club payments to a professional footballer who is in the business of playing football could be ordinary income from business, but if he is not in the business of playing football, then the payments would be ordinary income from personal services. • Prizes for sporting achievements (see [6.110]) received by a sportsperson whose sporting activities constitute a business will be ordinary income from that business: Stone v FCT: see Case Study [8.8]. On the other hand, if the sporting activities do not constitute a business, prizes received for sporting achievement may still be regarded as ordinary income from personal services: Kelly v FCT (1985) 16 ATR 478: see Case Study [6.6]. However, in the case of sportspeople whose sporting activities constitute a business, there may still be instances where sporting prizes may not be regarded as ordinary income if the prize is awarded for the personal qualities of the taxpayer: Stone v FCT. • There could be a broader range of deductions available if the taxpayer’s sporting activities are regarded as a business. For example, if a professional football player is regarded as being in the business of playing football, then any fees paid to a manager to enter into a contract with a new team would be deductible: Spriggs v FCT; Riddell v FCT. However, such fees would not be deductible if the football player’s sporting activities are not regarded as being a business. This is because the first limb of s 8-1 ITAA 1997 (only available to employees) requires that the expense is incurred in the course of earning the income, but agents fees are incurred before the income is earned. In recent years, the courts have been more likely to label professional sportspeople as being in business. This has been the case for sportspeople that regularly play team sports at a high level: Spriggs v FCT; Riddell v FCT. It has also been the case for taxpayers that compete in non-team sports at high levels of competitions, especially if the sportsperson also undertakes related commercial activities, such as seeking corporate sponsorship: Stone v FCT.
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Case study 8.8: Javelin thrower was carrying on a business In Stone v FCT (2005) 59 ATR 50, the taxpayer (Stone) was a world-class javelin thrower and was also a full-time employee in the Queensland Police Force. As well as performing her duties as a police officer, Stone competed successfully in national and international competitions, including being selected for the Australian Olympic squad and winning the women’s javelin event in the 1998 World Cup. During the tax year ending 30 June 1999, Stone earned $136,448 from her sporting pursuits. This sum consisted of prize money, grants from the Queensland Sports Academy, appearance fees and sponsorship fees. The sponsorship fees were paid for her wearing clothing of certain brands, as well as her agreeing to have advertising material on her sporting clothes and the motor vehicle that was provided to her. The taxpayer also employed a manager for a short time to manage her sponsorships and appearances.
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The High Court held that Stone was carrying on a business in relation to her sporting activities and that all cash receipts from this business were ordinary income under s 6-5 of ITAA 1997. The Court stated that although Stone lacked a clear profit motive, an examination of the relevant activities indicated that she was carrying on a business. In reaching this decision, the Court was particularly influenced by the fact that Stone had entered into sponsorship deals. The Court also mentioned that although the presence of a profit motive is a strong, though not conclusive, indication that the taxpayer is running a business, an operation can still be a business despite the taxpayer lacking a profit motive.
Case study 8.9: Professional team sportspeople are carrying on a business In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148, both taxpayers played football in their respective football leagues and arranged for their managers to negotiate new player contracts upon them changing clubs. Following the completion of the negotiations of the player contracts, the managers charged their clients a fee, which Spriggs and Riddell claimed as a tax deduction. One issue considered by the High Court was whether Spriggs and Riddell were carrying on a business and, if so, the extent of their business activities. Due to the rules of deductibility, management fees relating to entering contracts with new clubs would only have been deductible if the sport-playing activities were business activities: see [12.340]–[12.350]. It was accepted by all parties that activities outside their playing duties
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(eg, endorsement and media engagements) were business activities. However, the Commissioner contended that the older decision in Maddalena v FCT (1971) 2 ATR 541 should be followed. In Maddalena v FCT, the Court had held that professional football playing activities were employment activities and not business activities. The High Court found that Maddalena v FCT did not apply to the facts in Spriggs and Riddell and held that the taxpayers’ sports-playing activities were business activities. The Court distinguished Maddalena v FCT on the basis that in Maddalena v FCT the taxpayer played rugby part time and had no manager. In contrast, the taxpayers in Spriggs and Riddell played football full time and had managers. Furthermore, the Court was influenced by the fact that modern-day football had changed since the case of Maddalena v FCT in that changing clubs was easier and more structured than had previously been the case.
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Investment activities [8.90] Investment income will normally be characterised as income from property (see Chapter 9) because it is inherently passive in nature and is earned without showing sufficient of the elements of a business: FCT v Radnor Pty Ltd (1991) 22 ATR 344. However, whether investment income is property or business income can be an important distinction as it will affect the tax treatment of the transactions. Where investment income is classified as property income, the acquisition of the underlying investments, such as shares and rental property, will be treated as capital and the sale will not be ordinary income: Greig v FCT [2018] FCA 1084. Conversely, if the investment activity is classified as a business, the underlying investment, such as the shares, will be regarded as trading stock (see Chapter 17) and treated on revenue account as ordinary income, rather than as capital. Identifying investment activities as a business is a question of degree which will be determined from the facts, taking into account the previously identified indicators of a business: see [8.30]–[8.50]. For example, large superannuation funds and listed investment trusts are commonly in the business of investment. However, there has to be something more than a profit-making intention and frequent transactions to show that the taxpayer is carrying on a business of investing. In London Australia Investment Co Ltd v FCT (1977) 7 ATR 757, the High Court held that a business of investment was being carried on due to the high degree of activity in investing and reinvesting in shares to maintain a minimum dividend yield. In contrast, a business that invests for long-term growth, rather than
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speculative investment, will normally be classified as earning property income and not income from a business: AGC (Investments) Ltd v FCT (1992) 23 ATR 287; Smith and Commissioner of Taxation [2010] AATA 576. For example, a taxpayer who purchases a portfolio of shares as a long-term investment for capital growth, but occasionally sells some of the shares to restructure the portfolio, is not conducting a business of selling shares. This is illustrated by the Commissioner’s view that a self-managed superannuation fund that holds shares and/or rental property to earn passive income is not carrying on a business: Self-Managed Superannuation Fund Ruling 2009/1. Whereas a bank that holds a large portfolio of shares and regularly speculates on movements in the share market and trades in these shares to maintain liquidity is in the business of buying and selling shares. In Taxation Ruling 2019/ 1, the Commissioner expresses the view that a company can be taken to be carrying on a business even if the activities are quite limited. This would be the case even if the company’s income consists mainly of passive income such as rent or interest. Nevertheless, the statement in the draft ruling is qualified with the comment that each case has to be determined on the facts.
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Case study 8.10: Holding shares for long-term growth not carrying on an investment business In AGC (Investments) Ltd v FCT (1992) 23 ATR 287, the taxpayer (AGC (Investments)) was a subsidiary of an insurance company and was set up to earn dividend income and maximise long-term capital growth for the parent company. The share portfolio was professionally managed and the parent company treated the value as a capital reserve in its balance sheet. In 1987, the taxpayer decided to sell over 50% of its share portfolio, realising almost $80 million and a significant profit. AGC (Investments) then reinvested the proceeds into fixed interest securities. The Full Federal Court held that AGC (Investments) was not carrying on an investment business but was holding the shares for long-term capital growth. The key facts in reaching this decision were that there was clear evidence that the investments were undertaken for long-term growth rather than speculative returns. In addition, the shares were not bought and sold to maintain liquidity for the parent company. Under current legislation, the sale of these shares would be subject to capital gains tax: see Chapter 11. Most cases concerning the business status of share trading activities have involved facts relating to larger financial institutions. Even so, it is still possible
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250 [8.100] PRINCIPLES OF TAXATION LAW 2020 for an individual to be conducting a business of share trading. This is a question of fact as it is with all other decisions as to whether an activity is a business for tax purposes. For instance, in AAT Case 4083 [2011] AATA 545, it was held that an individual taxpayer trading shares in his own name was in the business of share trading for income tax purposes. The primary reasons for reaching this conclusion, despite the small number of sales in the year, were that the taxpayer operated on a large scale (millions of dollars), he normally traded regularly, he followed a systematic approach even though he did not have clear goals and he was often seeking volatile shares.
Land sales
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[8.100] As with other decisions as to whether a business is being carried on, it is difficult to draw a clear line between the sale of land that is capital as a “mere realisation” (disposal of an asset that is no longer required) of an asset and the business of property development. Where the firm’s primary activity is purchasing, developing and selling land, it is clearly undertaking an ongoing business of selling land: FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452. Conversely, a firm that sells a factory and accompanying land because the property is no longer required is clearly not in the business of selling land, even though it may conduct some other business in the factory. However, if the land could potentially be rezoned as residential and the firm decides to undertake extensive development activities, the question arises as to whether the firm has entered a new business of property development: see [8.170]–[8.200]. Whether the sale of land is part of an ongoing business activity will be resolved by considering the extent to which the elements of a business are present. However, land may also be sold as an isolated transaction, which may be classified as ordinary income: see [8.170].
Sharing economy [8.105] In recent years, there has been a rapid increase in the “sharing economy”, as it has become known. The concept of the sharing economy is that the Internet is used to connect a client with a service provider. Some of the more common examples are the renting accommodation space (rooms or whole houses) through such sites as Air BNB, Stayz and Booking.com, ride- sourcing through Uber, DiDi, Ola and GoCatch; providing personal services through Airtasker or Oneflare; retail activities operated through eBay; and renting parking space through Parkhound. All of these activities allow providers to make their services or product available to a wide range of potential clients without the usual infrastructure such as websites and advertising that businesses normally require to access their markets.
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The sharing economy has come under scrutiny by the Australian Taxation Office’s (ATO) Black Economy Taskforce as there is some concern that some operators in the sharing economy are treating receipts as cash and not considering whether they are assessable income. Providers operating in the sharing economy need to be aware of the possible income tax obligations that arise from providing services via these websites. These obligations will primarily depend on whether they have earned income from personal services (see Chapter 6) or whether they are conducting a business. There could also be other taxation implications such as liability to GST (see Chapter 25) and effects on CGT main residence concessions if part of your main residence is available to the public for accommodation: see later in this chapter.
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Earlier in this chapter, the characteristics of a business were discussed in detail, and this will be an important consideration as to whether the receipts from these activities are assessable or not as ordinary income under s 6-5 ITAA 1997. The primary distinction to be made is whether the activities are undertaken for recreational purposes as a hobby (not ordinary income) or conducted in a business-like manner to earn assessable income. Where these services are provided through a facilitating website, such as Uber or Air BNB, it will be very difficult to make the case that this is a private recreational activity (hobby) as there are significant characteristics of a business present: see [8.40]. For example: • pricing of the services on offer would indicate an intention to profit; • the scale of the operation may be small, but this does not exclude the activity from being a business if it is conducted in a business-like manner. Conducting the activity through a sharing economy website would be evidence of a business-like approach; • a commercial approach is evident as the sharing economy websites require a level of detail and professionalism in the offering of the service. For example, Air BNB requires details of the facilities offered in the accommodation, and they require a certain level of standard; • the provider is required to be organised and satisfy the requirement of the sharing economy website. For example, an Uber driver is required to meet certain requirements including a vehicle inspection; • there may or may not be sustained and frequent activities, but when these activities are undertaken, they show many of the characteristics of a business. Note: The Commissioner of Taxation considers income earned from the sharing economy to be assessable income. If it is established that operating in the sharing economy is a business activity, then the normal requirements of the income tax legislation will need to be
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252 [8.107] PRINCIPLES OF TAXATION LAW 2020 satisfied. Income will be assessable, and deductions can be used to reduce the taxable amount. There will also be the normal record-keeping requirements. Some of the tax implications of operating in the sharing economy include: • income is assessable income; • liability to GST if the turnover is $75,000 or greater; • interest relating to property, vehicles or other assets may be deductible in part or in full based on the degree to which the assets are used to earn assessable income; • possible depreciation deductions for depreciating assets or Div 43 write-off of buildings; • partial or complete loss of CGT main residence concessions through renting out part of a home that is designated as a main residence or making paid parking space available on private property; • requirements to register an Australian Business Number (ABN); and • requirements to keep records for tax purposes.
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Crowdfunding activities [8.107] The concept of raising funds from the public for many and varied purposes is by no means a new idea. In 1700s, Jonathon Swift established a process whereby wealthier citizens (the crowd) could provide funds to be lent to the poor in Dublin. However, the development of the Internet has facilitated the rapid growth of this form of fund raising where a project is funded by raising small contributions from a large number of people (contributor –the crowd). The process begins with the initiator (recipient) proposing to raise funds for a specific purpose (eg, to develop a new product). They then engage an Internet-based crowdfunding platforms (intermediary’s such as Mycause and GoFundMe) to promote and collect contributions, and then for a fee or commission pass the collected funds onto the initiator or recipient of the project. Crowdfunding has been used for a number of purposes including raising funds for bushfire and drought relief, business start-ups, technology development and recently, due to changes in government legislation (Corporations Amendment (Crowd- sourced Funding for Proprietary Companies) Act 2018), making it possible for proprietary companies to use crowdfunding for equity raising. The income tax impact on funds raised through crowdfunding will depend on the purpose the funds are raised for and the circumstances of the taxpayer(s) involved. Generally, crowdfunding will either be: • a donation (eg, drought relief); • reward-based (contributor receives goods or services based on the level of contribution); and
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• equity-based (the contributor obtains an interest in a project with rights to returns). For tax purposes, this means that the three parties involved in crowdfunding need to consider the tax implications of their transactions: • Initiator or recipient: Is this part of a business activity or not? • Crowdfunding platform (intermediary): Is this activity a business or are they operating as an agent? • Contributor: Are contributions a tax deduction and any return assessable? Initiator (recipient): Receipts from crowdfunding will be assessable if they are connected to carrying on a business (see [8.20]), or the receipts are an extraordinary or isolated transaction entered into with the intention of making a profit (see [8.170]). However, it is also necessary to consider whether or not the business has commenced at the time the crowdfunding arrangements begins (see [8.110]). If the business has not commenced at this stage, then the receipts will not be ordinary income under s 6-5 of ITAA 1997 unless it is an extraordinary or isolated transaction. Similarly, if the business has not commenced, then any expenses will not be deductible under s 8-1 of ITAA 1997, but it may be possible to obtain a specific deduction under s 40-880 (see [12.130]).
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Consideration also needs to be given to whether the project is of a capital nature as capital receipts are not ordinary income but potentially subject to CGT (see Chapter 11). Capital expenses are also not a general deduction, but some specific deductions may be available (see Chapter 14). Intermediary: If the intermediary is in the business of sourcing crowdfunding projects, promoting the scheme and collecting and distributing funds, then their receipts will be ordinary income from business and expenses will be deductible based on the normal tax deduction provisions (see Chapters 12– 14). Distributions to the initiator of the project will also be deductible as these are an expense (not capital) in carrying on the business (s 8-1 of ITAA 1997). However, if the intermediary acts as an agent (acts on behalf of the initiator) so that the funds received are not the income of the intermediary but simply passed to the initiator, then these funds are not ordinary income as they are not derived by the taxpayer. In this case, the only assessable income would be any commission received for acting as an agent. If the intermediary is a tax- deductible charity, then these receipts will be tax exempt (Div 50 of ITAA 1997) provided the charity does not breach its not-for-profit rules. Contributor: Contributions that are made as a donation to a tax-deductible charity will be tax deductible for amounts of $2 or more (see [13.130]). As
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254 [8.110] PRINCIPLES OF TAXATION LAW 2020 this is a donation, there will no right to receive any return and therefore there cannot be any assessable income. Some crowdfunding projects provide the promise of a return to the contributor depending on the level of contribution. For example, the initiator has designed a new wine preservation device and seeks funds to put the product into production. For a contribution of $100, the contributor is promised one free wine preservation unit (retail value $150) if the crowdfunding is successful and the product is manufactured. If the contributor is a private person, then this arrangement is private in nature and the cost of $100 is not deductible and the receipt of the free product is not assessable. However, if the contribution is entered in the course of the taxpayer’s business, the cost will be deductible and any goods or services provided in return will be assessable as ordinary income. Example 8.2: Taxation of a crowdfunded donation
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A tax-deductible charity raises funds for donation to drought-stricken farmers. The taxpayer making the donation will be entitled to a tax deduction for contributions of $2 or more (see [13.130]). Provided the charity does not breach its not-for-profit rules then the receipt of these donations will not be taxable income of the charity as they are exempt income. If the funds distributed are used for business purposes such as the purchase of farm supplies, stock feed and other deductible expenses, then the receipt will be assessable as ordinary income under the compensation principle (see Chapter 10). However, the use of these funds will also result in an equivalent deduction. The ATO has indicated the where these funds are spent on tax deductible expenses (eg, stock feed), then there will be no net taxable income as the assessable receipt will be offset by the equivalent deduction. If the funds are used for private purposes (eg, food and clothing), then they are not ordinary income as they are a non-assessable gift (see [6.90]).
Crowdfunding used to raise equity would be treated in the same manner as similar financial dealings that are currently undertaken.
Commencement and termination of business [8.110] Once it has been established that there is a business, it may also be necessary to determine whether a business is being “carried on” during the relevant tax period. This makes it necessary to identify the times when the
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business starts and when it ends. Transactions that occur before the business commences or after it has ceased are treated differently for tax purposes to those that occur during the business operation. For example, expenses incurred before the business starts, or after it ends, may not be deductible under the general deduction provision and may only be deductible under a specific provision: see [12.130]–[12.140]. Example 8.3: Preliminary expenses A taxpayer intending to start a new business may incur preliminary costs to explore whether the proposed enterprise has a reasonable chance of success. These costs may include professional advice, market research, feasibility studies, product testing, pilot production research, etc. If the business has not commenced, these expenses will not be deductible under s 8-1 of ITAA 1997, although it may be possible to obtain a deduction under statutory provisions such as s 40-880: see [12.130].
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Ascertaining the time of commencement of a business is a question of fact primarily based on the intention of the taxpayer at the relevant point in time: Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101. For example, product market testing may be undertaken before the start of operation, but it may also be an ongoing activity of the business once it has commenced trading. If product testing is conducted to determine whether there is sufficient demand to warrant commencing a new business, then this would be a preliminary expense and not within the scope of the business. Product testing of a new product line for a firm that already has 50 existing lines would be within the scope of the continuing business. A key question which the courts have used in drawing this line between preliminary expenses and operating expenses is: Has the taxpayer “committed” to commencing the business or merely deciding whether or not to go ahead? Softwood Pulp and Paper Ltd v FCT; Goodman Fielder Wattie Ltd v FCT (1991) 22 ATR 26. Case study 8.11: Feasibility study not a commitment to commence business In Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101, the taxpayer company was incorporated to establish a paper mill for a Canadian company. Following incorporation, Softwood Pulp undertook a feasibility study to ascertain whether the proposed mill would be viable. However, the project never proceeded due to a lack of funds, and the company never made any substantial income.
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The Supreme Court of Victoria found that no business was “carried on” as these expenses were to determine whether the mill was viable and, at this point, there had been no commitment to commence operations. These expenses were incurred before the income- earning activities commenced, and therefore they were not deductible under the law at the time.
Case study 8.12: Business had already commenced while land was being prepared for chestnut farming In FCT v Osborne (1990) 21 ATR 888, the taxpayer leased land for the purpose of planting and growing chestnuts. The taxpayer subsequently entered into a contract to buy chestnut plants and seedlings and also fertilised the soil due to the land having a nitrogen deficiency. However, after a year the taxpayer decided to abandon the chestnut venture because it was not economically feasible. The venture was abandoned before the taxpayer had planted chestnut seedlings or plants. The taxpayer wished to deduct the cost of leasing the land, depreciation on equipment and paying for labour.
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The Full Federal Court held that a business had already commenced when the taxpayer had taken steps to fertilise the land. However, the costs were not deductible for a separate reason in that they were of a capital nature: see Chapter 12 for a discussion on deductibility of capital expenses.
[8.120] Issues regarding the deductibility of preliminary expenses have been the main area of dispute that the courts have considered in relation to the commencement and ending of a business. Nevertheless, the same principle would reasonably apply to income earned prior to commencement, provided that the income did not fall into another category of ordinary or statutory income. Similar principles also apply when businesses cease to operate and are wound-up.
Example 8.4: Commencement of business Michelle has for many years been a very keen seamstress, and she made many of her children’s clothes when they were young. Occasionally Michelle has also made clothes for friends for special events, such as weddings and other formal functions. Twice her friends insisted on
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paying her amounts of about $300 for the clothes even though she never asked for any money. Now that that the family has grown up and left home, Michelle decided to look into renting a small shop and offer her services to do clothing repairs and alterations, as well as make garments to order for special occasions. Michelle’s first step prior to renting a shop was to talk to her accountant to see whether she thought this could be a viable enterprise. She also travelled to the nearest major town to investigate whether there were any other businesses offering similar services. On 1 January, Michelle entered a lease for a small shop and spent money on signs for the window, advertising in the local paper, additional stocks of supplies, a new sewing machine and computer to keep records and help with the design of the garments. On 4 March, Michelle received her first order and business has been quite good ever since.
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Prior to renting the shop, Michelle is clearly not carrying on a business as her sewing is mainly domestic and the small amount of income would be income from a hobby and not ordinary income under s 6- 5 of ITAA 1997. The costs of seeking advice from her accountant and exploring the availability of sewing services are most likely preliminary to commencement of the business as there is no commitment at this point to commence operations: Softwood Pulp and Paper Ltd v FCT (1976) 7 ATR 101: see Case Study [8.11]. Entering the lease agreement is a clear indication that Michelle has made a commitment to start her income- earning activity and is a strong indicator of the commencement of her business, even though no income is derived until some months later.
Step 2: Normal proceeds of a business [8.130] Identifying the factors that distinguish a business from a hobby or recreational activity is the first step in characterising business income as ordinary income under s 6-5 of ITAA 1997. The second step is to determine which receipts are the normal proceeds of the business and which are not. If a receipt is not earned from “carrying on” the usual business of the taxpayer, then it is not within the “normal proceeds” of the business, although it may still be assessable for other reasons: see [8.170]–[8.300]; Californian Copper Syndicate v Harris (1904) 5 TC 159. Characterising a receipt as part of the normal proceeds of the business requires: • an investigation of the nature of the business; and • an assessment as to whether the receipt shows a nexus with the identified business activity.
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Example 8.5: Are receipts normal proceeds of the business? Continuing Example 8.4, the nature of Michelle’s business is her activity as a seamstress, and therefore the normal proceeds of this business will be the earnings related to her seamstress activities. However, if Michelle had negotiated a two-year contract to repair uniforms for a local supermarket, but could not cope with the work and sold the contract to another business, then this receipt is not within the normal proceeds of her business. The nature of Michelle’s business does not include arranging and selling contracts, and therefore the money received from the disposal of this contract does not have a nexus with normal business activity. Consequently, the sale proceeds do not constitute the “normal proceeds” of the business. Although the sale of the contract is not the “normal” proceeds of the business, it may be assessable under other general concepts (FCT v Myer Emporium Ltd (1987) 163 CLR 199: see Case Studies [8.23] and [8.24]) or statutory provisions, such as capital gains tax: see [8.270].
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Nature of the business –broad or narrow approach? [8.140] The question of whether a receipt is the normal proceeds of the business is influenced by whether the court adopts a broad or narrow view of what activities make up the business. If a broad view of the business activities is adopted, it is more likely that unusual receipts could still be treated as business income: Memorex Pty Ltd v FCT (1987) 19 ATR 553; see Case Study [8.15]; GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR 1; see Case Study [8.14]. Conversely, if a narrower view is taken of the nature or the business, it will be less likely that an unusual transaction will be held to be normal proceeds of the business: Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188 (see Case Study [8.16]); FCT v Merv Brown Pty Ltd (1985) 16 ATR 218 (see Case Study [8.13]). Example 8.6: Narrow or broad identification of the nature of the business A narrow approach to the identification of the nature of the business may be to say that a scaffolding hire business is not in the business of selling scaffolding equipment. Therefore, any income from charges made because scaffolding had not been returned is not within the normal proceeds of the business as it is effectively a receipt for the sale of equipment. The narrow approach would be to look at the primary purpose of the business (hiring scaffolding equipment) and conclude that the receipts from the
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disposal of equipment are not from hiring and therefore are not within the scope of this business. Conversely, a broad approach to the identification of the nature of the business could be to say that income from charges made because scaffolding had not been returned is a normal and regular component of the hiring business. Therefore, any receipts resulting from the failure to return equipment would be within the normal proceeds of the business activity.
Australian courts do not explicitly express whether a narrow or broad approach is adopted when establishing the nature of the business. However, case authority suggests that a broader approach is more common, but if a broad approach is used, the courts then require a strong connection between the taxpayer’s core business and the unusual activity to show a nexus with the core business: Memorex Pty Ltd v FCT.
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Case study 8.13: Sale of unwanted import quotas not proceeds of business (narrow approach) In FCT v Merv Brown Pty Ltd (1985) 16 ATR 218, the taxpayer was a clothing importer, but changes to government policy reduced the profitability of some imported lines. As a result, the taxpayer decided to sell the import quotas for these less profitable items. The quotas sold only represented a small percentage of the total number of import quotas held by the taxpayer. The Full Federal Court held that the sale of the quotas was of a capital nature and not within the “normal proceeds” of the business. The majority identified the taxpayer’s business as the purchase and sale of clothing and material (narrow approach), and therefore the sale of the import quotas was not the normal proceeds of this business activity. This decision relied on the fact that the taxpayer did not normally sell quotas and that these sales were a reorganisation of the taxpayer’s business as a result of changes to government policy.
Case study 8.14: Receipts from contract within scope of business (broad approach) In GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR 1, two companies successfully tendered to coat pipes that were to be supplied to the State Electricity Commission of Western Australia (SECWA) for the construction of a natural gas pipeline. A requirement of the tender was
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260 [8.150] PRINCIPLES OF TAXATION LAW 2020
that the pipes be coated in Australia, which necessitated constructing a pipe coating factory. The taxpayer (GP Inter-national Pipecoaters Pty Ltd) was incorporated by the successful tender companies to construct the pipe coating facility and carry out the pipe coating required. SECWA paid the taxpayer a sum of over $5 million to cover some of the cost of constructing the pipe coating factory, and the taxpayer argued that the receipt of the money was capital and not within the scope of the business. The High Court held that the receipt was within the normal proceeds of the business because the money was received as a result of work which was required to be carried out due to successfully winning the tender to coat pipes. A broad approach was used to identify the scope of the business arising out of the successful tender, holding that the business included both the construction of the plant and the coating of the pipes.
Nexus of receipt with business
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[8.150] Having established the nature of the business, the second step is to ascertain whether the receipts in question have a nexus to the business activity and so are the normal proceeds of that business. Case law such as FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218 and Westfield Ltd v FCT (1991) 21 ATR 1398 (see Case Study [8.22]) indicates that receipts will be normal business proceeds when they are a product of: • a transaction that is part of the ordinary business activity, such as a share trader’s receipts from the sale of shares; or • a transaction that is an ordinary incident of the business activities –for example, the sale of ex-lease goods by a leasing company would in some circumstances be business income: see Case Study [8.15]. Some court decisions suggest that an important consideration in this second step is the frequency and magnitude of the activity that generated the receipt: Memorex Pty Ltd v FCT (1987) 19 ATR 553 (see Case Study [8.15]). However, each of the steps in this process is to some degree interrelated. For example, in FCT v Merv Brown Pty Ltd (1985) 16 ATR 218 (see Case Study [8.13]), the sale of the import quotas was held to be outside the normal proceeds of the business. This was because the nature of the business was limited to the sale of imported clothing and material, and the sale of quotas was infrequent and therefore not part of that business. On the other hand, if the sale of quotas was a regular activity, then it may have been included in the nature of the business.
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Case study 8.15: Sale of leased equipment was within the scope of the business
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In Memorex Pty Ltd v FCT (1987) 19 ATR 553, the taxpayer operated a business of selling and leasing computer equipment, as well as providing advice on the design of computer systems. The commercial life of the computer equipment was about five years. Due to the rapid development of the technology, some customers preferred to lease the equipment rather than purchase it outright. Typical lease agreements were two to four years, and at the end of the lease the equipment was either re-leased to the customer, returned or sold to the lessee. Receipts from the sale of the leased equipment were not a major component of the taxpayer’s business, and the taxpayer argued that they were capital in nature and not the normal proceeds of the business. The Full Federal Court held that receipts from the sale of the leased equipment were part of the normal proceeds of the business and were not capital in nature. In reaching this conclusion, the Court identified the nature of the business as selling and leasing of computer equipment and that the receipts from the sale of leased equipment showed a nexus with this core business activity. The nexus was established on the basis that, although these sales were not a major component of the business, they were of sufficient magnitude, frequency and regularity to be judged as a normal incident of the business operations.
Receipts that are the normal proceeds of a business are ordinary income under s 6-5 of ITAA 1997. However, if the receipt is not a normal proceed of the business, it may still be ordinary income as an isolated business transaction (see [8.210]): FCT v Myer Emporium Ltd (1987) 163 CLR 199 (see Case Studies [8.23] and [8.24]).
Non-cash business benefits [8.160] Under general principles, ordinary income does not include receipts that are not cash or convertible to cash: see [5.60]. Consequently, business income will also not include amounts that are non-cash business benefits: FCT v Cooke and Sherden (1980) 10 ATR 696 (see Case Study [5.2]). Following the decision in FCT v Cooke and Sherden, s 21A of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) was enacted with the aim of bringing these non- cash business benefits into the meaning or ordinary income by deeming the benefits as being convertible to cash. Section 21A of ITAA 1936 only applies to non-cash business benefits and not to other categories of income, such as property income or income from personal
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262 [8.160] PRINCIPLES OF TAXATION LAW 2020 services. Section 21A also does not deem non-cash business benefits to be ordinary income for tax purposes; it merely deems non-cash business receipts to be cash convertible and then prescribes a method of valuing the non-cash benefit. The result is that business receipts that are not ordinary income only because they lack cash convertibility are deemed to be cash convertible and therefore will constitute ordinary income. Therefore, before s 21A is applied, it is first necessary to determine if the benefit is truly income in nature as a benefit derived from carrying on a business, disregarding whether it is cash or convertible to cash. Provided the non-cash business benefit has the character of income, then s 21A(1) treats it as convertible to cash and s 21A(2) requires the benefit to be brought to account at its arm’s length value, less any amount that the taxpayer contributed to acquiring the benefit or to the extent that the recipient could have obtained a tax deduction if they had paid for the benefit themselves. To avoid double taxation, s 21A does not apply to non-cash business benefits that are non-deductible for the provider of the benefit (eg, entertainment expenses): s 21A(4). Also, to avoid dealing with very small amounts, s 23L(2) of ITAA 1936 exempts the application of s 21A if the total amount applicable for the tax year is $300 or less.
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Example 8.7: Non-cash business benefit Tan owns and operates a thriving mobile phone business located in a large city shopping centre. To promote its product, one of the mobile phone companies provides Tan with two new top-of-the-range mobiles each year. During the current tax year, Tan received two free mobile phones, each valued at $900. Both of these phones were locked, so that they could only be used on Tan’s account and the SIM cards were also locked so the phone could not be used with a different phone number. Tan kept one phone for his personal use and gave the other to his wife. As the phones cannot be used by anyone else, they cannot be converted to cash and therefore are not ordinary income under s 6- 5 of ITAA 1997: FCT v Cooke and Sherden (1980) 10 ATR 696. However, the benefit is received as an incident of carrying on the business and would be income of the business except for the fact that the phones are not convertible to cash. This satisfies the first requirement of s 21A(2) and (5) and, as a result, s 21A(1) deems the benefit be treated as if it is convertible to cash. Section 21A(2)(a) then brings the benefit to account at its “arm’s length value”, which is defined in s 21A(5) as the amount the taxpayer would have reasonably expected to pay had he or she been dealing at arm’s length. In this example, the arm’s length value will be the usual price of $900 each.
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The next step is to determine whether any of the value is excluded from the application of s 21A. Of the exclusions possible the only one that is relevant is whether Tan could have claimed a deduction had he paid for the phones. Clearly this would not be the case for the phone given to his wife, but Tan may be able to argue that the cost of the phone he used for work could be deductible. If Tan is successful in arguing that the phone he kept would have been deductible, if he acquired it, then he will have assessable income of $900 for his wife’s phone less any cost he may have contributed to the acquisition of the phone provided to his wife.
Extraordinary and isolated transactions Introduction
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[8.170] As discussed at [8.130]–[8.150], receipts of a business that are the normal proceeds of the business will be ordinary income. Transactions that are not within the normal proceeds of the business have generally been labelled by the courts as “extraordinary transactions”: FCT v Myer Emporium Ltd (1987) 163 CLR 199 (see Case Studies [8.23] and [8.24]); Westfield Ltd v FCT (1991) 21 ATR 1398 (see Case Study [8.22]). Extraordinary transactions may give rise to ordinary income or capital, and the remainder of this chapter discusses how the courts have attempted to make this distinction. Courts have also labelled transactions that are one- off in nature and not undertaken by an existing business operation as “isolated transactions”: FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]). Isolated transactions may also give rise, in some instances, to ordinary income and at other times will constitute capital.
Example 8.8: Extraordinary and isolated transactions A bed manufacturer owned five factories and decided to close one of its factories. It arranged to demolish the factory, then extensively developed the land and sold it. This would be an extraordinary transaction because when the taxpayer sells the land, it is in a continuing business of bed manufacturing. Since the proceeds from the development and sale of land are not the normal proceeds of the business, it is an extraordinary transaction. An example of an isolated transaction would be where an employee accountant owns a holiday house in the country on a large piece of land.
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He knocks down the house, extensively develops the land, builds multiple residential units and then sells them. This is an isolated transaction because it is not associated with an existing business. The case law discussed below indicates that proceeds from isolated and extraordinary transactions can generate ordinary income if they fall into at least one of three categories, where the transaction: • forms a business in itself: see [8.180]–[8.200]; • falls under the first strand of FCT v Myer Emporium: see [8.220]–[8.250]; or • falls under the second strand of FCT v Myer Emporium: see [8.260]. These categories are not mutually exclusive, so it is possible for a transaction to fall into more than one category. Taxation Ruling TR 92/3 gives the ATO’s view on this issue, but a tribunal decision held that parts of this ruling are “wrong and should be rewritten”: Case [1999] AATA 66; Case 1/99 (1999) 41 ATR 1117.
Transaction forms a business in itself under the principle in FCT v Whitfords Beach
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Principle applied to isolated transactions [8.180] Case law indicates that if an isolated transaction has sufficient indicators of a business (see [8.20]–[8.100]), then it will generate ordinary income even though it is a one-off transaction. In other words, if an isolated transaction exhibits sufficient characteristics of a business, then profit from it will be considered a form of business income and so will constitute ordinary income. This is more likely to be the case if an isolated transaction involves a sufficient amount of effort, capital and planning. The leading case on this issue is FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]), where the Full High Court held as ordinary income the profits from an extensive land development project undertaken by a company that previously had no other business activities. The difference between an isolated transaction that does or does not produce ordinary income under this principle was described in the English case Californian Copper Syndicate v Harris (1904) 5 TC 159, where the Court made a distinction between: • a “mere realisation” of a capital good made by enhancing its value is characterised as a capital gain; and • a gain made from carrying on a business is characterised as ordinary income.
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Example 8.9: Extensiveness of isolated transaction influences whether it generates ordinary income Jake had been a farmer for many years and retired from farming two years ago, and his land has been unused since his retirement. He has now decided to develop and sell his farm land, so that it can be used for residential purposes. The development was a very minor one and just involved clearing and subdividing the land. This is clearly an isolated transaction as it is a one-off event not undertaken by a continuing business. As the development of the land is relatively minor, the sale will not generate ordinary income. This is because the process of developing and selling the land did not involve much capital and/or effort and could not be said to have sufficient of the characteristics of a business. This will come under the first category of Californian Copper Syndicate v Harris (1904) 5 TC 159 and will constitute a “mere realisation” which is capital in nature.
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Sean is also farmer who, like Jake, became tired of farming. He gave up farming for a few years and left his land unused. He then decided to develop and sell his farm land, so that it can be used for residential purposes. Sean was directly involved in the development and sale of the land. The development was extensive and involved subdividing the land and arranging to have electricity, gas and sewerage supplied to each subdivided lot. It also involved Sean arranging to have roads built on the land. In other words, he developed the land so that each subdivided lot was ready to have a house built on it. Like Jake’s development and sale, this is an isolated transaction. However, since Sean has extensively developed the land before selling it, there is a strong argument that the isolated transaction has generated ordinary income. This is very much influenced by the fact that the development was extensive and required considerable effort and capital. Although the transaction was a one- off isolated transaction, it had enough characteristics of a business to conclude that the profits are ordinary income. This will come under the second category of Californian Copper Syndicate v Harris.
Case study 8.16: Isolated transaction –Proceeds held not to be ordinary income In Scottish Australian Mining Co Ltd v FCT (1950) 81 CLR 188, the taxpayer was originally a mining company which subsequently stopped operating as a miner. The taxpayer then extensively developed one of the pieces of land it had previously used for mining purposes and sold it. The
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development was very extensive and included laying roads and building a railway station. This case was heard in front of a single judge of the High Court, where Williams J held that the proceeds of sale were not ordinary income. Williams J stated that, since the taxpayer was not in the business of land sale, proceeds from the sale were not ordinary income. In the later High Court case FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692, at least two of the three judges that commented on Scottish Australian Mining Co Ltd v FCT (Mason and Wilson JJ) stated or implied that they believed that Scottish Australian Mining Co Ltd v FCT had been wrongly decided. Their reasoning was that, since the development of land was so extensive, it could be argued that the development activities had the characteristics of a business, so that its proceeds would have generated ordinary income. Given what the judges in FCT v Whitfords Beach said about Scottish Australian Mining Co Ltd v FCT, it could be argued that if Scottish Australian Mining Co Ltd v FCT were to be decided today, then the Court would find that the taxpayer generated ordinary income.
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Case study 8.17: Isolated transaction –Proceeds held to be ordinary income In FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692, the taxpayer (Whitfords Beach Pty Ltd) was a company that owned beachfront land. The company’s shareholders were fishermen who had formed the company, so that they could use the company’s land to access their fishing shacks. In other words, the taxpayer company originally owned the land, so that its shareholders could use it for recreational, rather than commercial, purposes. Several years later, the shares in Whitfords Beach Pty Ltd were sold to a property developer. It is important to note that Whitfords Beach Pty Ltd remained the owner of the land, as only the shares in the company were sold to the developer, not the land. The new shareholders changed the Articles of the taxpayer to state that the company’s purpose was to develop land (the Articles of a company were documents of a company that, among other things, stated the purpose of the company –companies incorporated nowadays would have a constitution instead). The taxpayer then extensively developed the land and sold it at a substantial profit. The Full High Court held that the profit from the developed land was ordinary income. Of the three judges who held that the profit only (not the gross receipts) was ordinary income, one (Gibbs CJ) stated that, had the development and sale been undertaken when the company was owned by its original shareholders (who were using the land for recreational
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purposes), the proceeds of the sale would not have generated ordinary income. The other two judges (Mason and Wilson JJ), who held that the sale had generated ordinary income, appeared to have relied on different reasoning to support their finding. Their conclusion was highly influenced by the fact that the development and sale was so extensive that it had the characteristics of a business. Both Mason and Wilson JJ implied that had the development and sale of the land been undertaken by the original shareholders, then the sale would still have generated ordinary income. However, they both indicated that the fact that the company had been bought by developers who changed its Articles strengthened the argument that the sale proceeds generated ordinary income. Given the majority opinion of Mason and Wilson JJ, there is a strong argument that their approach is the one that has set the law.
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Case study 8.18: Farmer who developed and sold farm land did not generate ordinary income In Statham v FCT (1988) 20 ATR 228, the deceased (the taxpayer was the trustee of the deceased’s estate) owned a piece of land on which he both lived and operated a farming business. Because the farm was financially unsuccessful, he had ceased farming and arranged for the local city council to develop the land. This included connecting the land to the electricity grid and constructing roads. The land was also subdivided and finally sold piece by piece through a real estate agent. The Full Federal Court held that the gain was not ordinary income but a “mere realisation”. The Court was influenced by the fact that the deceased had arranged for the council to develop the land, rather than arranging to do so himself. The Court was also influenced by the fact that the deceased used a real estate agent to sell the land and was not in any way directly involved in the sales process. The Court indicated that, had the deceased arranged to develop the land himself (rather than through the council), it would be more likely that the sale would have generated ordinary income.
Case study 8.19: Ex-farmer who extensively developed and sold land generated ordinary income In Stevenson v FCT (1991) 22 ATR 56, the taxpayer was a farmer who had owned land that he had used as a farm for many years. He gave up farming and had the land subdivided and extensively developed. Stevenson was
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in charge of the development and subsequent sale process and the sale of the land took place over a number of years. The Administrative Appeals Tribunal (AAT) held that the sale did generate ordinary income and was not a “mere realisation”. On appeal to the Federal Court (single judge), it was held that the AAT had not made an error in its decision. The Court was influenced by the fact that the taxpayer was the sole decision maker regarding the development process, that he had sought finance for the development and that he had controlled the marketing of the blocks.
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Case study 8.20: Ex-farmer developed land only to extent necessary to gain subdivision Casimaty v FCT (1997) 37 ATR 358 involved a taxpayer who had originally used land for farming, ceased farming and then followed on by subdividing, developing and selling the land. The development mostly consisted of constructing roads, providing water and sewerage facilities to the land and constructing external fencing. The taxpayer had only developed the land to the extent necessary to gain approval to have the land subdivided. The Federal Court (single judge) held that the taxpayer’s sale had amounted to a “mere realisation” and was not ordinary income. However, the Court did say that, had the taxpayer gone further in his development, such as building internal fences or units, then the Court would have been more inclined to find that the taxpayer had generated ordinary income. In other words, the Court’s finding that the profit was capital was influenced by the fact that the taxpayer had not done anything more than the minimum required to get subdivision approval. The Court also stated that it would have been more inclined to find that the taxpayer generated ordinary income had he participated more actively in the selling off the land, rather than leaving the whole sale process up to a real estate agent.
FCT v Whitfords Beach (see Case Study [8.17]) and later cases on the same issue show that there are no strict rules, only guidelines, in deciding whether an isolated transaction has amounted to a “mere realisation” or generates ordinary income. This means that, although in some cases it might be easy to distinguish between a “mere realisation” and a transaction that produces ordinary income, in more borderline cases it is difficult to predict what a court may decide should the case be disputed. However, Case Studies [8.16]– [8.19] do indicate that, at least in the case of land development, a taxpayer who is actively involved in the development and sales process (as opposed
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to delegating those activities) is more likely to fall under the principle in FCT v Whitfords Beach.
Principle applied to extraordinary transactions [8.190] Although the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 has only been applied to isolated transactions, there is an argument that it could also apply to extraordinary transactions. However, this issue has not been tested in court.
Example 8.10: How the principle in FCT v Whitfords Beach might apply to extraordinary transactions
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Bed Pty Ltd is a bed manufacturer that has four factories. It decides to close one of its factories and sell off the associated land. To do this, the company arranges to demolish the factory, subdivide the land and have gas, electricity and sewerage supplied to each piece of subdivided land. This is an extraordinary transaction because proceeds from developing and selling land are not the normal proceeds of a bed manufacturer. However, there is a convincing argument that since the process of developing and selling land was so extensive, Bed Pty Ltd was for that time not only a bed manufacturer, but also a land developer. This analysis leads to the conclusion that the profits from land sale would generate ordinary income. Pillow Pty Ltd also has four factories that it uses to manufacture pillows and it decides to close one of its factories. The company then arranges to demolish the factory, remove the concrete from the factory’s car park and sell the land without further development. This is an extraordinary transaction because the proceeds of selling land are not the normal proceeds of a pillow manufacturer, but this transaction would still not generate ordinary income. This is because developing the land for sale did not have sufficient characteristics of a business to be classed a business in itself.
Calculating ordinary income under the principle in FCT v Whitfords Beach [8.200] For most taxpayers, gross revenue will form assessable income, and deductions will be taken away from this to give taxable income. However, it was mentioned in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]) that for an isolated transaction that falls under the principle of that
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270 [8.210] PRINCIPLES OF TAXATION LAW 2020 case, it is the profit (not the total sales proceeds) that is assessable as ordinary income. This profit is calculated as the sales proceeds less the value of the land at the time the isolated transaction commenced and the costs of developing the land. Example 8.11: Calculation of profit from proceeds of an extraordinary transaction that falls under the principle in FCT v Whitfords Beach Nathan has been a farmer for 20 years. Two years ago his farm was worth $2 million, and at that time he ceased farming and undertook extensive redevelopment of the land. This development cost $4 million and when it was completed he sold the land piece by piece for a total of $11 million. Assuming that this transaction is covered by the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692, Nathan’s assessable income from the development and sale of the land is the profit of $5 million ($11 million –($2 million + $4 million)).
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Two strands of Myer [8.210] The important High Court case of FCT v Myer Emporium Ltd (1987) 163 CLR 199 (see Case Studies [8.23] and [8.24]) shows that the proceeds of an isolated or extraordinary transaction will be ordinary income if the conditions of one of the two approaches followed in the decision are satisfied. The two approaches applied in FCT v Myer Emporium have become known as the “first strand of Myer” and the “second strand of Myer”. These two strands are independent principles relied on by the Court in FCT v Myer Emporium in arriving at its conclusion that the taxpayer had generated ordinary income. For further discussion of: • the first strand of Myer: see [8.220]–[8.250]; • the second strand of Myer: see [8.260]; and • the facts of the case: see Case Studies [8.21] and [8.23].
Case study 8.21: FCT v Myer Emporium In FCT v Myer Emporium Ltd (1987) 163 CLR 199, the taxpayer (Myer) lent $80 million to its subsidiary, Myer Finance. Interest was chargeable on this loan at a commercial interest rate of 12.5% pa. At the time the loan was made, Myer intended to sell the “right to interest” on this loan
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to Citicorp. As planned, three days after Myer lent the money to Myer Finance, Myer sold the “right to interest” on this loan to Citicorp in exchange for Myer receiving a lump sum of approximately $45 million. This meant that Myer was still entitled to be repaid the principal of $80 million from Myer Finance. However, the interest on this loan was now to be paid by Myer Finance to Citicorp. The issue that the Full High Court had to decide was whether the $45 million received by Myer was ordinary income. The Full High Court decided that the proceeds were ordinary income. The reasoning of the Court is not particularly clear, but subsequent cases (see later discussion in this chapter) have interpreted the decision in FCT v Myer Emporium as meaning that the proceeds from an extraordinary or isolated transaction will be ordinary income if it satisfies the requirements of either what have now become known as the first strand or second strand of Myer. In this case, both the first strand of Myer (see Case Study [8.23]) and second strand of Myer (see Case Study [8.26]) were fulfilled, although fulfilling one of them would have been sufficient.
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First strand of Myer [8.220] The first strand of Myer expresses the principle that extraordinary or isolated transactions that satisfy three particular requirements will be ordinary income. The first two requirements originate from the case of FCT v Myer Emporium Ltd (1987) 163 CLR 199. The third requirement, although originally implied in FCT v Myer Emporium, was stated more explicitly in the case of Westfield Ltd v FCT (1991) 21 ATR 1398 (see Case Study [8.22]). The three requirements are: 1 There was a business operation or commercial transaction: see [8.230]. 2 There was a profit-making intention upon entering the transaction: see [8.240]. 3 The profit was made by means consistent with the original intention: see [8.250]. [8.230] Profit resulted from “business operation or commercial transaction”. If the relevant transaction is an extraordinary transaction, then the first requirement will be automatically fulfilled. As explained at [8.130]–[8.150], an extraordinary transaction occurs when a business undertakes a transaction that generates proceeds which are not the normal proceeds of that business. As an extraordinary transaction is undertaken by a business, the first requirement of a “business operation or commercial transaction” will always be satisfied.
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272 [8.240] PRINCIPLES OF TAXATION LAW 2020 With an isolated transaction, the first requirement of there being a “business operation or commercial transaction” will not automatically be satisfied. An isolated transaction occurs where there is a one-off transaction without a continuing business operation: see [8.180]. This means that an isolated transaction will only fulfil the first requirement if there is a “commercial transaction”. Unfortunately, there is little case law that explains what exactly is meant by the term “commercial transaction”. However, Ruling TR 92/3 gives a few examples of what the Commissioner believes is a “commercial transaction”, though it does not mention what case law the examples are based on. According to the ruling, a taxpayer who buys and resells $100,000 of gold bars in a short time is undertaking a commercial transaction. On the other hand, the ruling states that a taxpayer who purchases an investment property to earn rent and later sells it is not regarded as undertaking a commercial transaction.
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Although there is limited guidance as to when an isolated transaction will be considered a “commercial transaction”, this condition is more likely to be satisfied when the transaction concerned is entrepreneurial in nature, but it is less likely to be fulfilled if the transaction is of the type that a typical salary earner might enter into. Greig v FCT [2018] FCA 1084 (subject to appeal to the full Federal Court) highlights the uncertainty regarding whether the first strand of Myer requires that the taxpayer is carrying on a business. Although the Myer decision has primarily been applied to income, in this case the taxpayer argued that it applies to deductions. The taxpayer claimed a tax deduction under s 8-1(1)(b) for losses of $11.85 million realised on the sale of shares rather than treating the losses as a capital loss for CGT. He argued that the losses were revenue losses on the basis that they were incurred as a commercial transaction as was the case in Myer. Justice Thawley disagreed and held that the taxpayer was not in the business of dealing in shares and that the hope of a profit was not sufficient to make it a business or commercial transaction for the purposes of Myer. Depending on the appeal, this decision gives stronger authority that for Myer to apply the taxpayer must be in business. [8.240] Profit-making intention upon entering the transaction. The second requirement of the first strand of Myer is that the taxpayer had a profit-making intention upon “entering the transaction”. This profit-making intention need not be the taxpayer’s sole or dominant intention: FCT v Cooling (1990) 21 ATR 13 (see Case Study [8.24]). Many extraordinary or isolated transactions involve selling assets and, where a profit is realised, the time of “entering the transaction” will be when the asset was purchased. In other words, if the taxpayer did not have a profit-making intention when buying the asset, but had a profit-making intention only when selling it, the second requirement of the first strand of Myer would not be
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satisfied. In reality, there will often be a lack of clear evidence as to what a taxpayer’s intention was at the time of entering into the transaction. In August v FCT [2013] FCAFC 85, the Full Federal Court dismissed the taxpayer’s appeal from a single judge of the Federal Court and confirmed the decision that the gains made following the purchase, leasing and sale of several commercial shopping centres were ordinary income. This was despite the fact that these properties had been owned and leased for up to seven years. Central to this decision was that the facts showed there was an initial intention to purchase, develop, lease and then sell the shopping centres as long-term tenanted properties. The initial intention to profit via sale was critical to this decision even though the properties were leased to earn income for some time before sale. [8.250] Profit made by means consistent with original intention. For the first strand of Myer to be fulfilled, the way the profit is eventually made must be consistent with the original profit-making intention of the taxpayer upon entering the transaction: Westfield Ltd v FCT (1991) 21 ATR 1398. If the taxpayer has more than one intention upon entering the transaction, the way the profit was made need only be consistent with one of those intentions: August v FCT [2013] FCAFC 85.
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Case study 8.22: First strand of Myer not satisfied as the profit realised was inconsistent with the original intention In Westfield Ltd v FCT (1991) 21 ATR 1398, the taxpayer (Westfield) was in the business of designing, constructing and operating shopping centres. Westfield purchased a piece of land with the intention of jointly developing a shopping centre on the land with Australian Mutual Provident (AMP) Society. At the time of purchase, the taxpayer knew there was a possibility that it might end up selling the land to AMP Society rather than developing a shopping centre, but selling it was not its original intention. Eventually the taxpayer did sell the land to AMP Society rather than developing a shopping centre. The Full Federal Court held that the proceeds from sale were not ordinary income. It found that the transaction was an extraordinary transaction as the proceeds of the sale were not the normal proceeds of the taxpayer’s business, and these proceeds would be ordinary income if the requirements of the first strand of Myer were satisfied. However, the way the taxpayer made the profit (resale) was not consistent with the original profit-making intention (developing a shopping centre with AMP Society). The fact that at the time of purchase the taxpayer knew of the possibility of resale was not the same as the taxpayer having an intention to profit from resale. As a result, the first strand of Myer did not apply, and the sale proceeds were not ordinary income.
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Case study 8.23: The case of Myer The facts of FCT v Myer Emporium Ltd (1987) 163 CLR 199 are described in Case Study [8.21]. As discussed in Case Study [8.21], both the first and second strands of Myer were satisfied on the facts of this case. Specifically, the first strand of Myer was fulfilled because the taxpayer was running a business operation, had a profit-making intention upon entering the transaction (when it lent the money it intended to sell the right to interest a few days later) and the profit was eventually realised as initially intended.
Case study 8.24: Lease incentive falls under the first strand of Myer
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In FCT v Cooling (1990) 21 ATR 13, the taxpayer was a partner in a Brisbane law firm which wished to move premises. Upon signing the lease for the new premises, the landlord paid a lease incentive of which Cooling received a share. A lease incentive is when the landlord gives the lessee money as an inducement to enter into the lease. At that time it was common in Brisbane for lease incentives to be paid upon a commercial lessee entering into a long-term commercial lease because there was an excess of office space available for lease and it was difficult for landlords to attract a tenant. The Full Federal Court held that the lease incentive was ordinary income. The Court appeared to be of the view that the incentive was ordinary income because moving premises from time to time was in the ordinary course of the taxpayer’s business, which meant that the proceeds were the normal proceeds of the taxpayer’s business. In addition, the Court went on to say that, even if the proceeds of the transaction were not considered to be the normal proceeds, they would still be ordinary income due to the satisfaction of the requirements of the first strand of Myer. The Court noted that one of the purposes that the taxpayer had when entering the new lease was to make a profit from receiving the lease incentive. Although this was not its dominant intention, it was still one of its “not insignificant” purposes of entering into the lease.
Example 8.12: First strand of Myer applies to extraordinary transaction A television manufacturer owned three factories, and it purchased a vacant piece of land because it believed that the land would rise in value and could be sold in the future for a profit. Three years later, it sold the land at a profit without using the land in the meantime.
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This is likely to be considered an extraordinary transaction as income from speculating in real estate does not constitute the normal proceeds for a television manufacturer. Although it is an extraordinary transaction, it will be ordinary income as it satisfies the first strand of Myer. This is because:
• there was a business operation: the taxpayer is in the business of manufacturing TVs;
• there was a profit- making intention at the time the land was purchased: the land was purchased because the taxpayer believed it could later be sold for a profit; and • the way the profit was eventually realised was through selling the land. This is consistent with how the taxpayer intended to profit when entering the transaction, that is, when the taxpayer purchased the land.
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Case study 8.25: First strand of Myer applied to an Isolated Transaction In McCurry v FCT (1998) 39 ATR 121, the taxpayers were two brothers who in 1986 purchased a block of land with a run-down house on it. They obtained permission for and built three townhouses on the land. During May 1987, the taxpayers advertised the townhouses for sale but were unable to sell them. Subsequently, in June 1987, attempts to sell were put on hold, and the brothers and their families used two of the townhouses as their private residence as their family had purchased a nearby news agency. The third townhouse was also used by them for private purposes. After living in the townhouses for some time, they were again advertised for sale in July 1988 and subsequently sold in December 1988 for a substantial profit. Justice Davies from the Federal Court held that the profit was assessable as ordinary income. In substance he applied the principle in the first strand of Myer. One of the requirements for the first strand of Myer was that the profit must have resulted from either a business or a commercial transaction. As the taxpayers had no continuing business, the issue was whether the activity was commercial in nature. His Honour found that the venture, which involved purchasing the house and land, demolishing the house and building three townhouses, combined with the profit-making purpose, was commercial in character. However, his Honour did not appear to find that all the characteristics of the venture needed to be commercial, but
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rather that their presence in some aspects of this case clearly showed that it was a commercial activity. Furthermore, his Honour found that the taxpayers had an intention to profit from building and selling the townhouses when they initially purchased the land. This decision was reached despite the fact that the taxpayers claimed that at the time of purchase, they were unsure whether they intended to rent or sell the new townhouses. However, the Court found that this claim was not supported by the evidence. For instance, the evidence indicated that the brothers had never made inquiries as to how much rent they could collect on the townhouses. Consequently, the Court concluded that while the possibility of renting the townhouses did enter the minds of the brothers at the time of purchase, their dominant intention at this time had been to profit from selling the townhouses. Justice Davies also found the profit was made in a manner that was consistent with the taxpayers’ original intention when purchasing the land. This was despite the fact that the taxpayers had argued that the original profit-making venture was abandoned. The taxpayers’ argument was based on the fact that their first attempt to sell the properties failed, so they used them for private purposes, and only then re-advertised and sold them over a year later. However, his Honour found that the facts did not support the finding that the taxpayers’ original profit-making plan was abandoned. Rather, their initial plans had been temporarily interrupted.
Second strand of Myer [8.260] The Court in FCT v Myer Emporium Ltd (1987) 163 CLR 199 established that one of the reasons the proceeds in that case were ordinary income was due to what is now known as the “first strand of Myer”: see [8.220]–[8.250]. However, the Court also identified a second reason for the proceeds being ordinary income. This second reason has become known as the “second strand of Myer”. The second strand of Myer expresses the principle that the proceeds from a transaction will be ordinary income if the taxpayer sells the right to income from an asset without selling the underlying asset. This is an application of the compensation principle, where compensation for loss of income is deemed to be ordinary income: see [10.20]. Unlike the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 (see Case Study [8.17]) and the first strand of Myer, the second strand of Myer potentially only applies to a very narrow set of circumstances.
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Case study 8.26: Second strand of Myer The facts of FCT v Myer Emporium Ltd (1987) 163 CLR 199 are described in Case Study [8.21]. The second reason the Court held that the sale of the right to interest was ordinary income has become known as the “second strand of Myer”. The taxpayer sold the right to income while keeping ownership of the underlying property. Specifically, Myer sold the right to interest on the loan (the right to receive income that would have been ordinary income) and retained the underlying property (the right to be repaid). If Myer had continued to receive the interest from its loan, it would have clearly been ordinary income: see [9.20]. Therefore, by applying the second strand of Myer, the Court concluded that selling the right to receive an income stream for a lump sum will not change its nature as ordinary income. Even though the right to interest was received as a lump sum, it was still ordinary income as the payment was compensation for the loss of an income stream (the interest).
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Case study 8.27: Application of second strand of Myer In Henry Jones (IXL) Ltd v FCT (1991) 22 ATR 328, the taxpayer owned trademarks of certain brands of canned fruits. The taxpayer’s subsidiary manufactured and sold canned fruits, using the trademarks owned by the taxpayer. The taxpayer decided that the canned fruit business run by its subsidiary was not meeting profit targets and decided to sell the whole canned fruit business. However, the taxpayer did not proceed with the sale, but rather entered into an agreement with two other canned fruit producers (SPC and Ardmona) which gave them exclusive use of the taxpayer’s trademarks for ten years (the trademarks themselves were not transferred). In exchange, SPC and Ardmona were to pay the taxpayer royalties of 5% of the net sales of products that used the trademarks in question (subject to a minimum payment). A few months later, the taxpayer sold the right to these royalties to a third party in exchange for a lump sum of approximately $7.5 million. When the taxpayer entered into its initial royalty agreement with SPC and Ardmona, it had intended to sell the royalty agreement for a lump sum of $7.5 million. The Full Federal Court held that the first strand of Myer did not apply, but the second strand of Myer did and, as a result, the $7.5 million was found to be ordinary income. The Court based its reasoning on the view that the taxpayer did not have a profit-making intention of selling the rights to the royalties at the time of entering into the royalty contract. While it was true
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that at the time of entering the royalty agreement the taxpayer intended to sell rights under the agreement for $7.5 million, on the current facts, this did not constitute a profit- making intention. The Court appeared to state that this was because the intention of the taxpayer in entering this agreement was to dispose of its canned fruit business in the form of getting of a lump sum receipt and therefore the first strand of Myer did not apply. However, the second strand of Myer did apply because the taxpayer sold the right to what would be ordinary income for a lump sum, while retaining the underlying property. Henry Jones (IXL) disposed of its right to income (the royalties), but kept the underlying property (the trademark) and therefore the proceeds from the sale constituted ordinary income.
Statutory provisions that may apply to extraordinary and isolated transactions
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[8.265] Income from business activities may be assessable as ordinary income under s 6-5 of ITAA 1997 or as statutory income via s 6-10 of ITAA 1997. However, regardless of whether an amount is likely to be ordinary income, it is still necessary to consider whether any statutory provisions specifically apply to the receipt. This is important because some statutory provisions apply different tax rates, as is the case with capital gains which are taxed differently to ordinary income. If a receipt is both ordinary and statutory income under the Act, s 6-2 5 of ITAA 1997 states that it is included in assessable income only once and it will normally be taxed under the statutory provision rather than as ordinary income. The exception to this rule occurs if the statutory provision states that it only applies if the amount is not ordinary income: see [3.80]. For example, s 15-20 deems certain royalties to be assessable income but also states that the section does not apply if the royalty is ordinary income under s 6-5: s 15-20(2). The following discussion covers some of the more common statutory provisions that apply to receipts from business activities.
Capital gains tax [8.270] Extraordinary and isolated transactions that do not produce ordinary income and involve an asset acquired after 19 September 1985 will often be subject to capital gains tax (CGT). As explained in Chapter 11, gains that are
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subject to CGT may incur less tax than gains that are taxed under s 6-5 of ITAA 1997 as ordinary income. Consequently, it is important to be able to ascertain whether or not gains from extraordinary/isolated transactions are ordinary income or capital.
Section 15-10: Bounties and subsidies [8.280] Section 15- 10 of ITAA 1997 states that bounties and subsidies received in relation to carrying on a business are assessable as statutory income. A bounty or subsidy is a payment from the government in order to assist the recipient in carrying on its business. However, s 15-10 does not apply to gains that are ordinary income: s 15-10(b).
Example 8.13: Government subsidy –Assessability as statutory income A car manufacturer receives a government subsidy for every car it makes. These payments are ordinary income as they would be regarded as normal proceeds of the business. As the receipts are ordinary income, they would not be assessable under s 15-10 of ITAA 1997.
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Another car manufacturer receives a government subsidy to purchase new machinery for its existing factory. This receipt is not ordinary income as it would not be regarded as normal proceeds of the business and is not covered by the principal in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 or either of the strands of Myer. However, this receipt would be assessable under s 15-10 as being a bounty or subsidy received in relation to the business.
Section 15-15: Profit-making undertaking or plan [8.290] Section 15-15 of ITAA 1997 states that the profits from a profit-making undertaking or plan are assessable and so will constitute statutory income. However, s 15-15 does not apply to: • gains that are ordinary income (s 15-15(2)(a)); or • gains that involve assets purchased on or after 20 September 1985 (s 15-15(2)(b)). A profit-making undertaking or plan for the purposes of s 15-15 is a course of conduct that produces a profit and involves something more complex than the taxpayer simply buying and then selling property or outlaying money in the hope of making a return: Steinberg v FCT (1975) 5 ATR 565; Clowes v FCT (1954) 91 CLR 209.
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280 [8.300] PRINCIPLES OF TAXATION LAW 2020 In practical terms, s 15-15 will seldom apply because transactions that potentially are a profit-making undertaking or plan will often be ordinary income due to FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 and so will not be covered by s 15-15. The section also has limited application since it only applies to assets purchased before the introduction of CGT. Example 8.14: Section 15-15 –Difficulty of application In 1984, Jell Pty Ltd, a manufacturer of doors, purchased vacant land as an investment which it sells in the current tax year. This would not be assessable under s 15-15 of ITAA 1997 because it is a mere “buy and sell” and so would not constitute a profit-making undertaking or plan. Jack farms land that he purchased in 1983. He is tired of farming, so he subdivides the farm land, installs amenities on it and then builds roads and townhouses on the subdivided land. Jack then sells the subdivided lots one by one. Although this is a profit-making undertaking or plan, it is unlikely to be assessable under s 15-15. This is because the profit from this transaction is likely to be ordinary income under the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 and s 15-15 does not apply to gains that are ordinary income.
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Section 25A: Profit from sale of asset acquired with the purpose of resale [8.300] Section 25A of ITAA 1936 makes assessable certain profits from selling an asset that was initially acquired for the purpose of resale. However, s 25A will seldom apply because of the following limitations: • it only applies to assets purchased prior to 20 September 1985 (s 25(1A)); and • it only applies where the intention to profit by resale that existed at the time of purchase was the sole or dominant purpose of the taxpayer: Eisner v FCT (1971) 2 ATR 3.
Example 8.15: Profit from asset acquired with purpose of resale and subsequently assessable under s 25A Alan purchased vacant land in 1983 with the sole purpose of reselling it at a profit. He sells it in the current tax year and realises a profit of $500,000. This profit will be assessable under s 25A of ITAA 1936 because
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it was made from selling an asset that was purchased with the purpose of making a profit by reselling it. For property purchased before 20 September 1985, it will become more and more difficult to establish that there was, at the time of the purchase, a profit-making intent through resale. This is because, as time passes, it will become more difficult to elicit evidence and also the longer property is held, the more likely it was held for some other purpose than simply resale at a profit.
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Questions [8.310] 8.1 After entering into a management agreement two years ago for the purpose of starting a business in cattle breeding next year, Georgina paid $5,250 by cheque to ACM, whose business was transferring embryos from stud cows to ordinary breeding cows. Under the agreement she was guaranteed six calves in the next two years. If the venture failed, ACM remained liable to supply the calves from another source. Having paid her fees for Year 2, she did not receive any subsequent notification that the implants in her recipient cows were successful. She did not follow up after the implantation notices to find out whether any of her cows were pregnant. Nor did she enquire whether her cows had been implanted a second time as contemplated by the terms of the Management Agreement, which provided that each recipient cow would be implanted once in each of the 12-month contractual periods. She said that she had spoken to her accountant who told her things were progressing, but slower than anticipated. After paying her Year 2 Fees in June, Georgina heard nothing specific from ACM except by way of newsletters containing general information. She made no attempt to contact ACM in the current year about extending the lease on her recipient cows. She said she was going through a very difficult time. Her 12-month-old child had contracted a serious illness and she had to focus on looking after him. Is Georgina carrying on business? 8.2 Axis Holdings Ltd was founded eight years ago by Lucas and Tait, who were the initial shareholders and directors. Lucas and Tait had for many years been involved in property development. Seven years ago, Axis purchased two properties in an area where there was extensive real estate development. For six years, the properties were used for cattle breeding and the properties were improved for that purpose.
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282 [8.310] PRINCIPLES OF TAXATION LAW 2020 Owing to unforeseen circumstances, the cattle breeding proved to be unprofitable and there was an imminent zoning change whereby the properties could only be disposed of in 100-hectare lots instead of 25-hectare lots. Axis therefore arranged to subdivide the land up into 25-hectare blocks and sold the whole property to one purchaser. The Commissioner assessed Axis on the gross receipts in s 6-5 of ITAA 1997. Discuss. 8.3 Peter is a farmer with 15 hectares of land on which he has grown oranges since 1970. He inherited the land from his father in that year. The farm has gradually been surrounded by urban development and, three years ago, following complaints from neighbours about pesticides, he decided to sell the land. Two years ago, Peter contracted with a consulting engineer and surveyor who prepared a subdivision plan and who applied to the local council for rezoning. Peter was not directly involved in the plan or the rezoning, which was granted by the council later that year. Nearly all expenses were paid by Peter, although he had to borrow $120,000 to cover some incidental expenses. Following completion of the development, the land went on sale through a real estate firm and to date 150 of the 200 blocks have now been sold for residential housing. Blocks sell for an average of $150,000 each.
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Advise Peter as to his tax liability, if any. 8.4 Five years ago, Bruce purchases 10 hectares of land for $1 million in an area that was ripe for subdivision. At the time of purchase he intended to get planning permission from the local council to develop the land by subdivision and then resell it at a profit, but instead he leased it for grazing horses. Three years ago, Bruce attempted to get planning permission to subdivide his 10 hectares, but it proved very difficult, and finally in March of the current tax year the local council refused permission to subdivide. Bruce reluctantly sold the land in May for $3 million. What are the tax consequences of Bruce’s sale? 8.5 Two years ago, Peta purchased a house in Kew. This house had two old tennis courts down the back which were in poor condition. She purchased the property for two reasons: • so that she and her family could live in the house; and • so that she could build three units on the tennis courts and sell them at a profit. In the current tax year, the tennis club next door offered to buy the old tennis courts, but only if Peta first restored them to good condition.
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Peta decided to accept the club’s offer instead of going ahead with her plan to build and sell units. Peta spent $100,000 on preparing the tennis courts for sale. This involved a great deal of work. Peta had to resurface the tennis courts and build new fences around them. She then sold the tennis courts in the current tax year to the tennis club for $600,000. Ignoring capital gains tax, discuss whether the receipt of $600,000 is ordinary income under s 6-5. 8.6 Mrs Jones is the owner of a large racehorse stud and horse training business. She employs eight staff and holds a training licence. Mrs Jones’ involvement in the racing business is her full-time occupation and she attends as many race meetings as possible (over one per week). Mrs Jones is also a very keen punter, betting on both her own and other horses, and during the last year she had several very big wins which netted her $120,000 in winnings for the year. Discuss whether the receipt of $120,000 is ordinary income under s 6-5. 8.7 Pierre has operated his market garden business in Queensland for the last 25 years. During recent flooding, his total crop was destroyed along with most of his buildings, irrigation equipment and fencing. As a result of this flood, Pierre received a payment from the Government of $300,000 to purchase new green houses for raising seedlings so he can get back into business more quickly. He also received a payment from the Government of $50,000 to dispose of damaged crops. 8.8 New Coal Pty Ltd (New Coal) is a large coal mining company with several large coal mines in Australia. During the current tax year, New Coal employed a consulting firm to investigate the feasibility of the company constructing and operating a coal fired power station. New Coal has never operated a power station in the past. Discuss whether the proposal to investigate the viability of the power station is a separate business for tax purposes or would it be within the scope of the existing coal mining business? 8.9 Kerryn works full time as an employee accountant. She loves to sing and regularly records songs she wrote herself and posts them on YouTube. For the last three years she would on average spend approximately 20 hours a week on this activity. Because her cousin Joel owned a recording studio, she was able to use his recording facilities for free. Occasionally Kerryn would dream that one day she would be discovered as a star and could make enough money to retire from her job, though in reality Kerryn told herself that this was unlikely to happen. On average, Kerryn would post a new song on YouTube every two weeks.
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Since Kerryn found quite a following (some of her songs had over 100,000 hits), in an attempt to profit from her new found fame, she auctioned some of her old clothes and jewellery online (that she had bought many years ago) and manages to sell them for $8,000. Advise Kerryn on whether the $8,000 would constitute ordinary income.
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9 Income from property
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Key points...................................................................................................... [9.00] Introduction.................................................................................................. [9.10] Interest��������������������������������������������������������������������������������������������������������� [9.20] Discounts and premiums....................................................................... [9.30] Timing of interest receipts......................................................................... [9.50] Division 16E, s 26BB and s 70B of ITAA 1936........................................... [9.60] Taxation of financial arrangements –Div 230 of ITAA 1997....................................................................................... [9.70] Interest and compensation.................................................................... [9.80] Interest relating to compensation for damages for property......................................................................................... [9.90] Interest relating to compensation for damages for personal injury............................................................................ [9.100] Section 51-57: Exemption of post-judgment interest on personal injury compensation.................................................... [9.110] Interest compensation and CGT.............................................................. [9.120] Section 15-35: Interest on overpayment and early payment of tax.................................................................................. [9.130] Interest portion of instalment payments............................................. [9.140] Dividends..................................................................................................... [9.150] Rental and lease income............................................................................ [9.160] Rent....................................................................................................... [9.160] Lease premiums................................................................................... [9.170]
Section 15-25 –Amount received for lease obligation to repair......................................................................................... [9.180] Royalties...................................................................................................... [9.190] Introduction.......................................................................................... [9.190] Assessability of royalties..................................................................... [9.200] Annuities..................................................................................................... [9.210] Questions..................................................................................................... [9.220]
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Key points [9.00] • Property income is an application of the “flow” concept of ordinary income. • Interest is usually ordinary income as it flows from the lending/ investment of capital. • Payments on loans to compensate for increased risk of non-repayment may not be interest. • Loan discounts and premiums may alter the timing of taxable income. • The timing for tax purposes of gains on financial instruments is subject to legislation under Div 16E, s 26BB and s 70B of ITAA 1936 and Div 230 of ITAA 1997. • Interest paid as a part of compensation payments is treated differently for taxation purposes depending on whether it is paid for the loss of property or as damages for personal injury. • In Australia, the courts have been reluctant to carve out interest from capital payments unless it is clearly identifiable. • Dividends are ordinary income, but they are specifically made assessable as statutory income under s 44 of ITAA 1936. • Division 974 of ITAA 1997 provides rules for distinguishing payments of dividends from payments of interest. • Rent is ordinary income even when received as a one-off lump sum. • Lease premiums are capital unless the taxpayer is in the business of receiving premiums or the premium is a substitute for rent. • Royalties include payments that are calculated based on the usage of intellectual property. Royalties can also be payments based on the quantity/value resources taken from a taxpayer. • Most royalties are ordinary income and those that are not are assessable under s 15-20 of ITAA 1997.
Introduction [9.10] Chapter 5 outlined the essential characteristics of income that have been developed by the courts, one of which is the notion that income “flows” from capital. As a result, receipts such as interest, rent, royalties and dividends that “flow” from the passive ownership of capital investments will be ordinary income under s 6-5 of ITAA 1997. Following the “fruit and tree” analysis (see [5.10]), these receipts are generated from capital without the capital being diminished in any way. For example, interest flows from fixed- term investments, rent flows from the ownership of property, dividends flow from investments in shares and royalties flow from intellectual property, such as copyright.
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Income earned from the passive ownership of capital is generally known as property income, but this is not to be confused with the gains realised on the sale of the property itself. Taxation of the gains from the sale of the property itself may be assessable as business income, subject to capital gains tax or other relevant statutory provisions. Property income is a class of ordinary income, but certain forms of property income may also be specifically deemed assessable as statutory income. It is important to distinguish whether property income is ordinary or statutory income because this may influence the amount that is assessable and/or the tax due. If a receipt is both ordinary and statutory income under the Act, s 6-25 of ITAA 1997 states that it is included in assessable income only once and it will normally be taxed under the statutory provision rather than as ordinary income. The exception to this rule occurs if the statutory provision states that it only applies if the amount is not ordinary income: see [3.80]. For example, s 15-20 deems certain royalties to be assessable income but also states (s 15-20(2)) that the section does not apply if the royalty is ordinary income under s 6-5. In this chapter, the main areas of property income are discussed as ordinary or statutory income under the following headings: • interest: see [9.20]–[9.140]; • dividends: see [9.150]; • rental and lease income: see [9.160]–[9.180]; • royalties: see [9.190]–[9.200];
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• annuities: see [9.210]. Figure 9.1: Overall guide Income from property
Interest
Dividends
Rent and lease income
Royalties
Annuities
s 6–5
s 6–5
s 6–5
s 6–5
s 6–5
Div 16E, s 26BB, s 70B ITAA 36
s 44 ITAA 36
S 15–25 ITAA 97
S 15–20 ITAA 97
s 27H ITAA 36
Div 230, s 15–35, s 51–57 ITAA 97
Div 974 ITAA 97
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Interest [9.20] Most people understand the common use of the term “interest” to mean the cost of borrowed funds or the return from fixed-term investments, such as bank term deposits or debentures. In this form, receipts of interest provide a clear example of income from property which is therefore ordinary income and assessable under s 6-5 of ITAA 1997: Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671 (see Case Study [9.1]). However, the term “interest” is not specifically defined in the tax legislation and therefore it is necessary to rely on case authority for a definition. In Riches v Westminster Bank Ltd [1947] AC 390 at 400, interest is described as “a payment which becomes due because the creditor has not had his money at the due date”. Interest therefore is the return that flows from the lending of money and is the compensation for the loss of use of that money. The capital sum lent is not affected by the payment of interest providing a clear application of the “flow” concept of income. Although interest in its normal form is ordinary income, there are some specific statutory provisions which impact on the taxation of interest. In addition, there are issues relating to the timing of its assessability and whether it may in some circumstances be treated as capital.
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Discounts and premiums [9.30] Commercial rates of interest are relatively easy to establish for various types of lending, but these rates are substantially influenced by the degree of risk associated with the debt. Lenders may increase the standard interest rate to account for the increased risk of non-repayment or they may retain the standard rate of interest and negotiate a discount or premium on the debt. A discounted loan is one where the amount provided to the borrower is less than the amount of the loan. A loan premium is one where the borrower has to repay more than the amount advanced by the lender. Example 9.1: Loan discounts and premiums Loan discount XYZ Pty Ltd arranges a loan of $1 million (notional principal) for one year to finance the development of a new production process. This loan is an interest-only loan and the interest rate is well below that expected for similar loans. The principal of $1 million is to be repaid in full at the end of the one-year term. However, the lender advances only $900,000 to XYZ Pty Ltd, not the full $1 million, but the loan agreement states that the full $1 million has to be repaid. The $100,000 difference between the amount advanced and the amount repaid is known as the “discount”.
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Note that interest will still be paid on the $1 million even though only $900,000 is advanced to the borrower. Loan premium ABC Pty Ltd arranges a loan of $900,000 (notional principal) for one year to finance the development of a new production process. This is an interest-only loan and the interest rate is well below the rate that might be expected for similar loans. However, at the end of the loan, ABC Pty Ltd is required to repay $1 million, consisting of the $900,000 debt plus a “premium” of $100,000. In this case, the annual interest will still be based on the $900,000 borrowed.
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Difference between discounts and premiums The difference between a loan discount and premium is very subtle and may best be understood by comparing the two notional principals for each of the arrangements above. With the discount arrangement, the notional principal is $1 million with a discount of $100,000, which means that only $900,000 is received by the borrower. On the other hand, with the loan premium, the notional principal is $900,000 and the borrower has to pay an additional premium of $100,000 on maturity of the debt giving a total repayment of $1 million. The other important difference is that for the loan discount, interest is levied on the principal of $1 million, but on the loan premium, the interest is only charged on the $900,000 advance.
It may appear from Example 9.1 that loan premiums and discounts are no more than different terms for the same arrangement, that is, paying back a larger amount than the amount received. In addition, the discount or premium could be simply seen as a substitute for interest. However, these types of financial arrangements have also been developed to alter the timing of assessable income and as an attempt to characterise the discount or premium as capital rather than ordinary income: Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671.
Case study 9.1: Interest or compensation for risk In Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671 (an English case), the English taxpayer lent money to an associated Finnish company just before the outbreak of World War II. The taxpayer was not in the business of lending money, but determined that there was a high level of risk associated with this loan. As a result, the taxpayer required a much higher rate of return than would normally be accepted, but this was not achieved by charging a higher-than-usual interest rate. In fact, the stated interest rate was comparable to normal commercial lending. The additional risk
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of non-repayment was catered for by the borrower being required to pay both a premium and a discount on the debt. The House of Lords accepted the argument by the taxpayer that the benefits received as a result of the discount and premium were capital in nature and not interest. The Court appears to have taken into account in this decision the facts that a commercial rate of interest was charged and that the taxpayer was not in the business of lending money. [9.40] The importance of the decision in Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671 is that it shows that there is a distinction between interest which is ordinary income and a capital return that results from an allowance for risk. However, this case is also important as it is often cited as authority for the principle that if the discount is simply a replacement for interest, then it will be ordinary income. This same conclusion would be reached via the application of the first strand of Myer: see [8.220].
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Case study 9.2: Gain on a discounted security was ordinary income In FCT v Hurley Holdings (NSW) Pty Ltd (1989) 20 ATR 1293, the taxpayer’s main business was investing in the hotel industry. The company had realised some of its investments so that they could be held in a more liquid form until the managing director’s son took control of the company. As part of this process, the taxpayer purchased a discounted bill for $442,200 with a face value of $500,000 and a maturity date of just over one year. No actual interest was paid on this investment, but on maturity, the value of the investment had increased by $57,800, which is a notional return of 13% on the original investment of $442,200. The Commissioner assessed the $57,800 as ordinary income, but the taxpayer argued that it was capital. The Federal Court held that the gain made on the realisation of the investment was ordinary income. In reaching this conclusion, Gummow J distinguished the facts in this case from Lomax v Peter Dixon & Son Ltd [1943] 1 KB 671. The basis of this distinction was because Hurley Holdings did not receive interest and the discount was more akin to a substitute for interest and not simply an increase in capital value. This same conclusion was reached through the application of the first strand of Myer: see [8.220]. With the increased complexity and sophistication of financial markets, and the application of the first strand of Myer, the courts may be more inclined in today’s financial climate to view premiums and discounts as ordinary income.
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Nevertheless, the decision in Lomax v Peter Dixon and Son Ltd is good authority and it is still conceivable that a genuine discount or premium could be held to be capital if: • interest was payable on the loan; • the interest and the terms of the loan were commercially justifiable; and • the discount took into account the risk of non-repayment.
Timing of interest receipts [9.50] Even though discounts or premiums will generally be ordinary income, deferring the receipt of the gain to when the debt is redeemed may delay the time when the gain is assessable as interest is normally derived and assessable on a cash basis. For example, if interest is paid on an annual basis, the interest will be derived and assessable under s 6- 5(2) of ITAA 1997 in that year. However, to the extent that the gain is realised via a discount or premium at the end of the loan, it will not be derived and assessable under s 6-5(2) until that later date: FCT v AGC (1984) 15 ATR 982.
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Deferral of the taxation of interest earned by way of a discount or premium may cause an imbalance in the taxation system. This happens if the borrower can claim a deduction on a yearly basis, but the lender only has assessable income when the loan is repaid. As a result of this potential imbalance, a range of legislation was introduced to counter the possible deferral of tax through discount and premium arrangements.
Division 16E, s 26BB and s 70B of ITAA 1936 [9.60] Division 16E of ITAA 1936 deals with the timing of assessable income and deductions relating to discount and deferred interest payments on “qualifying securities”. Division 16E only affects the timing of assessable income and deduction and does not determine whether or not these payments are assessable. This means that the first step when presented with a premium or discount on a qualifying security is to determine whether the discount or premium is ordinary income. If it is ordinary income, then the second step is to apply Div 16E. The effect of Div 16E is that the gains made on these securities are included in assessable income of the lender annually over the life of the loan. This will be the case even though the actual receipt of these monies may not occur until the end of the loan. Under this Division, the borrower is also entitled to a deduction on an annual basis, regardless of when the discount or deferred interest is paid.
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292 [9.60] PRINCIPLES OF TAXATION LAW 2020 Sections 26BB and 70B of ITAA 1936 apply to “traditional securities” acquired after 10 May 1989. These provisions deem premiums and discounts to be assessable income to the recipient and deductible for the payer, even when they are capital in nature. Traditional securities are taxed on realisation and are not taxed on an annual basis like those subject to Div 16E. The distinction between “qualifying securities” and “traditional securities” is based on the amount of the premium/discount. Traditional securities have a return (other than periodic interest) equal to or less than 1.5% pa and qualifying securities have a return (other than periodic interest) of greater than 1.5% pa, or where the return cannot be determined at the time of issue. Example 9.2: Difference between qualifying and traditional securities Two 10-year loans are available, both with a repayable face value of $1,000. The first is issued at $750 and the second is issued at $900. The benchmark amount for differentiating between the qualified and traditional security is $150 (1.5% × 10 years × $1,000). The first loan’s return is $250 ($1,000 –$750), which is greater than the $150 benchmark and so would be a qualifying security. The second loan’s return is $100 ($1,000 –$900), which is less than the $150 benchmark and so would be a traditional security.
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Example 9.3: Illustration of Div 16E –Qualifying security Kathie lends money under a four-year loan with a repayable face value of $20,000. However, the loan is subject to a discount and is issued at $17,000. This is a qualifying security because the return due to the discount is greater than 1.5% pa: ($20,000 –$17,000) = $3,000 which is a return of $750 pa ($3,000/4 years) or 3.75% pa ($750/$20,000) of the $20,000 loan. The first step is to decide whether the discount of $3,000 is income or capital. This will depend on the individual facts of the case, such as what (if any) interest rate is charged in addition to the discount. If the $3,000 is ordinary income, then, under Div 16E, its assessability will be apportioned over four years (the life of the loan). On the other hand, if it is capital, Div 16E will not apply, but Kathie will almost definitely be subject to capital gains tax upon repayment of the loan: see Chapter 11. Furthermore, any actual interest payable during the term of the loan will be Kathie’s ordinary income.
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Example 9.4: Illustration of s 26BB –Traditional security Cindy lends money under a four-year loan agreement. The terms are that the repayable face value is $20,000, but the loan is subject to a discount so that the loan is issued at $19,000. This is a traditional security because the return due to the discount is less than 1.5% pa: ($20,000 – $19,000) = $1,000 which is a return of $250 pa or 1.25% pa of the $20,000 loan. The $1,000 gain will be Cindy’s statutory income under s 26BB at the end of the term of the loan. Any interest payable during the term of the loan will be Cindy’s ordinary income.
Taxation of financial arrangements (TOFA) –Div 230 of ITAA 1997
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[9.70] Division 230 of ITAA 1997 was introduced into the ITAA 1997 because the previous timing provisions for financial instruments did not adequately cater for some of the more complex and newer financial arrangements. It was also justified on the basis that the previous provision did not take into account the time value of money, that is, because of inflation and lost interest earning capacity, $1 earned today is more valuable than $1 earned in one year’s time. These rules apply to financial instruments acquired on or after 1 July 2010, but a taxpayer may also elect to apply these rules from 1 July 2009. The primary aim of the Taxation of Financial Arrangements (TOFA) provisions is to reduce the mismatch between the timing of the deductions for payments on financial instruments and the timing of the assessability of those payments. This will effectively reduce the opportunity for deferral of the income from these arrangements and will treat all the gains as income, rather than capital. The TOFA rules are very complex and have been subject to frequent amendment. However, these rules do not apply to individuals and therefore only apply to a limited number of taxpayers such as those dealing with bonds, promissory notes, debentures and risk shifting arrangements. Taxpayers not subject to the TOFA provisions will still be taxed under Div 16E, s 26BB and s 70B of ITAA 1936.
Interest and compensation [9.80] Interest is normally the return to the lender/investor for the loss of the use of funds: see [9.20]. However, interest may also be paid on damages and compensation payments to compensate for the time lag between the loss and the receipt of the compensation. For example, a person injured in a car
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294 [9.90] PRINCIPLES OF TAXATION LAW 2020 accident who receives $100,000 compensation, but has to wait 12 months for the final decision and receipt of payment, may be entitled to interest on the $100,000 because of the delay. If the compensation itself is ordinary income, any interest paid on the compensation will also be ordinary income under the compensation principle: see [10.20]. However, if the compensation itself is not ordinary income, the question arises as to the tax treatment of the interest component of the compensation payments: Federal Wharf Co Ltd v DCT (1930) 44 CLR 24 (see Case Study [9.3]). These interest payments may be: • ordinary income; • capital because it cannot be separated from compensation of a capital nature (this may be subject to capital gains tax, although some capital compensation is exempt from CGT: see [11.290]); • capital for other reasons, such as being pre- judgment interest on personal injury payments: see [9.100]; or • specifically made exempt by the ITAA 1997: see [3.90]. Before considering the impact of the specific statutory provisions on interest relating to compensation for loss of capital, it is first necessary to understand how these receipts have been categorised by the courts. Case law shows that different approaches may be used for compensation for the loss of property and compensation for personal injury: Federal Wharf Co Ltd v DCT (1930) 44 CLR 24; Whitaker v FCT (1998) 38 ATR 219.
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Interest relating to compensation for damages for property [9.90] The decision in Federal Wharf Co Ltd v DCT (1930) 44 CLR 24 illustrates that interest compensation relating to property will be ordinary income where the interest component of the compensation is a clearly identifiable amount. This is effectively an application of the compensation principle. However, if the capital and interest components are undissected (the components of the compensation cannot be ascertained), then the court is more likely to treat the total compensation as capital, even though it may include some component of income, such as interest: see [10.240]. Case study 9.3: Interest on capital compensation is ordinary income In Federal Wharf Co Ltd v DCT (1930) 44 CLR 24, the taxpayer’s property was compulsorily acquired under legislation and the relevant Act allowed for interest at the rate of 4% pa to be paid on the amount owing from the time of acquisition to the time the compensation was paid. The compensation for the loss of property was clearly capital, but Federal
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Wharf argued that the 4% pa (interest) component formed part of the compensation for resumption of the land and was also capital. The High Court held that the interest component of the compensation was ordinary income because it was paid to account for the fact that the taxpayer had been deprived of the use of the funds that it was due. Rich J followed the analogy that if the funds were received immediately, they could have been invested and any interest received would be ordinary income. In Federal Wharf Co Ltd v DCT, the interest component of the compensation was clearly identifiable. As a result, it was possible for the Court to separate the capital component for the resumption of the land from the income component in the form of interest.
Interest relating to compensation for damages for personal injury [9.100] Interest paid as part of compensation for personal injury can be separated into pre- judgment and post- judgment interest. Pre- judgment interest is interest accumulated between the time of the event giving rise to the compensation and the time of the judgment; post-judgment interest is the interest accrued between the time of the judgment and the time of receipt of the compensation.
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Case study 9.4: Pre-judgment and post-judgment interest In Whitaker v FCT (1998) 38 ATR 219, the taxpayer was awarded compensation of about $808,000 following surgery which left her blind. The sum awarded included pre-judgment interest of $65,000. Whitaker also received approximately $288,000 in post-judgment interest because the compensation remained unpaid for over two years due to the case being appealed. The Commissioner included both the post-and pre- judgment interest in the taxpayer’s assessable income. On appeal to the Full Federal Court, it was held that the pre-judgment interest was capital in nature and not ordinary income, but the post- judgment interest was ordinary income and therefore assessable. The Court had little difficulty in concluding that the post-judgment interest was ordinary income because it was paid to compensate for the delay in the payment of the compensation. This interest had nothing to do with the damages awarded for the injury. However, pre-judgment interest was seen as part of the compensation awarded for the injury suffered and therefore was capital in nature.
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Although the judgment was unanimous, the reasoning varied but generally related to the fact that although the pre-judgment interest is compensation for being deprived of the money, the amount is not certain until the award is made and it is just one component of the compensation for the loss suffered. It was also suggested that it could not reasonably be assumed that these funds would have been available for investment as they did not crystallise until the judgment was made. Note that the decision in this case relating to post-judgment interest has been made redundant due to the enactment of s 51-57: see [9.110].
Section 51-57: Exemption of post-judgment interest on personal injury compensation [9.110] The decision in Whitaker v FCT (1998) 38 ATR 219 generated considerable media interest and political debate regarding the issue of whether it was fair and equitable to tax post-judgment interest from personal injury compensation. Consequently, retrospective legislation was introduced, effective from the 1992– 1993 tax year, to exempt post-judgment interest from assessable income.
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Under s 51-57 of ITAA 1997, the interest is exempt if it relates to damages for personal injury and is in respect of the period between the original judgment and the ending of any appeal process or the time of any out-of-court settlement. Any interest arising between settlement and the date of receipt of the compensation is not covered by the s 51-57 exemption. This interest would be subject to the decision in Whitaker v FCT and would be categorised as ordinary income.
Interest compensation and CGT [9.120] Compensation of a capital nature may be subject to CGT provided it is not exempted by s 118-37 of ITAA 1997: see Chapters 10 and 11. As a result, any interest component that cannot be clearly identified may be included in the amount subject to CGT. For example, where the compensation is for a capital loss and in the form of an undissected amount (see [10.240]), then the total amount of compensation will be treated as capital. This will be the case even if the final amount was determined after consideration of compensation for the loss of use of funds (ie, interest).
Section 15-35: Interest on overpayment and early payment of tax [9.130] Where a taxpayer has paid his or her tax but has disputed the assessment and is successful in having the tax assessment reduced, the
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taxpayer is entitled to be paid interest on the overpaid tax: Taxation (Interest on Overpayments and Early Payments) Act 1983 (Cth). The refund of the tax already paid will therefore include compensation in the form of interest to account for the fact that the tax had previously been overpaid. This compensation, paid in the form of interest, is specifically deemed to be assessable under s 15-35 of ITAA 1997. Although such payments will also constitute ordinary income, they will be assessable only under s 15-35, as gains that are both ordinary and statutory income are taxed under the statutory provision (s 6-25) unless the specific provision requires otherwise: see [3.80].
Interest portion of instalment payments [9.140] Interest could also be imputed into periodic payments for capital items. For example, on the sale of a retail business, the vendor may agree that the purchaser can pay for the business with equal quarterly payments over a three-year period. This type of arrangement is commonly known as a “term sale” or “vendor financing” and may occur where purchasers cannot obtain their own finance.
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If this type of arrangement states a specific interest rate to be charged on the outstanding balance, then that interest will clearly be ordinary income. However, if no explicit interest rate is included in the agreement, the issue arises as to whether there is an implied interest included in the periodic payments. Australian courts have generally been reluctant to impute an interest component into periodic capital payments and are more inclined to treat the total amount as capital if there is no identifiable amount of interest: Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28. However, these amounts may be subject to the CGT provisions: see Chapter 11. Example 9.5: Interest component of periodic capital payments Mr Gan wishes to sell his gardening and home maintenance business as a going concern, and he has a willing purchaser. Mr Gan has advertised the business (equipment, customer lists and forward bookings) for $160,000, but he would sell it for $150,000. The potential purchaser is very keen to buy the business, but she cannot obtain the finance for the purchase. As a result, Mr Gan agrees to sell the business for 10 quarterly payments of $16,000 each and secures the payments by taking a mortgage over the purchaser’s private home. There is no mention of interest in the agreement. As there is no mention of interest in this contract, the full payment will most likely be treated as capital. However, provided CGT is applicable,
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Mr Gan will have realised a capital gain for tax purposes on the date of the agreement to sell. As a result, he will be subject to tax on the gain in the year of the sale, regardless of the fact that he will not be paid in full until over two years later.
Dividends
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[9.150] Dividends are paid to company shareholders as their share of company profits. It therefore follows that dividends flow from the ownership of shares and are ordinary income under s 6-5 of ITAA 1997. However, dividends are also specifically made assessable as statutory income under s 44 of ITAA 1936 and because of s 6-25 of ITAA 1997, this specific provision has precedence over the general provision, s 6-5: see [3.80]. Consequently, dividends are brought to assessable income via s 44 rather than s 6-5: see [21.40]. Section 6(1) of ITAA 1936 defines a “dividend” as including: • any distribution in the form of money or property that a company makes to its shareholders; and • any amount credited by the company to any of its shareholders as shareholders. The meaning of “dividend” for tax purposes is discussed in detail at [21.130], but in most situations, it will be clear what a dividend is. However, over the years, many complex financial instruments have been developed in an attempt to alter the tax effect of benefits paid to shareholders. This has created some confusion as to whether the payments are interest on debt, dividends or of a capital nature. Of particular concern is whether the payments by a company are dividends paid to the holder of shares (equity) or interest paid on debt. This distinction is important as it alters the tax treatment for both the company and the investor. Example 9.6: Company payment on debt Rupert has lent (debt) $50,000 to his family private company, of which he is a shareholder, and the agreement is that the company pays Rupert 8% pa interest and the debt is to be repaid at the end of three years. In this case, the company will have a tax deduction for the interest payment and Rupert will be assessable on the interest receipt as ordinary income. The repayment of the loan at the end of three years is capital in nature with no income tax implications for either the company or Rupert. The important characteristics of Rupert’s investment are that there is a known fixed amount of return and the repayment of the capital is also agreed to.
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Example 9.7: Company payment on equity Gertrude purchases $50,000 of shares (equity) in a private company. Gertrude will only receive a dividend from her investment if the company makes a profit and decides it can afford to distribute a dividend to its shareholders. If the company does pay a dividend to Gertrude, the company will not be able to claim the payment as a deduction because it is not an expense, but a distribution of profits. Gertrude will have assessable income under s 44 of ITAA 1936, but may be entitled to a rebate via the dividend imputation system to account for the tax the company has already paid on its profits before paying the dividend: see [21.420]. The only means for Gertrude to realise the capital value of her shares is to sell them or for the company to buy them back, both which could give rise to CGT: see Chapter 11.
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The important characteristics of Gertrude’s investment in equity are that the returns are not certain and the capital value can only be realised through sale. The main differences between investments in debt and equity are: • the different level of risk borne by the investor, in that lenders are exposed to less risk than shareholders; and • the different tax treatments. Given the different tax treatment of investments in debt and equity, companies have devised securities which blur the boundary between payments of interest and dividends. This has been done to alter the tax situation for both the company and investor. As a result, Div 974 of ITAA 1997 was enacted to provide a clearer definition of debt and equity investments. These rules are very complex, but in essence, the distinction between debt and equity is made on the basis of the certainty of the return and the level of risk to which the investor is exposed.
Rental and lease income Rent [9.160] Rent is a payment by one party in exchange for the exclusive possession of the other party’s property for an agreed amount of time. The receipt of rent by a lessor clearly constitutes ordinary income as it is income from property. Under the flow concept, rent is income that flows from an investment in property: see [5.100]. Although rent receipts are usually periodical in nature, rent will still constitute ordinary income when it is paid as a lump sum.
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Lease premiums [9.170] A lease premium is a payment by a potential lessee to induce a lessor to enter a lease agreement with the lessee. Receipt of a lease premium by a lessor is normally treated as capital because it is regarded as a receipt for realising an interest in the asset. Lease premiums that are capital will usually be assessable under the CGT provisions: see Chapter 11. However, lease premiums will constitute ordinary income in either of the two following situations: • where the taxpayer is in the business of receiving lease premiums: Kosciusko Thredbo Pty Ltd v FCT (1983) 15 ATR 165 (see Case Study [9.5]). This is usually only the case if the taxpayer regularly receives lease premiums; and • where the lease premium is in reality a substitute for rent: Dickenson v FCT (1958) 98 CLR 460.
Example 9.8: Lease premium –Capital
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Pete owns a rental property and wants to find a tenant to enter a one- year rental agreement. He believes he can charge rent of $1,500 per month, but at this rate, he receives far more prospective tenants than he expected. One particular applicant, Alex, offers to pay Pete a one-off premium of $1,200 on top of the rent if he is chosen as the tenant, and Pete accepts this offer. The rent of $1,500 will be ordinary income, but the lease premium of $1,200 will be capital and subject to CGT.
Example 9.9: Lease premium –Business income Build Pty Ltd builds and rents out office buildings. It regularly enters into three-year leases with its tenants. Every time it finds a new tenant, it charges the tenant a one-off lease premium on top of the monthly rent. Because it owns many offices, Build Pty Ltd regularly receives lease premiums. In this instance, receipt of the lease premiums would constitute ordinary income and would be assessable under s 6-5 of ITAA 1997. The receipt of the lease premiums is regarded as normal proceeds of Build Pty Ltd’s business because it receives them on a regular basis as part of its business activities.
Example 9.10: Lease premium –Substitute for rent Jemima owns a rental property and wants to charge $1,800 rent per calendar month. However, a friend of hers told her that lease premiums
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are not ordinary income. As a result, she enters into a lease agreement with a tenant where she is paid $1,000 per month rent and $800 per month “premium”. The $1,000 per month rent would be ordinary income and assessable under s 6-5. The $800 per month “premium” would also be ordinary income in this situation as it is clearly a substitute for rent.
Case study 9.5: Taxpayer in business of receiving lease premiums In Kosciusko Thredbo Pty Ltd v FCT (1983) 15 ATR 165, the taxpayer, in its capacity as a tenant, entered into a 45-year lease of a State park. The taxpayer then proceeded to develop the land, which included building facilities and apartments. The taxpayer subsequently sublet the apartments and other facilities to various tenants and received lease premiums upon granting some of these leases. The Court held that the lease premiums constituted ordinary income as they were part of the normal proceeds of the taxpayer’s business. This was because the receipt of lease premiums was repetitive and an essential ingredient of the taxpayer’s business. Consequently, the scope of the taxpayer’s business included receiving lease premiums.
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Section 15-25 –Amount received for lease obligation to repair [9.180] Section 15-25 of ITAA 1997 states that amounts received by a lessor from a lessee due to the lessee failing to comply with a lease obligation to repair the premises are assessable income. However, s 15-25 will only apply where: • the lessee has used the premises for producing assessable income; and • the payment is not ordinary income. Example 9.11: Amount assessable under s 15-25 Alice owns an office that she leases to Bob. Bob runs a consulting business from the leased premises. There is a condition in the lease agreement that Bob must make any necessary repairs to the office and that if he fails to do so, he must pay a contractual penalty to Alice. The office requires repairs and Bob fails to carry them out. As a result, Bob pays Alice money as determined under the lease agreement. This amount is assessable under s 15-25. Note that there is an equivalent deduction under s 25-15 for expenses incurred in carrying out these repairs.
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Royalties Introduction
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[9.190] A royalty is a payment that is calculated based on the usage of intellectual property or the quantity/value of a substance taken, such as coal taken from a mine. The following would be royalties: • When a taxpayer is paid for use of his or her intellectual property. For example, Simone wrote a book and, as a result, owns the copyright to it. A publisher then enters into an agreement with Simone to publish and sell her book in exchange for giving her $2 per sale. This payment constitutes a royalty because it is calculated based on the usage of the copyright. • When the owner of intellectual property agrees to sell his or her intellectual property for an amount based on its usage. For instance, Steve writes a book and owns the copyright to it. A publisher who wishes to publish and sell Steve’s book offers to give him $2 per sale in consideration for Steve selling the copyright to the publisher. The amount received by Steve will constitute a royalty. This differs from the first example because in the first example, the author retains ownership of the copyright, but in this example, the copyright is being sold. Nevertheless, in both cases, the payments constitute royalties as the amounts are calculated on the usage of intellectual property. • Where someone is paid to produce intellectual property and the payment is based on its subsequent usage. For instance, Christie agrees with a publisher to write a book for them in exchange for a payment of $2 per book sold. The copyright in this example will always have been owned by the publisher because, under copyright law, if a writer enters a contract to write a piece for someone (such as a publisher), the copyright usually rests with the party that is paying. However, despite the fact that Christie never owned the copyright, the payment will still be a royalty because it is calculated according to the usage of intellectual property. • Where a taxpayer is paid for his or her physical resources based on the quantity of resources taken. For example, Alexia owns land that has oil reserves. A mining company pays her $20 for every barrel of oil that it extracts from her land. This amount will constitute a royalty.
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Case study 9.6: Taxpayer paid for timber taken from his land in receipt of royalty In McCauley v FCT (1944) 69 CLR 235, the taxpayer was a dairy farmer who owned land with trees on it. The taxpayer entered into an agreement with Laver, where Laver would cut and take the trees from the taxpayer’s land. The agreement stated that Laver would pay the taxpayer an amount based on the quantity of timber that had been cut and removed from the land. The High Court held by a 2:1 majority that the payment received by the taxpayer was a royalty as it was a payment made in relation to the amount of timber removed.
Assessability of royalties
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[9.200] Section 15- 20 of ITAA 1997 deems royalties to be assessable as statutory income. However, s 15-20 does not apply to royalties that are ordinary income under s 6-5 of ITAA 1997. This means that royalties that are ordinary income will be assessable under s 6-5 and those that are not ordinary income will be assessable under s 15-20. This raises the issue of which royalties are ordinary income. Royalties that are a product of exploiting intellectual property (such as the first three points in the list at [9.190]) will constitute ordinary income. In the case of Stanton v FCT (1955) 92 CLR 630 (see Case Study [9.7]), the majority arguably implied that payments for physical resources (such as the last of the points at [9.190]) will be capital royalties. However, the case law on what constitutes a capital royalty is unclear, and it is also arguable that royalty payments for physical resources are ordinary income.
Case study 9.7: Farmer’s receipt from a sawmiller for right to take timber was not a royalty In Stanton v FCT (1955) 92 CLR 630, the taxpayer was a farmer who granted a sawmiller the right to come on to his land and remove timber in exchange for a predetermined sum to be paid quarterly. The agreement also prescribed a maximum amount of timber that could be removed and gave a proportionate reduction of the payment if less than this maximum was removed. For instance, if only half the timber was removed, then the taxpayer would end up receiving only half the pre-agreed amount.
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The High Court held that the payments received by the farmer were not royalties and were capital in nature. Consequently, the payment was not assessable as it was not ordinary income and s 15-20’s predecessor did not apply as the payment was not a royalty. The Court stated that the taxpayer’s receipt was not a royalty because the agreement expressed the payment as a predetermined amount. This was despite the fact the agreed pro-rata reduction of the predetermined payment meant that, in substance, the amount paid was linked to the amount of timber removed. In other words, the Court appeared to define royalty by its form rather than its substance. If this case was decided today, it is likely that the Court would still find that the payment was not a royalty. However, it is likely that a modern court would find that the payment was ordinary income under other grounds. For instance, it is possible that the court would find the payment is ordinary income as the normal proceeds of the taxpayer’s farming business. This is likely because courts may now take a wider view of what are normal business proceeds: see [8.130]–[8.160]. Furthermore, even if modern courts decided that the payment did not constitute normal business proceeds, they are likely to find that the payment was ordinary income due to satisfying the first strand of Myer: see [8.220]–[8.250]. Finally, if a court held that such a payment was not ordinary income, it would be assessable under the CGT provisions: see Chapter 11.
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Annuities [9.210] An annuity is a stream of payments that occur at regular intervals (eg, monthly or quarterly), and this may be for a fixed length of time or for the life of an individual. Where the annuity is purchased, it is known as a “purchased annuity”, which occurs where the taxpayer pays an entity, such as an insurance company, a lump sum in exchange for that entity paying the taxpayer a regular income stream. The main two types of annuities are fixed-term and life annuities. A fixed- term annuity is where the payments are made by the annuity provider for a predetermined amount of time. A life annuity occurs when the terms of the annuity contract state that annuity payments are to be made for the rest of the recipient’s life. At the end of the annuity period, the original purchase price of the annuity will usually have been totally consumed and the recipient will not be entitled to any final capital payment. In effect, the provider of the annuity has repaid over the life of the annuity the purchase price plus any interest earned during the annuity period. However, in some limited cases, the
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taxpayer will be entitled to receive part of the purchase price of the annuity at the end of the annuity period, but this ultimately depends on the term of the annuity agreement. Example 9.12: Fixed-term and life annuities A taxpayer purchases an annuity from an insurance company for $100,000 in exchange for a 10-year annuity. The terms of this particular annuity provide the taxpayer with regular payments for the next 10 years that amount to $14,500 pa. This is an example of a fixed-term annuity. Another taxpayer pays an annuity provider $60,000 in exchange for the taxpayer receiving regular payments of $7,000 pa for the rest of his life. This is an example of a life annuity. Under case law, the full amount of the regular annuity payments is regarded as ordinary income: Egerton-Warburton v DCT (1934) 51 CLR 568. This is an unjust outcome because only part of the annuity payment is a real gain, whereas the rest is a return of the taxpayer’s purchase price, which is capital: see [5.70]. As a result, the Government enacted s 27H of ITAA 1936, which makes the return of the annuity’s capital component tax free. Section 27H only applies to non-superannuation annuities as superannuation annuities are subject to other legislative provisions: see Chapter 18.
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Example 9.13: Section 27H of ITAA 1936 reduces assessable component of annuity Stan pays $80,000 in exchange for an eight- year annuity that pays $13,000 pa. Under the terms of the agreement, Stan is not entitled to have any of the purchase price returned at the end of the eight years. Stan’s purchase price of $80,000 apportioned over the term of the annuity amounts to $10,000 per year. This means that, due to s 27H, $10,000 of the yearly annuity income is tax free. The other $3,000 will be assessable as ordinary income.
Questions [9.220] 9.1 Your client has invested $10,000 in a savings bond that matures in five years’ time and pays interest at 8% pa, but the interest is paid as a lump sum on the redemption of the bond in five years’ time. How will the interest be treated for income tax purposes?
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306 [9.220] PRINCIPLES OF TAXATION LAW 2020 9.2 Your client has purchased an investment apartment that has a rent guarantee from the developer of 5% pa for a period of four years. During the current financial year, your client has been unable to rent the apartment, so is relying on the rent guarantee payment to compensate her for not being able to find a tenant. The developer is due to pay the amount as a lump sum and your client is not sure whether the amount is income. Advise her. 9.3 Your client was injured in a work-related accident and has received damages of $300,000 for the loss of his ability to work. In the final judgment, the Court awarded $12,000 in pre-judgment interest and $5,000 in post-judgment interest. Which amounts, if any, are assessable income? 9.4 Your client makes most of her income from writing hit songs for various performing artists and receives a large amount of royalties from overseas record companies. Is this assessable income and how will it be taxed? 9.5 Your client has just written his first book of his experience as a hostage of a terrorist group. He spent the last two years writing the book and he has received two offers from a publishing company that wished to publish his book. The first offer is to purchase the copyright for a lump sum payment of $10,000 provided your client gives up future claims to the copyright and royalties. The second offer is to pay 10% of the sale price of each book sold provided your client agrees to assign the copyright in the book to the publisher for 10 years. Discuss the effect on assessable income of each of the two offers. 9.6 Your client is a parent who lent $40,000 to her son to provide a short- term housing loan. The agreement is that the son will repay $50,000 at the end of five years. Reconsider this question in light of the following facts. The loan was made to the son without any formal agreement and without any security provided for the sum lent. In addition, the client (the mother) has informed you that she told her son that he need not pay interest. However, the son repaid the full amount after two years and included in his payment an additional amount which was equal to 5% pa on the amount borrowed. Only one cheque was presented for the total amount. Discuss the effect on the assessable income of the parent. 9.7 Helen is 68 years old and single. Three years ago (when she was 65) she purchased a lifetime annuity for a lump sum of $1 million (not through her superannuation) that will give her an income of $60,000 a year for the rest of her life. The annuity has no guaranteed minimum annuity period and no amount payable to her estate upon her death. Assume
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that according to the government actuarial tables, a 65-year-old female has a life expectancy of 89. How would Helen’s $60,000 receipt be treated for income tax purposes? 9.8 Ms Kim works as a nurse at the local private hospital and in addition to her private home, she owns a commercial property which she rents to a tenant who operates a retail business from the property. As part of the rental agreement Ms Kim requires a bond of $2,000 to be paid on signing of the rental agreement, and the tenant also agrees to rectify any damage to the property caused by the tenant. During the current tax year, the tenant stopped paying rent and on inspection of the property Ms Kim found the tenant had vacated and there was $3,000 worth of damage caused by the tenant. As a result, she retained the full $2,000 bond and used it to repair the damage caused by the tenants.
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How will Ms Kim’s retention of the $2,000 bond be treated for income tax purposes?
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10
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Principles of compensation Key points.................................................................................................... [10.00] Introduction................................................................................................ [10.10] Compensation for losses incurred by individuals.................................... [10.40] Compensation for loss of salary or wages.......................................... [10.60] Loss of earnings vs loss of earning capacity...................................... [10.80] Compensation received by way of insurance or indemnity.............. [10.90] Compensation for loss of physical abilities...................................... [10.100] Compensation for pain, suffering or medical expenses.................. [10.110] Compensation under anti-discrimination legislation........................ [10.120] Compensation paid by financial institutions..................................... [10.130] Structured settlements...................................................................... [10.140] Compensation for business losses.......................................................... [10.150] Compensation for breach of contract –ordinary trading contracts......................................................................... [10.170] Compensation for breach of contract going to fundamental structure of business.................................................................. [10.190] Compensation for loss of asset –depreciable assets...................... [10.200] Compensation for loss of asset –capital assets............................... [10.210] Compensation for loss of asset –trading stock................................ [10.220] Compensation by way of insurance proceeds................................. [10.230] Composite claims..................................................................................... [10.240] Reimbursement of previously deducted expenses................................ [10.260] Questions................................................................................................... [10.300]
Key points [10.00] • Generally, a compensation receipt or damages award takes on the character of the item it replaces. This is known as the “replacement principle”.
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310 [10.10] PRINCIPLES OF TAXATION LAW 2020 • The common law “replacement principle” may be supplemented or overridden by statutory provisions of the ITAA 1936 or ITAA 1997. • Compensation for loss of salary or wages will generally be assessed as ordinary income. • Compensation for loss of physical abilities, pain, suffering or medical expenses will generally be a capital receipt and exempt from income tax consequences. • Compensation under anti-discrimination legislation may be assessable income depending on the circumstances. • Division 54 of ITAA 1997 provides that certain annuities and lump sums provided under structured settlements and structured orders to persons who have suffered personal injury are exempt from income tax. • Compensation payments or damages received for breach of an ordinary trading contract will be assessed as ordinary income. • Compensation payments or damages received for a breach of contract going to the fundamental structure of the business will be assessed as a capital gain. • The taxation consequences of compensation received for the loss of an asset depends on the type of underlying asset; depreciable assets will be dealt with under the depreciation provisions, trading stock will be dealt with under the trading stock provisions and capital assets will be subject to common law principles. • Compensation received under an insurance or indemnity policy may be assessable under s 15-30 of ITAA 1997. • Where a composite claim cannot be dissected into its component parts, the whole amount will be treated as capital and assessed as such. • The “replacement principle” does not apply to the reimbursement of previously deducted expenses. Rather, the reimbursement itself is considered to determine whether the receipt is income or capital.
Introduction [10.10] Compensation or damages may be received by a taxpayer for a variety of reasons. This chapter divides compensation and damages receipts into two categories: compensation or damages received by individual taxpayers outside the ordinary course of a business and compensation or damages received by taxpayers during the ordinary course of a business. The first category includes compensation or damages received by an employee, as well as those received in a private or personal capacity. Compensation or damages may be received from an employer, through workers’ compensation or a private insurance policy, or directly from another party. The second category includes compensation or damages received by a business for some type of loss or injury to that business. The loss may be in
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the form of a reduction in profits, temporary cessation or reduction in business or damage to the asset structure of the business. Again, the compensation or damages may be received through an insurance policy or from another party. [10.20] As a general principle, a compensation receipt or damages award takes on the character of the item it replaces: FCT v Dixon (1952) 86 CLR 540. Consequently, where the indicia of ordinary income are present for the amount being replaced, any compensation received in lieu of that amount will itself be considered ordinary income and assessable under s 6-5 of ITAA 1997. Alternatively, a compensation receipt or damages award in lieu of capital or a capital item will be capital in nature and subject to the capital gains tax provisions of the ITAA 1997. This is known as the “replacement principle” and applies to all compensation receipts unless it is overridden by a statutory provision of the Income Tax Assessment Acts. Often compensation or damages that replace income will be in the form of a lump-sum payment. The fact that the compensation is paid as a lump sum will not alter its character where the substituted item is income in nature.
Figure 10.1: Overall guide
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Is an amount received compensation, damages or a reimbursement of previously deducted expenses?
Compensation or damages are received
Compensation or damages for loss incurred by an individual
Compensation or damages for loss incurred by a business
See [10.40]
See [10.150]
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A reimbursement for a previously deducted expense is received
See [10.260]
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312 [10.30] PRINCIPLES OF TAXATION LAW 2020 Prima facie, the replacement principle applies to all compensation or damages receipts. However, this principle is not extended to apply to the reimbursement or refund of previously deducted expenses, as a receipt to compensate or reimburse deductible outgoings is not characterised as income simply because it is a reimbursement of expenses previously deducted. Where a taxpayer receives a reimbursement of previously deducted expenses, the taxation consequences of that receipt are determined by reference to the character of the receipt itself, rather than the item it replaces. [10.30] The following guide considers the individual types of compensation or damages receipts within specific categories. While the replacement principle generally applies to these categories, there are circumstances where specific rules have been developed and statutory provisions need to be considered. The categories below make it possible to consider the common law application of the principles and specific statutory provisions which supplement or override the replacement principle.
Compensation for losses incurred by individuals
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[10.40] Compensation or damages received by a taxpayer not carrying on a business will relate to either income-producing circumstances or personal circumstances. In Chapter 6, the concept of income from personal services and employment is discussed. The doctrines set out in that chapter are the fundamental principles to be applied to determine the consequences of a compensation or damages payment received by an individual taxpayer. Students should review these concepts. “Income from personal exertion” is income consisting of earnings, salaries, wages, commissions, fees, bonuses, pensions, superannuation allowances and retiring gratuities, allowances and gratuities received in the capacity of employee or in relation to any services rendered. These amounts are assessable as ordinary income under s 6-5 of ITAA 1997. To determine whether an amount is income from personal exertion, the courts have established certain indicia. Amounts that do not satisfy the indicia of income from personal exertion are generally considered non-assessable, non-exempt income, that is, the amounts are not subject to income tax. Of course, there may be statutory income provisions that override the common law and include an amount as assessable income. [10.50] Compensation or damages received by an individual will generally fall into one of five categories. With the underlying principles of income in mind, the consequences of the following compensation or damages receipts received by an individual are set out in Figure 10.2
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Figure 10.2: Compensation received by an individual What type of loss has the taxpayer suffered?
Compensation for loss of salary or wages
Compensation for loss of physical abilities
Compensation for pain, suffering or medical expenses
Compensation under anti-discrimination legislation
Structured settlements
See [10.60]
See [10.100]
See [10.110]
See [10.120]
See [10.140]
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Compensation for loss of salary or wages [10.60] In Chapter 6, it was established that salary and wages are ordinary income and assessable under s 6-5 of ITAA 1997. Applying the replacement principle, compensation or damages that replace salary or wages will also be assessed as ordinary income. Compensation for loss of salary or wages often results as a consequence of a policy of insurance held by an employer, such as a workers’ compensation policy (or other statutory injury compensation payment) or a policy of insurance taken out by the individual being compensated. The taxation consequences of a payment which substitutes lost salary or wages under either type of insurance policy are straightforward and will be assessable as ordinary income under the replacement principle. [10.70] There are circumstances, however, where a payment is made directly by the taxpayer’s employer to a current or past employee. In these situations, if there is no reference to lost wages, it may not be so obvious as to what the payment is for. Case study 10.1: Compensation payment held to be ordinary income In FCT v Dixon (1952) 86 CLR 540, the employer made payments to its employees who enlisted in the armed forces during World War II. The payment, which was the difference between the salary paid by the employer and the salary paid by the armed forces, was made voluntarily and without any conditions attached. The Commissioner assessed the taxpayer on the payments on the basis that they constituted ordinary income. The High Court held that the receipts
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314 [10.80] PRINCIPLES OF TAXATION LAW 2020
were assessable as ordinary income. In particular, Fullager J concluded that the amounts were ordinary income as they were compensation for wages (and periodical payments) that would have otherwise been received.
Case study 10.2: Compensation payment held to be ordinary income In C of T (Victoria) v Phillips (1936) CLR 144, the taxpayer, a director of a company, entered into a contract in which he agreed to serve as managing director for 10 years. In the sixth year, the contract was terminated by the employer and the taxpayer was compensated with monthly payments corresponding to the amounts the taxpayer would have received under the contract. The Court held that the new payments were in the nature of income as they were of the same nature as those they replaced. In both FCT v Dixon and C of T (Victoria) v Phillips, the payments were periodical. However, the receipt of compensation or damages as a lump sum will not alter its assessability where the lump-sum payment is for loss of income only or a portion of the lump-sum payment is identifiable and quantifiable as income: Determination TD 93/58.
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Example 10.1: Lump-sum compensation Adele manages Belinda’s business. Adele’s contract provides that Belinda is required to pay her a 5% share of the profits from the business. Adele calculates that Belinda has only been paying her 4% of the profits of the business due to an error in the figures. Belinda agrees to pay Adele $50,000 to make up for the mistake. The $50,000 is assessable income in the hands of Adele as it is compensation for losses of an income nature: see Determination TD 93/58. It is irrelevant that the compensation is paid as a lump sum. The receipt is income only, as there is no capital component. It is also not relevant that the basis of the calculation of the lump sum cannot be determined.
Loss of earnings vs loss of earning capacity [10.80] Where compensation is awarded, it is necessary to ensure that any compensation is received for lost earnings as opposed to a payment for the loss of earning capacity. Although this can be difficult to do, this is demonstrated by the different results in Sommer v FCT (2002) 51 ATR 102 as compared to Coward v FCT (1999) 41 ATR 1138.
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Case study 10.3: Compensation receipt held to be ordinary income In Sommer v FCT (2002) 51 ATR 102, the taxpayer was a medical practitioner specialising in stress management. He became unable to work and claimed compensation under a Professional Income Replacement Policy. Ultimately the taxpayer was paid a lump sum of $140,000 as consideration for the cancellation of the policy. The taxpayer claimed that the lump sum was a capital amount and therefore not assessable as ordinary income. The Court, in finding for the Commissioner, held that the sum was ordinary income as the purpose of the insurance was to replace a revenue receipt.
Case study 10.4: Compensation receipt held to be capital Sommer v FCT can be contrasted with Coward v FCT (1999) 41 ATR 1138, where the taxpayer, having reached 65 years of age, converted weekly personal injury compensation payments to a lump sum. The AAT held that, while the weekly payments replaced lost wages, the lump sum was capital in character as it related to a loss of earning capacity.
Example 10.2: Loss of salary or wages Jamie, an apprentice chef, slices his index finger off during work. Jamie is paid $5,000 in workers’ compensation for lost wages.
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The $5,000 which replaces lost income is assessable as ordinary income.
Compensation received by way of insurance or indemnity [10.90] Compensation received by way of insurance or indemnity which is not assessable as ordinary income may still be assessable under s 15-30 of ITAA 1997. Section 15-30 provides that a taxpayer’s assessable income includes an amount received by way of insurance or indemnity for the loss of an amount if the lost amount would have been included in assessable income, and it is not assessable as ordinary income under s 6-5.
Compensation for loss of physical abilities [10.100] A compensation or damages payment for the loss of a physical ability, such as the loss of a limb, eye or finger, is a capital receipt. Further, the
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316 [10.110] PRINCIPLES OF TAXATION LAW 2020 compensation or damages payment relating to the taxpayer personally or the taxpayer’s occupation will be exempt from capital gains tax implications under s 118-37 of ITAA 1997. Section 118-37(1)(a)(i) exempts from capital gains tax consequences any gain or loss made from a CGT event relating directly to compensation or damages received by the taxpayer for any wrong or injury suffered in the taxpayer’s occupation. Section 118-37(1)(a)(ii) exempts from capital gains tax consequences any gain or loss made from a CGT event relating directly to compensation or damages received by the taxpayer for any wrong, injury or illness the taxpayer or a relative suffers personally. Section 118-37(1)(b) exempts compensation or damages received by a trustee for the same reasons as s 118-37(1)(a) of ITAA 1997. Section 118-37(1)(ba) goes on to exempt from capital gains tax consequences a CGT asset that is received by a beneficiary of a trust to the extent that the CGT asset is attributable to compensation or damages that the trustee receives in relation to a wrong or injury to a beneficiary or a wrong, injury or illness suffered personally by a relative. Any post-judgment interest received on a personal injury compensation payment is also exempt from tax under s 51-57. This will cover interest accrued from the time the original judgment is made to the time when the judgment is finalised, for example, when the period for lodging an appeal ends.
Example 10.3: Loss of physical ability
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Jamie, an apprentice chef, slices his index finger off during work. In addition to the $5,000 Jamie is paid in workers’ compensation for lost wages, he is awarded $10,000 for the loss of the finger. The $10,000 is considered a capital receipt. In addition, the amount will be exempt from capital gains tax under s 118-37 of ITAA 1997, which exempts from CGT any sum received by way of compensation or damages for any injury suffered by Jamie either to his person or in his vocation.
Compensation for pain, suffering or medical expenses [10.110] Any compensation or damages received for pain, suffering or medical expenses is replacing lost capital and therefore will be a capital receipt.
Example 10.4: Award of medical expenses Jamie, an apprentice chef, slices his index finger off during work. In addition to the $5,000 Jamie is paid in workers’ compensation for lost wages and the $10,000 he is awarded for the loss of the finger, Jamie is awarded $6,000 to cover his out-of-pocket medical expenses.
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The $6,000 is considered a capital receipt. In addition, the amount will be exempt from capital gains tax under s 118-37 of ITAA 1997, which exempts from CGT any sum received by way of compensation or damages for any injury suffered by Jamie to his person or in his vocation.
Compensation under anti-discrimination legislation [10.120] Compensation paid because of claims made under the Commonwealth or State anti-discrimination legislation, for example, the Sex Discrimination Act 1984 (Cth), may be assessable income depending on the circumstances of the payment. To illustrate the operation of the income tax law in relation to these types of compensation payments, in Ruling IT 2424, the Commissioner provides common examples which serve as a guide. However, it is stressed in the Ruling that the determination of the character of a compensation payment and, in particular, whether it is liable to tax in the hands of an employee depends upon the nature of the payment.
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As with other types of payments, the broad principle is that a compensation payment in substitution of lost earnings or for income which would otherwise have been earned is in the nature of income and is subject to income tax. On the other hand, compensation payments for psychological and emotional injury, such as injury to feelings, humiliation, embarrassment, depression and anxiety, are capital in nature. Such an amount will be exempt from capital gains tax by virtue of s 118-37(1) of ITAA 1997: see [11.290]. [10.125] The Commissioner offers the following examples of compensation awarded under anti- discrimination legislation, along with the likely tax consequences: • Hiring practice –Compensation for failure to offer employment would normally make up for lost wages and therefore be ordinary income. Any part of the compensation payment that relates to psychological or emotional injury would be capital in nature and not subject to income tax. • Sexual harassment –Compensation paid for sexual harassment will generally be a payment made for psychological and emotional injury, injury to feelings, humiliation and embarrassment, loss of self-esteem, anxiety or distress, or loss of enjoyment of life. Any of these payments will be capital in nature and not subject to income tax. • Terms and conditions of employment –An employee may be compensated where the terms of employment discriminate on the basis of sex, marital status or pregnancy. For example, an employee may receive less salary than a peer or have less flexibility in working hours. Compensation paid for these types of claims may be made
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318 [10.125] PRINCIPLES OF TAXATION LAW 2020 up of both assessable and non- assessable receipts. A payment will generally make up for lost wages, salary or bonus and will be considered income in nature. Further, compensation may be paid for psychological and emotional injury, such as frustration, and is capital in nature. • Opportunities for promotion –Any payment made for loss of a higher salary, due to discrimination in relation to promotion, is considered income and therefore subject to income tax. Payment compensating for impairment to prospects for future promotion or future earning capacity, as well as payment for psychological and emotional injury, is capital in nature. • Dismissal –A compensation payment received because of unlawful dismissal is considered to be made “in consequence of the termination of any employment of the taxpayer”. Therefore, the payment is considered an employment termination payment and is subject to income tax in accordance with the employment termination payment provisions. See [6.260] onwards for a discussion of employment termination payments.
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Example 10.5: Compensation paid under anti-discrimination legislation Jane applies for a position at her local supermarket. She is awarded the position and starts work four days per week. A month after starting work Jane has an appraisal where her employer states that they are very happy with her work. At the same appraisal, Jane notifies her employer that she is pregnant. Two days later Jane is advised that her employer is no longer satisfied with her work and that her employment is being terminated. Jane lodges a complaint with the Human Rights and Equal Opportunity Commission seeking appropriate redress and compensation from the employer. She requests that her employment be reinstated and that the employer make up lost wages during the intervening period and that compensation be paid for injury to feelings, loss of self-esteem and humiliation. Jane is ultimately successful in receiving $2,000 in lost wages and $10,000 for injury to feelings. A compensation payment paid to Jane to make up for lost earnings is considered to be income according to ordinary concepts. The whole of the payment is included in Jane’s assessable income in the year it is received. A payment to compensate for damages for injury to feelings is a payment of a capital nature and is not liable to tax.
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Compensation paid by financial institutions [10.130] The recent inquiry into banking practices has resulted in bank customers receiving compensation. This compensation is generally for loss of an investment, refund or reimbursement of fees, or interest. Where the compensation is for the loss of an investment which the taxpayer has already disposed of, the compensation will be treated as additional capital proceeds from the disposal. If the investment is still held by the taxpayer, the cost base of the asset will need to be adjusted by the amount of compensation. Where compensation is in the form of a refund of fees paid for financial advice, the tax consequences will depend on whether the original payment was claimed as a deduction or whether it was part of the cost base of an asset. If no deduction was claimed, the reimbursement will not be included in assessable income. If, however, an amount was included in an asset’s cost base, an adjustment will need to be made. Where compensation is in the form of interest, that amount will be assessable as ordinary income.
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Structured settlements [10.140] Division 54 of ITAA 1997, which applies from 26 September 2001, provides that certain annuities (periodic payments) and lump sums provided under structured settlements and structured orders to persons who have suffered personal injury are exempt from income tax. Division 54 applies to compensation or damages paid other than compensation paid by an employer or under a workers’ compensation claim. A “structured settlement” is defined as an agreed settlement in writing of a claim that is for compensation or damages for personal injury where at least part of the payment is in the form of an annuity. A “structured order” is defined as an order by the court in respect of a claim for compensation or damages for personal injury where at least part of the payment is in the form of an annuity. Division 54 does not prevent part of the compensation being in the form of a lump sum; however, there must be at least one annuity purchased out of the compensation or damages receipt. Without Div 54, any annuity would be assessable under s 27H of ITAA 1936. Despite perceived benefits, structured settlements have not generally been taken up. In 2007, the income tax exemption for structured settlement payments underwent a review. The principal recommendation of the review was to retain Div 54 in its current form without any extension. On 20 March 2008, the Federal Government responded to the recommendations of the review, agreeing to retain Div 54 and commenting that “structured settlements may be adopted in the future”. However, there has been no other progress.
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320 [10.150] PRINCIPLES OF TAXATION LAW 2020
Compensation for business losses [10.150] As with compensation received by an individual, compensation received by a business will be subject to taxation consequences in accordance with the replacement principle. Compensation or damages received by a taxpayer carrying on a business will either replace an amount that otherwise would have been received from transactions carried out in the ordinary course of business or compensate for the loss of capital or a capital item. Income from business is considered in Chapter 8. The doctrines set out in that chapter are the fundamental principles to be applied to determine the consequences of a compensation or damages payment received by a business. Students should review these concepts. Once the existence of a business is established, it is necessary to determine the scope of the business as not all receipts of the business are assessable as income. Receipts within the scope of the business will constitute assessable income, as will some receipts which have been considered to fall outside the ordinary scope of the business: see FCT v Myer Emporium Ltd (1987) 163 CLR 199 and FCT v Whitfords Beach Ltd (1982) 12 ATR 692. On the other hand, receipts of capital are subject to the capital gains tax provisions of the ITAA 1997.
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In addition to the income taxation consequences of a compensation receipt, the GST consequences also need to be considered. The GST consequences will depend on whether the payment constitutes consideration for a supply and whether that supply is a taxable supply. Students should review the concepts discussed in Chapter 25. The Australian Taxation Office (ATO) approach to GST on compensation payments is set out in GST Ruling GSTR 2001/4. [10.160] With these principles in mind, the consequences of the following types of compensation or damages received by a business are set out in Figure 10.3.
Compensation for breach of contract –ordinary trading contracts [10.170] Applying the replacement principle, compensation payments or damages received for breach of an ordinary trading contract will generally be assessed as ordinary income. Compensation or damages for loss of anticipated profits will fall within this category, as will a breach of contract for the sale of goods. The courts have consistently found that such compensation or damages are assessable as income.
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Figure 10.3: Compensation received by a business Ordinary trading contract See [10.170] Compensation for breach of contract Going to the fundamental structure of the business See [10.190]
What type of compensation has the business received?
Asset is a depreciable asset See [10.200] Compensation for loss of an asset of the business Asset is a capital asset See [10.210] Compensation by way of insurance proceeds where the amount is not assessable as ordinary income See [10.230]
Asset is trading stock See [10.220]
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Case study 10.5: Compensation for breach of ordinary trading contract In Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512, the taxpayer had entered into four forward selling contracts with American and German customers for the sale of rutile. Subsequent to the contracts, the market for rutile collapsed and the price fell. Following this turn of events, the contracts were cancelled and the taxpayer received compensation by way of lump sums. The Commissioner assessed the taxpayer on the lump-sum compensation payments. The High Court held that the payments were ordinary income in the hands of the taxpayer despite the fact that the contracts in question ensured a regular market for the taxpayer’s goods. It was concluded that the mining operations had been abandoned not because of the cancellation of the contracts, but rather because of the collapse of the market in general. [10.180] A similar result was reached in Allied Mills Industries Pty Ltd v FCT (1989) 20 ATR 457.
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322 [10.190] PRINCIPLES OF TAXATION LAW 2020
Case study 10.6: Compensation for breach of ordinary trading contract In Allied Mills Industries Pty Ltd v FCT (1989) 20 ATR 457, the taxpayer had an agreement to be the sole distributor of Peek Frean Australia’s biscuits, which included Vita-Weat biscuits. The taxpayer became the sole selling and distribution agent for Peek Frean biscuit products in Australia, Papua New Guinea and Fiji. The agreement could be terminated on six months’ notice, but the taxpayer was to be offered the right to manufacture and sell Vita-Weat for a minimum of 10 years. Instead of this original agreement being followed, the parties agreed to terminate the distribution agreement in return for a lump-sum payment of $372,700. The Commissioner included this amount in the taxpayer’s assessable income. The Full Federal Court held that the amount was assessable as ordinary income. In coming to this conclusion, the Court held that the taxpayer was not parting with a substantial part of its business, ceasing to carry on business or disposing of the fixed framework of its business.
Example 10.6: Compensation for breach of ordinary trading contract
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A tenant fails to vacate a commercial property at the end of the lease. The landlord sues and is awarded damages in the amount of the difference between rent paid by the tenant and rent which is obtainable on the open market. The damages awarded are ordinary income in the hands of the landlord: see Raja’s Commercial College v Gian Singh & Co Ltd [1976] 2 All ER 801.
Compensation for breach of contract going to fundamental structure of business [10.190] Compensation for breach of contract may go further than a payment to compensate for loss of trading income. In this case, the amount may be considered capital. An amount may be considered a capital sum where the payment is for a breach of contract that goes to the fundamental structure of the business. Usually the termination of the contract results in the cessation of the business as a whole. One such example is Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28, where the Full High Court held that compensation amounts paid as a result of the termination of a contract were capital receipts because the termination led to the cessation of the taxpayer’s business.
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Case study 10.7: Compensation for breach of contract going to fundamental structure of business In Californian Oil Products Ltd (in liq) v FCT (1934) 52 CLR 28, the taxpayer was the exclusive distributor in Australia of the products of an American company. This was the taxpayer’s only business. The American company subsequently decided to have a local subsidiary distribute the products and terminated the contract, which led to the closure of the taxpayer’s business. Despite the fact that the termination agreement provided for semi-annual payments over the same period as the original contract, the payments were held to be capital receipts because the termination of the contract resulted in the cessation of the taxpayer’s business.
Example 10.7: Compensation for breach of contract going to fundamental structure of business
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Betty has a contract with a UK company to act as the sole distributor of Ester’s Exquisite Jewellery range. There is such a demand for Ester’s Exquisite Jewellery in Australia that Betty does not distribute any other products. The contract, which is for a period of five years, is terminated by Ester after two years. Betty and Ester come to an agreement regarding compensation for the early termination of the contract. Based on estimated earnings, Betty is to receive $20,000 per year for the next three years. The compensation paid to Betty is capital in nature and will not be ordinary income, despite being calculated by reference to the lost income and paid over the same period as the terminated contract. However, Betty will need to consider the capital gains tax consequences of the receipts: see Ruling TR 95/35.
Compensation for loss of asset –depreciable assets [10.200] Any compensation received for the loss or damage to a depreciable asset will be dealt with under the depreciation provisions. Where the compensation relates to the disposal of the asset, it is necessary to make any required balancing adjustments under Div 40 of ITAA 1997.
Compensation for loss of asset –capital assets [10.210] Compensation in relation to capital assets depends on whether the asset has been rendered permanently destroyed or disabled or merely
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324 [10.210] PRINCIPLES OF TAXATION LAW 2020 temporarily disabled. Generally, an amount that relates to the permanent disablement of the asset is considered capital in nature. Case study 10.8: Compensation for loss of capital asset In Glenboig Union Fireclay Co Ltd v IR Commissioner of Inland Revenue [1922] SLT 182, the taxpayer, the lessee of land which contained fireclay, was in the business of mining clay deposits. A railway company had tracks running over part of the land. It exercised certain statutory powers preventing the taxpayer from working parts of the land. The taxpayer was paid compensation calculated by reference to the profits that would have been earned from the unworked part of the land. Despite the method of calculating the compensation payment, the House of Lords held that the amount was capital in nature as part of the taxpayer’s company was “sterilised” and destroyed by the exercise of the statutory power. In contrast to Glenboig Union Fireclay v IR Commissioner, compensation paid in relation to an asset that has been rendered temporarily disabled will generally be considered income in nature: see Ensign Shipping Co Ltd v IR Commissioner of Inland Revenue (1928) 12 TC 1169 and Burmah Steamship Co Ltd v IR Commissioner of Inland Revenue (1931) 16 TC 67.
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An amount that compensates for temporary disablement will need to be assessed on the facts: see, for example, Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 73 ATR 28. Case study 10.9: Damages for defamation In Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 73 ATR 28, the taxpayer carried on business, which included performing laser eye surgery. The taxpayer successfully sued for damages for defamation and was awarded $844,624. The question before Sackville J was whether $812,726 actually received after allowing for $31,898 in costs was “income according to ordinary concepts”. The taxpayer claimed damages on two alternative bases: the loss it sustained by the reduction in the value of its business attributable to the defamatory publications or the loss of profits sustained during a closed period by reason of the reduction in the number of laser procedures attributable to the defamatory publications. The second basis was accepted by the Supreme Court. However, in deciding the assessability of the damages, Sackville J held that the damages were to compensate the taxpayer
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for the injury to its reputation in the way of business. His Honour went on to state that the fact that the award was calculated by reference to loss of profits did not alter the character of the payment. It was compensation for injury to a capital asset and thus the payment was not income according to ordinary concepts.
Compensation for loss of asset –trading stock [10.220] Section 70-115 of ITAA 1997 provides that a taxpayer’s assessable income includes an amount received by way of insurance or indemnity for a loss of trading stock as long as that amount is not assessable as ordinary income under s 6-5. Consequently, it is necessary to consider whether an amount received for loss of trading stock is ordinary income under the common law principle. This issue was considered by the High Court in FCT v Wade (1951) 84 CLR 105, where it was held that a lump-sum compensation payment paid to a taxpayer who carried on the business of dairy farming was income. The compensation was paid for the loss of dairy cows which were condemned and destroyed.
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Given that receipts from the sale of trading stock are ordinary income under s 6-5, an amount received to replace lost trading stock will be ordinary income. Therefore, it is difficult to see when s 70-115 would be applied. However, it may be argued that s 70-115 extends beyond the common law proposition with the use of the words “by way of … indemnity” to capture a statutory right to compensation not caught by the common law principle. Example 10.8: Compensation for loss of trading stock Bob is a poultry farmer who breeds chickens to sell for meat. Due to excessive amounts of pesticides in chicken food obtained from Barry, a local wheat farmer and poultry food producer, Bob suffers the loss of 80% of his chickens. Barry is found liable to compensate Bob for the losses suffered. As Bob is being compensated for loss of trading stock, the compensation will be ordinary income under s 6-5 (or, alternatively, assessable under s 70-115): see Gill v The Australian Wheat Board [1980] 2 NSWLR 795.
Compensation by way of insurance proceeds [10.230] Section 15-30 of ITAA 1997 provides that a taxpayer’s assessable income includes an amount received by way of insurance or indemnity for
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326 [10.240] PRINCIPLES OF TAXATION LAW 2020 the loss of an amount if that amount would have been included in assessable income, and the amount was not assessable as ordinary income under s 6-5. Where an amount may be assessable as ordinary income and statutory income under s 15-30, the ordinary income provisions will prevail. It may also be necessary to consider whether the right under the insurance policy is an asset for capital gains tax purposes where the payment of a claim gives rise to a capital gain. There are specific provisions dealing with the recovery of losses under insurance policies where the loss relates to livestock and timber. Section 385-130 provides that where the livestock is an asset of a primary production business, the insurance payout may be included in assessable income in equal instalments over a five-year period. A similar provision applies for the loss of trees on land held for the purposes of manufacture or sale in the course of carrying on a business.
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Composite claims [10.240] The above discussion assumes that a compensation or damages payment is easily identifiable as a substitute for income or capital. Often, however, taxpayers receive an undissected lump-sum payment representing compensation for both a loss of income and a loss of capital or capital assets. This will be common where there is an out-of-court compromise settlement. Where the compensation or settlement payment received is for unliquidated damages, the courts have been reluctant to apportion the sum received into income and capital components. Instead, the whole amount is treated as capital. If, however, there is a portion of the lump-sum payment that is identifiable and quantifiable as income, the Commissioner considers that part of the compensation will be assessable as ordinary income: Determination TD 93/58.
Example 10.9: Composite claim Charles, the owner of land, agrees to accept a payment of $100,000 in compensation for its compulsory resumption. In addition, interest of 10% on the principal sum is to be paid. The compensation paid to Charles under the settlement includes an amount of $20,000 for interest. The $20,000 is assessable income under s 6-5 of ITAA 1997 as it can be identified and quantified by the parties.
[10.250] The question as to the assessability of a lump-sum payment arose in McLaurin v FCT (1961) 104 CLR 381.
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Case study 10.10: Composite claim In McLaurin v FCT (1961) 104 CLR 381, the taxpayer’s grazing property was damaged by a fire that started on NSW Railway land. Compensation of £12,350 was paid to the taxpayer by NSW Railways in full settlement of a claim for damages. The claim was for a sum of £30,240 under a number of heads of damage, including damages to pastures, loss of livestock, damage to wool and loss of fencing. The settlement amount was computed by reference to the various items; however, the taxpayer was not aware of the calculations. The Commissioner included a portion of the settlement payment in the taxpayer’s assessable income. The High Court held that no part of the lump sum was assessable as ordinary income. In coming to this conclusion, the Court made it clear that where the payment is in respect of a claim of unliquidated damages and is made or accepted under a compromise which treats the settlement as a single undissected amount, the amount is to be considered as a whole. A similar conclusion was reached in Allsop v FCT (1965) 113 CLR 341: see Case Study [10.11].
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Given that an undissected amount of compensation or damages is treated as capital, it may be subject to the capital gains tax regime. The capital gains tax consequences of a capital receipt are considered by the Commissioner in Ruling TR 95/35. Where it is possible to attribute the capital receipt to an underlying asset, the cost base of that underlying asset will attach to the compensation or damages receipt. Where there is no underlying asset, CGT events H2 (see [11.120]) and C2 (see [11.70]) should be considered.
Reimbursement of previously deducted expenses [10.260] Compensation that replaces lost income is in itself considered income and assessable to the recipient. A logical expansion of this principle would provide that a reimbursement of a previously deducted expense (a revenue expense) would be assessable income. However, as a common law proposition, the courts have not adopted this principle. Case study 10.11: Reimbursement of previously deducted expense In FCT v Rowe (1997) 187 CLR 266, the High Court rejected the notion that, as a general principle of law, an amount paid as compensation for or reimbursement of a deductible expense is income within ordinary
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concepts. In that case, the taxpayer had been allowed a deduction for legal expenses incurred in relation to his suspension from a Queensland Shire Council. After being cleared of all wrongdoing, the Queensland Government made an ex gratia payment in the equivalent amount of the expenditure incurred. The High Court concluded that it was necessary to determine whether the receipt was income according to ordinary concepts and, in this case, it was not. The High Court in FCT v Rowe clearly rejected the notion that a reimbursement of a previously deducted expense is itself income. Rather, the courts have adopted the approach that the assessability of a reimbursement of a previously deducted expense is determined by reference to the receipt itself and the ordinary concepts of income, which are discussed in Chapter 5. Several cases have discussed the application of the common law concepts where a taxpayer has received a reimbursement of a previously deducted expense. The cases generally centre on the question of whether the reimbursement can be considered as received in the ordinary course of carrying on a business.
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[10.270] The cases of Allsop v FCT (1965) 113 CLR 341, HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 and Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171 all demonstrate the application of the common law principle of income according to ordinary concepts to reimbursements of previously deducted expenses. Case study 10.12: Reimbursement of capital receipt In Allsop v FCT (1965) 113 CLR 341, the taxpayer, Allsop, was an interstate carrier who paid fees for haulage permits. The fees were subsequently held to be unconstitutional and the taxpayer sued to recover the fees. The claim was settled prior to the trial and, upon the execution of a deed of release, Allsop was paid £37,500. The Commissioner assessed the taxpayer on the basis that the amount recovered was assessable income. The Court concluded that the sum received was not a reimbursement of fees paid, but rather a payment for settlement of a claim. That being the case, the sum was not assessable as ordinary income, but rather a capital receipt. [10.280] A year later, the High Court was again faced with a similar issue.
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Case study 10.13: Reimbursement received in ordinary course of business In HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537, the taxpayer had paid, for a period of four years, royalties under protest to the Forests Commission of Victoria. The taxpayer, who had been claiming the royalties as a deduction for taxation purposes, eventually convinced the Commission that the royalties had been miscalculated and a refund was voluntarily paid to the taxpayer. The Commissioner included in the taxpayer’s assessable income the amount of the refund. The High Court concluded that the refund did not acquire the character of income because it was made as payment for previously deducted expenses. However, the ordinary concepts of income were applied to conclude that the payment was income to the taxpayer as the refund was received in the course of the taxpayer’s business.
Case study 10.14: Reimbursement an incident of business
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Also supporting the notion that a reimbursement may be assessable income is the Federal Court decision in Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171. In that case, Hill J held the reduction in sales tax liability that had previously been allowed as a deduction was “so intimately connected with Warner’s business of selling records, cassettes and the like, that it must be treated as being an incident of that business, even if not an ordinary incident of that business” (at 182). Consequently, based on the tests in FCT v Myer Emporium Ltd (1987) 163 CLR 199, the gain was “stamped” with the character of income. [10.290] So far, the common law position in relation to the reimbursement of previously deducted expenses has been considered. It is also necessary to consider the statutory provisions of the ITAA 1997 which affect the common law position. Division 20 includes amounts in a taxpayer’s assessable income to reverse the affect of certain kinds of deductions. In particular, it includes in a taxpayer’s assessable income amounts received, either by the taxpayer or another entity, by way of insurance, indemnity or other recoupment if it is for a deductible expense and it is not otherwise assessable income. Division 20 divides amounts received into two categories: an amount received by way of insurance or indemnity (s 20-20(2)) and other recoupments (s 20-20(3)). Other recoupments must be of an amount deducted under one of the specific provisions listed in s 20-30, which include bad debts, rates or taxes, tax-related
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330 [10.300] PRINCIPLES OF TAXATION LAW 2020 expenses, embezzlement or larceny by an employee, capital allowances and foreign exchange losses. The first category of reimbursements in s 20-20, an amount received by way of insurance or indemnity, was previously found in s 26(j) of ITAA 1936. The meaning in s 26(j) of “indemnity or recoupment” has been considered by the courts. Case study 10.15: Meaning of “indemnity or recoupment” In FCT v CSR Ltd (2000) 45 ATR 559, the taxpayer received a lump- sum settlement from an insurer who had previously refused to pay an indemnification. The Commissioner assessed the settlement payment as an indemnity to reimburse the taxpayer for a previously deducted outgoing. The Full Federal Court held that as the payment was an undissected lump sum in settlement of all claims against another party, it could not be said to be a reimbursement of a previously deducted outgoing. A similar conclusion was reached in the case of Allsop v FCT (1965) 113 CLR 341: see Case Study [10.11].
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Questions [10.300] 10.1 David disturbed two prison escapees who were attempting to break into his car. He suffered serious head injuries as a result of being bashed by the men and spent three months recuperating in hospital. The escapees were later recaptured, found guilty of the assault and sentenced to an additional two years in jail. David applied for and was awarded $30,000 compensation under the Victims Compensation Act 1987 (NSW) for his pain and suffering resulting from the assault. Marina, David’s wife also received $20,000 compensation under this Act. She was able to establish that the fear she now had of driving a car alone was attributable to the assault on her husband and she was therefore entitled to compensation for the loss of enjoyment of life. What are the tax consequences of the compensation receipts? 10.2 While cycling home from work, Mark is hit by a car and seriously injured. He spends the next three months in hospital. Due to the severity of his injuries, at the end of the three months, Mark is declared unable to work again. After protracted legal proceedings, Mark receives the following sums of money: • $500,000 from the insurer of the driver who hit Mark; • $15,000 in lost wages through a workers’ compensation payment; and
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10: Principles of coMpensation [10.300] 331
• $100,000 for the permanent loss of the sight in one eye. How is each of these amounts assessed? 10.3 Alice, an employee of Acme Co, is sexually harassed by a workmate. Alice complains to the company and seeks compensation for the humiliation and indignity she has suffered. In return for signing an agreement in which she surrenders any rights she may have against the company, Alice receives from the company an amount of $35,000 and resigns from the company. The payment is calculated on the basis of six months’ salary, including long service and annual leave entitlements. What are the tax consequences of the compensation receipt? 10.4 Jenny and Mark have their own business producing furniture for both wholesale and retail clients. Unfortunately, their factory was burned to the ground because of an electrical fault. Jenny and Mark lost everything. They had various insurance policies which provided for the following amounts of compensation: • $1 million for the loss of the factory; • $500,000 for the loss of machinery and other depreciable assets; • $200,000 for loss of trading stock; and • $50,000 each to Jenny and Mark for loss of income while the business was not operating. What are the tax consequences of each of these amounts? 10.5 At the start of the current tax year, Colin installs a water tank at his rental property for $3,000. Colin claims a deduction for the decline in value of the water tank under Div 40 of ITAA 1997 using the prime cost method and an effective life of 10 years. Colin also applies for and receives a Queensland State Government rebate of $1,000 as a recoupment of his expenditure on the water tank. Is the $1,000 assessable in the hands of Colin? 10.6 Hospitality Pty Ltd (“Hospitality”) carries on a business of providing catering services for corporate events. Their major client is an Australian airline. Hospitality is contracted to run the airline’s airport premium customer lounges across Australia, providing the food and beverage as well as service staff in each lounge. The duration of the contract is five years, with an annual charge of $5 million payable in monthly instalments. This represents approximately 80% of Hospitality’s annual revenue. Recently, the airline reviewed its operations and decided to terminate the contract one year early, that is, at the end of the fourth year. The airline agreed to pay Hospitality the balance of the contract of $5 million, but sought to mitigate the amount payable by claiming that the work performed by Hospitality was of a poor standard. After lengthy negotiations, Hospitality and the airline agreed to settle their
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claims for a final amount of $4.7 million. Is the $4.7 million ordinary income in the hands of Hospitality? 10.7 Felicity sought financial advice from Makemoneyfast Bank in 2015. She paid $5,000 for advice which involved advising her to invest $500,000 into one of their managed funds. It was a fund which was labelled high- risk, high-return. The fund performed badly, and Felicity disposed of her investment for $250,000 in the current tax year. In the same year, Makemoneyfast Bank reviewed the advice given to Felicity and determined that, based on her instructions that she wanted to ensure the money was “safe”, the advice should have been to invest in a conservative “low-risk” fund. As a consequence, the Bank paid Felicity $200,000 in compensation, including a refund of $5,000 on the fee for the original financial advice and $50,000 in lost interest. Felicity had claimed a tax deduction for the fee. Advise Felicity of the tax consequences. 10.8 Ozzie Bank has agreed to pay thousands of its customers compensation for charging interest above the agreed rate, failing to activate offset accounts and failing to switch customers from an interest-only loan to a principle and interest loan. Compensation is in the form of damages for poor advice, additional interest charges and lost opportunity. Advise the recipients of the compensation of their tax liability. Would it make any difference if the loan related to their main residence or a rental property?
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11 Capital gains tax
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Key points.................................................................................................... [11.00] Introduction................................................................................................ [11.10] Step 1 –Have you made a capital gain or a capital loss?....................... [11.30] Question 1: Has a CGT event happened to the taxpayer?................. [11.40]
Subdivision 104-A: Disposals.................................................................. [11.50] Subdivision 104-B: Use and enjoyment before title passes.................. [11.60] Subdivision 104-C: End of a CGT asset................................................... [11.70] Subdivision 104-D: Bringing into existence a CGT asset....................... [11.80] Subdivision 104-E: Trusts........................................................................ [11.90] Subdivision 104-F: Leases..................................................................... [11.100] Subdivision 104-G: Shares.................................................................... [11.110] Subdivision 104-H: Special capital receipts......................................... [11.120] Subdivision 104-I: Australian residency ends...................................... [11.130] Subdivision 104-J: CGT events relating to rollovers............................ [11.140] Subdivision 104-K: Other CGT events................................................... [11.150] Subdivision 104-L: Consolidated groups and multiple entry consolidated groups...................................................................... [11.160] Question 2: Is the asset a CGT asset?............................................... [11.170] Collectables............................................................................................ [11.180] Personal use assets................................................................................ [11.190] Separate CGT assets.............................................................................. [11.200] Time of acquisition of CGT asset........................................................... [11.210] Question 3: Does an exception or exemption apply?...................... [11.220] Disregarded capital gains and losses on certain assets...................... [11.230] Exempt or loss denying transactions.................................................... [11.280] Anti-overlap provisions.......................................................................... [11.310] Small business relief.............................................................................. [11.320] Main residence exemption.................................................................... [11.380] Death....................................................................................................... [11.425] Question 4: Can there be a roll-over?............................................... [11.430]
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334 [11.00] PRINCIPLES OF TAXATION LAW 2020 Step 2 –Work out amount of capital gain or loss................................. [11.440] What is a capital gain or loss?........................................................... [11.450] What factors come into calculating a capital gain or loss?.............. [11.460]
Capital proceeds..................................................................................... [11.470] Cost base................................................................................................ [11.480] Reduced cost base................................................................................. [11.500]
Step 3 –Work out your net capital gain or loss for the income year............................................................................ [11.510] Calculation 1....................................................................................... [11.520] Calculation 2....................................................................................... [11.530] Calculation 3....................................................................................... [11.540] Calculation 4....................................................................................... [11.550] Calculation 5....................................................................................... [11.560]
Capital losses.......................................................................................... [11.570]
Indexation figures.............................................................................. [11.580]
Current index reference base................................................................ [11.580]
Questions................................................................................................... [11.590]
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Key points [11.00] • CGT affects a taxpayer’s income because assessable income includes the net capital gain for the income year. As such, there is no such thing as a separate capital gains tax. Rather, capital gains are taxed as statutory income under ITAA 1997. • A taxpayer’s net capital gain for an income year is the total of the capital gains for the income year minus certain capital losses for the income year. • Capital losses cannot be deducted from assessable income. This is known as quarantining. However, capital losses may be carried forward to be offset against capital gains in future income years. • A taxpayer makes a capital gain or a capital loss only if a CGT event happens, that is, CGT applies only to realised gains. • Most CGT events involve a CGT asset. • There are certain exemptions or exceptions that reduce the capital gain or loss or allow the taxpayer to disregard it altogether. • Gains and losses made on assets acquired before 20 September 1985 are generally exempt from CGT. • There are certain rollovers which allow a taxpayer to defer a capital gain or loss from a CGT event. • A taxpayer generally makes a capital gain if he or she receives capital amounts (known as capital proceeds) which exceed the total costs (known as the cost base) associated with the CGT event.
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• A taxpayer generally makes a capital loss if he or she receives capital amounts (known as capital proceeds) which are less than the total costs (known as the reduced cost base) associated with the CGT event. • In certain circumstances, a taxpayer may be able to take into account inflation or apply a general discount to a capital gain.
Introduction [11.10] The topics covered so far have considered whether a receipt is income or capital and whether that receipt is ordinary or statutory income. The focus has then been on the tax consequences of a receipt of income. This chapter considers the consequences of a receipt of capital or, more specifically, capital gains tax. Gains that are assessable under the CGT regime are a form of statutory income. The capital gains and capital losses provisions (commonly referred to as capital gains tax or CGT) are contained in Pts 3-1 and 3-3 of Ch 3 of ITAA 1997. Part 3- 1 deals with capital gains and losses general topics, while Pt 3-3 deals with special topics, such as rollovers and small business concessions.
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A taxpayer’s income tax liability is affected by CGT because assessable income includes the net capital gain for the income year (s 102-5(1)), where net capital gains consist of the total capital gains for the year reduced by certain capital losses. A taxpayer cannot deduct a net capital loss. However, a loss may be carried forward to be offset against gains in future years. The starting point for considering the application of the capital gains tax provisions is generally Div 104 which contains all of the CGT events. Once it has been established that there is a CGT event, it is possible to consider the other Divisions of the CGT Parts of the Act. For example, it will be necessary to consider Div 108 which provides a definition of a CGT asset, Div 110 which provides the rules relating to the cost base of the asset, Div 116 which provides the rules relating to the capital proceeds from the event and Div 118 which provides many of the exemptions available. [11.15] One of the most important aspects of calculating a taxpayer’s net capital gain is determining whether the general discount percentage applies. The general discount percentage is applied at the third step outlined below after determining whether there is a gain or loss and the amount of that gain or loss. However, because it ultimately reduces the net capital gain to be included in assessable income, it is worth noting at the outset. A 50% general discount applies to qualifying capital gains: s 115-5. To qualify, the asset must be acquired at least 12 months before the CGT event giving rise to the gain. The general discount percentage is discussed further in [11.540]. [11.20] Taxpayers need to be aware of the types of situations where a capital gain or loss may arise. Most taxpayers will be aware that a gain or
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336 [11.30] PRINCIPLES OF TAXATION LAW 2020 loss may arise where there is the disposal of a CGT asset. However, while most CGT events involve a CGT asset, the trigger for a gain or loss is a CGT event. Examples of CGT events include leases, inheritance, subdividing land, goodwill, contracts, options, a company liquidation, leaving Australia, marriage breakdown, working from home, shares, a civil court case, trusts, bankruptcy and incorporating a company: s 100-10(3) of ITAA 1997. To determine whether a taxpayer is affected by the CGT provisions, it is necessary to follow a three-step process described in Div 100 of ITAA 1997. Within each of these three steps, we ask a series of questions to ultimately determine the affect of the CGT provisions on a taxpayer’s liability to pay income tax. Figure 11.1: Determining CGT effects on taxpayer
Step 1
Step 2
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Step 3
Have you made a capital gain or loss? See [11.30]
Work out the amount of capital gain or loss See [11.440]
Work out the net capital gain or loss for the income year See [11.510]
Step 1 –Have you made a capital gain or a capital loss? [11.30] The first step is to determine whether the taxpayer has made a capital gain or loss. To help us determine whether there is a capital gain or loss in the current income year, we ask four questions.
Question 1: Has a CGT event happened to the taxpayer? [11.40] A taxpayer makes a capital gain or loss if, and only if, a CGT event happens: s 102-20 of ITAA 1997. Therefore, the first step in the CGT process is to determine whether a CGT event happens to the taxpayer’s situation. If more than one CGT event happens, subject to certain exceptions, you use the one
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that is the most specific to the situation: s 102-25(1). The capital gain or loss will be taken into account in the tax year in which the CGT event happens. Figure 11.2: Capital gain or loss?
Question 1
Question 2
Question 3
Question 4
Has a CGT event happened to the taxpayer? See [11.40]
Is the asset a CGT asset? See [11.170]
Does an exception or exemption apply? See [11.220]
Can there be a roll-over? See [11.430]
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Division 104 sets out all of the CGT events for which a taxpayer can make a capital gain or loss. Division 104 also tells you how to work out whether the taxpayer has made a gain or loss from the CGT event and the time of the CGT event. The Division also contains some exceptions for gains and losses, as well as some of the cost base adjustment rules. A summary of CGT events is contained in s 104-5. There are 12 major categories of CGT events: • 104-A – disposals; • 104-B –use and enjoyment before title passes; • 104-C –end of a CGT asset; • 104-D –bringing into existence a CGT asset; • 104-E – trusts; • 104-F – leases; • 104-G – shares; • 104-H –special capital receipts; • 104-I –Australian residency ends; • 104-J –CGT event relating to rollovers; • 104-K –other CGT events; • 104-L –consolidated groups and MEC groups.
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Subdivision 104-A: Disposals [11.50] CGT event A1 is the most common CGT event. CGT event A1 happens if a taxpayer disposes of a CGT asset: s 104-10(1) of ITAA 1997. A disposal occurs where there is a change in ownership because of some act or event or by operation of law. However, a change of ownership does not occur if the taxpayer stops being the legal owner, but continues to be the beneficial owner, or merely because of a change of trustee: s 104-10(2).
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The time of CGT event A1 is when the taxpayer enters into the contract or, if there is no contract, when the change of ownership occurs: s 104-10(3). Where there is more than one contract –for example, an original contract and a subsequent contract varying the terms –the date of disposal will be determined by reference to the contract which gives rise to the obligation to sell or transfer the asset: FCT v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 44 ATR 370. Further, in the context of an acquisition, the court has held that an oral contract, whether enforceable or not, will determine the date of acquisition: McDonald v FCT (1998) 38 ATR 563. However, where the contract is preliminary and not the actual contract for acquisition, the date of acquisition will be the latter contract: Elmslie v FCT (1993) 26 ATR 611. Where there is no contract, the time of the event will be the time of the change of ownership to be determined on the facts –for example, the provision of access to the property, such as the handing over of the keys. Where CGT event A1 occurs, you make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base and you make a capital loss if those proceeds are less than the asset’s reduced cost base: s 104-10(4). The cost base is generally the total costs associated with the CGT event (see [11.480]), while the capital proceeds are generally the amount the taxpayer receives, or is entitled to receive, from the CGT event: see [11.470]. Example 11.1: Event A1 In June 2019, Kylie enters into a contract to sell land. The contract is settled in October 2019. Kylie makes a capital gain of $50,000. The $50,000 gain is made in the 2018–2019 income year, that is, the year in which the contract is entered into, and not the 2019–2020 income year. Source: Adapted from s 104-10 of ITAA 1997.
Case study 11.1: Time of disposal In FCT v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 44 ATR 370, the taxpayer was a subsidiary of a US company involved in the pharmaceuticals and healthcare product market. On 31 May 1991,
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the taxpayer entered into a contract with Roche to sell its business. On 30 August 1991, a number of amendments were made to the original agreement, including an adjustment to the purchase price and the name of the purchaser. The issue before the High Court was whether the relevant date of the contract for CGT purposes was 31 May 1991 or 30 August 1991. The High Court held that it is a question as to which contract gave rise to the obligation to effect the disposal. In this case, although the terms of the original agreement were varied in August, the obligation established on 31 May 1991 did not change. Therefore, the date of disposal for CGT purposes was 31 May 1991.
Subdivision 104-B: Use and enjoyment before title passes [11.60] CGT event B1 happens if a taxpayer enters into an agreement under which the right to the use and the enjoyment of a CGT asset owned by the taxpayer passes to another entity and title in the asset will or may pass to that entity before the end of the agreement: s 104-15(1) of ITAA 1997. The time of the event is when the other entity first obtains the use and enjoyment of the asset: s 104-15(2).
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Example 11.2: Event B1 Mark agrees to rent an investment property to John for a period of two years. The agreement entered into by the parties provides that at any time during the two-year period John has the right to purchase the property from Mark. Event B1 occurs when Mark starts renting the property.
Subdivision 104-C: End of a CGT asset [11.70] Category C, dealing with the end of a CGT asset, contains three separate events. CGT event C1, the loss or destruction of a CGT asset, happens if a CGT asset that the taxpayer owns is lost or destroyed: s 104-20(1) of ITAA 1997. The time of CGT event C1 is when the taxpayer first receives compensation for the loss or destruction or, if no compensation is received, when the loss is discovered or the destruction occurred: s 104-20(2).
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Example 11.3: Event C1 Erin owns a factory that burns down. She has insurance which compensates her for the loss. CGT event C1 happens when the factory is destroyed, and the time of the event is when she receives the insurance payment. CGT event C2, covering cancellation, surrender and similar endings, happens where the taxpayer’s ownership of an intangible asset ends by the asset: • being redeemed or cancelled; or • being released, discharged or satisfied; or • expiring; or • being abandoned, surrendered or forfeited; or • if the asset is an option –being exercised; or • if the asset is a convertible interest –being converted: s 104-25(1). The time of CGT event C2 is when the taxpayer enters into the contract that results in the asset ending or, if there is no contract, when the asset ends: s 104-25(2).
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Example 11.4: Event C2 Tim has a contract with Acme Co to be the exclusive supplier of their widgets for the next 10 years. Acme Co terminates the agreement with Tim after five years. Tim is paid $5,000 as compensation for the early termination of the contract. CGT event C2 happens as Tim’s intangible asset, that is, his rights under the agreement, have come to an end. Later we will see that the capital gain will be the $5,000 less any costs associated with the event (eg, legal fees).
CGT event C3, the end of an option to acquire shares, happens if an option that a company or trustee of a unit trust granted to an entity to acquire a CGT asset, which is shares in the company (or units in the unit trust or debentures in the company or unit trust), ends because it is not exercised by the latest time for its exercise, is cancelled, released or abandoned: s 104-30(1). Event C3 only deals with company issued options. All other options are dealt with as a D2 event, with the difference being the time of the event. The time of event C3 is when the option ends: s 104-30(2).
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Example 11.5: Event C3 On 1 January 2019, Gina pays Acme Co $100 for the right to acquire 10,000 shares in the company for $1 per share. The option to acquire shares must be exercised within 12 months of entering into the option. Gina decides not to exercise the option. As a result, the option expires and CGT event C3 happens on 1 January 2020. Acme Co makes a capital gain of $100 (less any associated expenses) on 1 January 2020.
Subdivision 104-D: Bringing into existence a CGT asset [11.80] Category D, bringing into existence a CGT asset, has four separate events. CGT event D1 happens where a taxpayer creates a contractual or other legal right in another entity: s 104-35(1). The bringing into existence of an asset which triggers a CGT event D1 often leads to a CGT event C2 when the asset created comes to an end.
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Example 11.6: Event D1 Bart sells his business to Lucy. As part of the agreement, Bart agrees not to operate a similar business within a 5-km radius for the next two years. Lucy pays $10,000 for Bart to agree to this restraint of trade. A contractual right in favour of Lucy has been created. If Bart breaches the contract, Lucy can enforce that right. CGT event D1 happens when the contract for the restraint of trade is entered into and Bart will have a capital gain. At the end of the two- year period, CGT event C2 will happen and Lucy will have a capital loss. Source: Adapted from s 104-35 of ITAA 1997.
CGT event D2 happens if a taxpayer grants an option to an entity or extends an option already granted: s 104-40(1). Event D2 does not happen if CGT event C3 applies to the situation, that is, the option is for the acquisition of shares in a company.
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Example 11.7: Event D2 Ben pays Sara $5,000 for an option to purchase her business. The one- month option is granted on 1 January 2020. Ben decides not to exercise the option. CGT event D2 happens on 1 January 2020 and Sara has a capital gain of $5,000 less any associated expenses. If Ben exercises the option, CGT event D2 is ignored and CGT event A1 happens: see [11.50]. CGT event D3 happens if a taxpayer who owns a prospecting entitlement or mining entitlement grants the right to receive income from the operation of the entitlement: s 104-45(1). CGT event D4 happens if a taxpayer enters into a conservation covenant over land that he or she owns: s 104-47(1).
Subdivision 104-E: Trusts [11.90] There are ten CGT events relating to trusts listed in subdiv 104-E of ITAA 1997: • creating a trust over a CGT asset –CGT event E1; • transferring a CGT asset to a trust –CGT event E2; • converting a trust to a unit trust –CGT event E3; Copyright © 2019. Thomson Reuters. All rights reserved.
• capital payment for trust interest –CGT event E4; • beneficiary becoming entitled to a trust asset –CGT event E5; • disposal to beneficiary to end income right –CGT event E6; • disposal to beneficiary to end capital interest –CGT event E7; • disposal by beneficiary of capital interest –CGT event E8; • creating a trust over future property –CGT event E9; • annual cost base reduction exceeds cost base of interest in AMIT –CGT event E10.
Subdivision 104-F: Leases [11.100] There are five CGT events relating to leases listed in subdiv 104-F of ITAA 1997: • granting a lease –CGT event F1; • granting a long-term lease –CGT event F2;
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• lessor pays lessee to get lease changed –CGT event F3; • lessee receives payment for changing lease –CGT event F4; • lessor receives payment for changing lease –CGT event F5. Example 11.8: Event F4 On 1 January 2020, Jake (the lessee) enters into a lease. On 1 May 2020, Jake agrees to waive a term. Eastfield (the lessor) pays Jake $1,000 for this. If Jake’s cost base at the time of the waiver is $2,500, it is reduced from $2,500 to $1,500. On 1 September 2020, Jake agrees to waive another term. Eastfield pays Jake $2,000 for this. If Jake’s cost base at the time of the waiver is $1,500, Jake makes a capital gain of $500 and the cost base is reduced to nil. Source: Adapted from s 104-125 of ITAA 1997.
Example 11.9: Event F5 Eastfield owns a shopping centre. Con (the lessee of a shop in the centre) pays Eastfield $10,000 for agreeing to change the terms of its lease. Eastfield incurs expenses of $1,000 for a solicitor and $500 for a valuer. Eastfield makes a capital gain of $8,500. Source: Adapted from s 104-130 of ITAA 1997.
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Subdivision 104-G: Shares [11.110] There are two CGT events relating to shares listed in subdiv 104-G of ITAA 1997. CGT event G1 happens if a company makes a payment to a taxpayer in respect of shares the taxpayer owns in the company and the payment is not a dividend: s 104-135(1). CGT event G3 happens if a taxpayer owns shares in a company and a liquidator or administrator declares the shares worthless: s 104-145(1).
Subdivision 104-H: Special capital receipts [11.120] There are two CGT events relating to special capital receipts listed in subdiv 104-H of ITAA 1997. CGT event H1 happens if a deposit paid to a taxpayer is forfeited because a prospective sale or other transaction does not proceed: s 104-150(1).
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Example 11.10: Event H1 Barry decides to sell land to Judy. A contract of sale for $120,000 is entered into, and Judy pays Barry a 10% deposit. Judy fails to complete the contract, and the deposit is forfeited. CGT event H1 happens, and Barry has a capital gain of $12,000 less any costs associated with the failed transaction. CGT event H2 happens if an act, transaction or event occurs in relation to a CGT asset that the taxpayer owns, and the act, transaction or event does not result in an adjustment being made to the asset’s cost base or reduced cost base: s 104-155(1). Example 11.11: Event H2 Max owns land on which he intends to construct a manufacturing facility. A business promotion organisation pays Max $50,000 as an inducement to start work early. No contractual rights or obligations are created by the arrangement. The payment is made because of an event (the inducement to start construction early) in relation to Max’s land, so a CGT event H2 happens and Max has a capital gain of $50,000 (less any costs associated with starting early).
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Source: Adapted from s 104-155 of ITAA 1997.
Subdivision 104-I: Australian residency ends [11.130] There are two CGT events relating to the ending of Australian residency listed in subdiv 104-I of ITAA 1997. CGT event I1 happens when a taxpayer stops being an Australian resident: s 104-160(1). However, an Australian resident individual may choose to disregard making a capital gain or capital loss, in which case the assets will be deemed to be taxable Australian property until a CGT event happens to those assets or the taxpayer becomes an Australian resident again. CGT event I2 happens if a trust stops being a resident trust for CGT purposes: s 104-170(1).
Subdivision 104-J: CGT events relating to rollovers [11.140] There are five CGT events relating to rollovers listed in subdiv 104-J of ITAA 1997 (note that CGT event J3 has been repealed):
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• company ceasing to be a member of wholly owned group after rollover –CGT event J1; • change of status of replacement asset for a rollover under subdiv 152- E –CGT event J2; • trust failing to cease to exist after rollover under subdiv 124-N –CGT event J4; • failure to acquire replacement asset and to incur fourth element expenditure after a rollover under subdiv 152-E –CGT event J5; • cost of acquisition of replacement asset or amount of fourth element expenditure, or both, not sufficient to cover disregarded capital gain – CGT event J6.
Subdivision 104-K: Other CGT events [11.150] There are 12 CGT events listed in subdiv 104-K of ITAA 1997. They are as follows: • incoming international transfer of emissions unit –CGT event K1; • bankrupt pays amount in relation to debt –CGT event K2; • asset passing to tax-advantaged entity –CGT event K3; • CGT asset starts being trading stock –CGT event K4; • special collectable losses –CGT event K5; • pre-CGT shares or trust interest –CGT event K6;
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• balancing adjustment events for depreciating assets and s 73BA depreciating assets –CGT event K7; • direct value shifts –CGT event K8; • carried interests –CGT event K9; • certain short-term forex realisation gains –CGT event K10; • certain short-term forex realisation losses –CGT event K11; • foreign hybrids –CGT event K12.
Subdivision 104-L: Consolidated groups and multiple entry consolidated groups [11.160] There are seven CGT events relating to consolidated groups and multiple entry consolidated (MEC) groups listed in subdiv 104-L of ITAA 1997: • loss of pre-CGT status of membership interests in entity becoming subsidiary member –CGT event L1; • where pre-formation intragroup rollover reduction results in negative allocable cost amount –CGT event L2;
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346 [11.170] PRINCIPLES OF TAXATION LAW 2020 • where tax cost setting amounts for retained cost base assets exceeds joining allocable cost amount –CGT event L3; • where no reset cost base assets and excess of net allocable cost amount on joining –CGT event L4; • where amount remaining after step 4 of leaving allocable cost amount is negative –CGT event L5; • error in calculation of tax cost setting amount for joining entity’s assets –CGT event L6; • where reduction in tax cost setting amounts for reset cost base assets cannot be allocated –CGT event L8.
Question 2: Is the asset a CGT asset?
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[11.170] Most CGT events involve a CGT asset. Division 108 of ITAA 1997 defines the various categories of assets that are relevant to working out a taxpayer’s capital gains and losses. A “CGT asset” is defined as any kind of property or a legal or equitable right that is not property: s 108-5(1). The definition includes part of, or an interest in, an asset as defined, goodwill or an interest in it, and an interest in an asset of a partnership. Division 108 also sets out when land, buildings and capital improvements are taken to be separate CGT assets. The first part of the definition contained in s 108-5(1)(a) provides that a CGT asset is any type of property, including both tangible property, such as land and buildings, as well as intangible property, such as copyright and patents. The second part of the definition contained in s 108-5(1)(b) provides that a CGT asset is a legal or equitable right that is not property. This category includes those assets which are not transferable, such as the right to sue, and rights under an insurance contract. Examples of CGT assets from s 108-5 include the following: • land and buildings; • shares in a company; • units in a unit trust; • options; • debts owed to you; • a right to enforce a contractual obligation; and • foreign currency. While the definition of “CGT asset” is very broad, there are certain things that are not considered CGT assets. Generally, a right which is not property must be enforceable by legal or equitable proceedings. For example, general freedoms, such as the right to work, are not CGT assets nor are the right of a landlord to enter into a lease and the right to a refund. Although, the Commissioner of Taxation has recently expressed the view that bitcoin is a CGT asset.
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It is important to classify CGT assets into their relevant categories as special rules apply to each. The relevant categories of assets in Div 108 are as follows: • CGT assets; • collectables: see [11.180]; and • personal use assets: see [11.190]. Each CGT asset needs to be classified into one of the three categories as there are special rules that apply to collectables and personal use assets. An item not considered to fall within the subcategories collectables or personal use assets is a general CGT asset.
Collectables [11.180] “Collectable” is defined in s 108-10(2) of ITAA 1997 as: • artwork, jewellery, an antique or a coin or medallion; or • a rare folio, manuscript or book; or • a postage stamp or first day cover, that is used or kept mainly for personal use or enjoyment.
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It is important to remember that there are two limbs to this definition. First, the item must be one of the kind listed. For example, the Commissioner considers that an antique is an “object of artistic or historical significance that is of an age exceeding 100 years”: Determination TD 1999/40. Second, the asset must be used or kept mainly for personal use or enjoyment. This means that artwork that is purchased as an investment rather than to enjoy will not be considered a collectable. Where an item is defined as a collectable, there are four specific rules that apply: 1. Capital gains and capital losses made from collectables are disregarded where the first element of the asset’s cost base is $500 or less. 2. When working out the cost base of a collectable, disregard the third element (non-capital costs of ownership). 3. Capital losses from collectables can only be used to reduce capital gains from collectables. This is known as a quarantining rule. Any losses not used in the current tax year can be carried forward to be offset against gains from collectables in future years. Note, however, that the quarantining rule only applies one way –that is, you are able to offset losses from the sale of ordinary CGT assets against gains from collectables.
Example 11.12: Losses from collectables Bridgette has a capital gain from collectables of $200 and capital losses from collectables of $400. She has other capital gains of $500. She has a net capital gain of $500 and a net capital loss of $200.
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The $200 loss can be carried forward to be offset against any capital gain from collectables she has in future tax years. However, it cannot be used to reduce the $500 capital gain. Source: Adapted from s 108-10 of ITAA 1997.
Example 11.13: Gains from collectables but losses from ordinary CGT assets Brodie has a capital gain from collectables of $200 and capital losses from ordinary CGT assets of $600. She has other capital gains of $500. She has a net capital gain of $100, as the losses can be used to reduce both the $200 capital gain and the $500 capital gain.
4. If you own collectables that are part of a set, then that set of collectables is treated as a single collectable.
Example 11.14: Sets Lily buys a set of three books for $900. If the books are of equal value, she has acquired the books for $300 each. However, the books are taken to be a single collectable. Lily will not get the exemption in s 118-10 because she acquired the set for more than $500.
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Source: Adapted from s 108-15 of ITAA 1997.
Personal use assets [11.190] “Personal use asset” is defined in s 108-20(2) of ITAA 1997 as a CGT asset (other than a collectable) that is used or kept mainly for personal use or enjoyment. Where an item is defined as a “personal use asset”, there are four specific rules that apply: 1. Capital gains made from personal use assets are disregarded where the first element of the asset’s cost base is $10,000 or less. 2. When working out the cost base of a personal use asset, disregard the third element (non-capital costs of ownership). 3. A capital loss made from a personal use asset is disregarded. 4. If you own personal use assets that are part of a set, then that set of personal use assets is treated as a single personal use asset.
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Examples of personal use assets include: • a television at home; • mobile telephone for private use; • a bicycle; • a yacht owned for personal use and enjoyment. Section 108-20(3) provides that a personal use asset does not include a land or a building. Further, if an asset is considered a collectable, it will not be treated as a personal use asset. Given that a gain made from a personal use asset acquired for $10,000 or less is disregarded, it is difficult to think of many personal use assets which would be subject to tax on any gains. Examples commonly cited are yachts and racehorses.
Separate CGT assets [11.200] Subdivision 108-D of ITAA 1997 provides special rules for separate CGT assets. In particular, it provides an exception to the common law principle that what is attached to the land is part of the land, special rules about buildings and adjacent land and rules about when a capital improvement to a CGT asset is treated as a separate asset.
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The following specific rules are provided: • If land is acquired on or after 20 September 1985, a building or structure on the land is taken to be a separate asset if the depreciating asset or research and development balancing adjustment provisions apply.
Example 11.15: Separate CGT assets Mills Pty Ltd constructs a timber mill on land it already owns. The building is subject to a balancing adjustment on disposal, loss or destruction. The timber mill is considered a separate CGT asset. Source: Adapted from s 108-55(1) of ITAA 1997.
• If land was acquired before 20 September 1985, a building or structure constructed on the land is taken to be a separate CGT asset if the contract for construction was entered into on or after that day or, if there is no contract, the construction started on or after that day.
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Example 11.16: Separate CGT assets Acme Co purchases a block of land with a building on it on 1 January 1980. On 1 January 2010, Acme Co enters a contract to have another building erected on the land. The second building is taken to be a separate CGT asset. Source: Adapted from s 108-55(2) of ITAA 1997. A depreciating asset that is part of a building is a separate CGT asset. Example 11.17: Separate CGT assets Acme Co carries on a business of producing widgets from its factory. It installs new bathrooms for the employees. The plumbing fixtures and fittings are depreciable assets. They are separate CGT assets to the factory. The factory will be subject to the CGT provisions, but the depreciable assets will be disregarded for CGT purposes. Source: Adapted from s 108-60 of ITAA 1997. Land acquired on or after 20 September 1985 that is adjacent to land already owned is taken to be a separate CGT asset if the two parcels of land are combined into the one title.
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Example 11.18: Separate CGT assets In 1980, David purchased a block of land. In 1990, David purchased the adjacent block of land and amalgamated the two titles into one. The second block is a separate CGT asset. A capital gain will be made on the second block when the land is disposed of. Source: Adapted from s 108-65 of ITAA 1997. A capital improvement is a separate CGT asset to the land if: • a balancing adjustment provision applies to the land; • the cost base of the capital improvement to an asset acquired before 20 September 1985 is more than the improvement threshold for the relevant income year and more than 5% of the capital proceeds from the event; or • the total cost base of related capital improvements to an asset acquired before 20 September 1985 is more than the improvement threshold
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for the relevant income year and more than 5% of the capital proceeds from the event. The improvement threshold is $50,000 indexed from 1985. For the year ended 30 June 2018, it is $147,582 (TD 2017/16); for the year ended 30 June 2019, it is $150,386 (TD 2018/8) and for the year ended 30 June 2020, it is $153,093. Example 11.19: Improvements to CGT assets In 1980, William purchased a boat. In 1991, he installed a new mast for $30,000. He sold the boat in 2019–2020 for $150,000. Assuming the cost base of the improvement in the year of sale is $41,000, the improvement will not be considered a separate CGT asset as it is below the $153,093 threshold. Therefore, the capital gain or loss on the boat will be fully exempt. Source: Adapted from s 108-70 of ITAA 1997.
Time of acquisition of CGT asset
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[11.210] The time of the acquisition of a CGT asset needs to be considered for two specific reasons. First, an asset acquired before 20 September 1985 is generally exempt from capital gains tax. Second, indexation or the CGT general discount only applies where an asset is held for at least 12 months. Acquisition rules are dealt with in Div 109 of ITAA 1997. In general, a taxpayer acquires an asset when he or she becomes its owner: s 109-5(1). Where a taxpayer acquires a CGT asset as a result of a CGT event, specific rules contained in s 109-5(2) will apply before the general provision. For example, s 109-5(2) provides that where there is event A1 and an entity disposes of a CGT asset to a taxpayer, the taxpayer acquires the asset when the disposal contract is entered into or, if none, when the entity stops being the assets owner. Specific rules will also apply where a CGT asset comes into existence without a CGT event. For example, a taxpayer may construct or create a CGT asset. In this case, the time of acquisition is when the construction or work that resulted in the creation started: s 109-10 Item 1. It should be noted that s 109-10 Item 1 only applies where the taxpayer or the taxpayer’s agent constructs the asset. If the asset is created by an independent contractor, s 109-5(1) will apply as the asset is constructed by the contractor with the taxpayer’s acquisition date being at some later date when ownership is passed to the taxpayer.
Question 3: Does an exception or exemption apply? [11.220] Where it is determined that there is a CGT event, it is necessary to establish whether there is an exception or exemption that would reduce the
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352 [11.230] PRINCIPLES OF TAXATION LAW 2020 capital gain or loss or allow the taxpayer to disregard it. We have already briefly discussed some of these exceptions and exemptions when we considered Div 104 and the special rules relating to collectables and personal use assets. The exemptions for capital gains and capital losses on these assets, as well as many other exemptions, are contained in Div 118 of ITAA 1997. The most common exception that we saw in Div 104 applies to CGT events where the CGT asset was acquired before 20 September 1985. Where this is the case, the capital gain or loss is generally disregarded. In this section of the chapter, we are going to consider some of the other common exemptions. Exemptions can be divided into four broad categories:
• • • •
exempt gains and losses on certain assets: see [11.230]; exempt or loss denying transactions: see [11.280]; anti-overlap provisions: see [11.310]; and small business relief: see [11.320].
Disregarded capital gains and losses on certain assets
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[11.230] Cars, motor cycles and valour decorations. A capital gain or capital loss made from a car, motor cycle or similar vehicle, or a decoration awarded for valour or brave conduct, is disregarded in terms of CGT: s 118-5 of ITAA 1997. “Car” is defined in s 995-1 to mean a motor vehicle designed to carry a load of less than one tonne and fewer than nine passengers. Any capital gain made on the disposal of a decoration awarded for valour or brave conduct is ignored provided the taxpayer did not pay any money or give property for it. [11.240] Collectables and personal use assets. A capital gain or capital loss made from a collectable is disregarded if the first element of its cost base is $500 or less: s 118-10(1). Where a capital loss is made from a collectable with a cost base of more than $500, it can only be used to reduce capital gains from collectables: s 108-10(1). A capital gain from a personal use asset is disregarded if the first element of its cost base is $10,000 or less (s 118- 10(3)), while a capital loss from a personal use asset is always disregarded: s 108-20(1). [11.250] Assets used to produce exempt income. Subject to certain exceptions, a capital gain or capital loss made from a CGT asset that is used solely to produce exempt income or non-assessable non-exempt income is disregarded: s 118-12(1). [11.260] Shares in a PDF. A capital gain or capital loss made from a CGT event happening in relation to shares in a pooled development fund is disregarded: s 118-13.
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[11.265] Investments made in start-up companies. From 1 July 2016, there is a CGT exemption for investments made in a start-up company where they are held for more than 12 months and less than 10 years: subdiv 360-A. [11.270] Depreciating assets. A capital gain or capital loss made from a CGT event that involves the disposal of a depreciating asset is disregarded provided the event is also a balancing adjustment event where the asset was used wholly for a taxable purpose and the decline in value was worked out under Div 40: s 118-24(1). If the asset was not used wholly for a taxable purpose, any disposal of it may give rise to both a capital gain or loss and a balancing adjustment. [11.275] Trading stock. A capital gain or capital loss made from a CGT asset is disregarded if the asset is trading stock: s 118-25 of ITAA 1997. This is because the treatment of trading stock is dealt with in Div 70 of the ITAA 1997.
Exempt or loss denying transactions
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[11.280] Subdivision 118-A of ITAA 1997 contains various exempt or loss denying transactions, for example, payments made under certain government grants and arrangements. However, the two most common exemptions in this category relate to compensation payments (see [11.290]) and gambling or competitions: see [11.300]. [11.290] Compensation. A capital gain or capital loss is disregarded if it is made from a CGT event that relates directly to compensation or damages received for any wrong or injury suffered in an occupation or for any wrong, injury or illness that a taxpayer or a relative suffers personally: s 118-37(1) (a) and (b). In Ruling TR 95/35, the Commissioner states that the exemption includes out-of-court settlements and should be read as widely as possible to cover the full range of employment and professional type claims and include claims for discrimination, harassment and victimisation (or any directly related claims) arising out of State and Commonwealth anti-discrimination legislation, as well as wrongful dismissal. It should be noted that not all compensation payments are exempt. For example, compensation for a breach of contract may still be assessable: see Chapter 10. [11.300] Gambling and competitions with prizes. A capital gain or capital loss made from a CGT event relating to gambling, a game or a competition with prizes is disregarded: s 118-37(1)(c). However, the exemption will not apply to capital gains or losses where the taxpayer is considered to be in the business of gambling under the ordinary income provisions.
Anti-overlap provisions [11.310] The most important anti- overlap provision is s 118- 20 of ITAA 1997, which provides that any capital gain made from a CGT event is reduced
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354 [11.320] PRINCIPLES OF TAXATION LAW 2020 if, because of the event, a provision of the Act includes an amount in the taxpayer’s assessable income or exempt income: s 118-20(1). In essence, if an amount is considered ordinary or statutory income under another provision of ITAA 1997 or ITAA 1936, that amount will not be included in the capital gain. Example 11.20: Reducing capital gains where the amount is otherwise assessable Ross purchases land in 1995 as part of a profit- making scheme. In December 2019, he sells it for a profit of $100,000. This amount is included in his assessable income as ordinary income under s 6-5 of ITAA 1997. Ross determines that the capital gain he made from the land is $70,000. This amount will be reduced to zero as the ordinary income is greater than the capital gain. Further anti- overlap provisions include eligible termination payments (s 118-22), film copyright (s 118-30) and research and development: s 118-35.
Small business relief [11.320] As a measure to help small business, provided the basic conditions for relief are satisfied, any capital gains arising from the disposal of the business can be reduced by various concessions in Div 152 of ITAA 1997. The four available small business concessions are as follows: Copyright © 2019. Thomson Reuters. All rights reserved.
• 15-year exemption: see [11.340]; • 50% reduction: see [11.350]; • retirement concession: see [11.360]; and • rollover relief: see [11.370]. [11.330] Basic conditions for relief. For a taxpayer to be able to access the CGT small business relief, certain conditions must be met. The three basic conditions, contained in subdiv 152-A of ITAA 1997, are as follows: • The entity must be a small business entity or a partner in a partnership that is a small business entity, or the net value of assets that the entity and related entities own must not exceed $6 million. A taxpayer will also be a small business entity if it is an individual, partner, partnership, company or trust that is carrying on a business and has an aggregated turnover of less than $2 million in the previous or current year (either as an estimate or an actual turnover). From 1 July 2016, the aggregate
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turnover test for a small business has increased to $10 million. However, this new threshold does not apply to CGT concessions. • The CGT asset must be an active asset. An active asset may be a tangible asset or an intangible asset. The asset will be an active asset if it is used or held ready for use in the course of carrying on the business or, if an intangible asset, it is inherently connected with the business – for example, goodwill.
• If the asset is a share or interest in a trust, there must be a CGT concession stakeholder (a significant individual or spouse of a significant individual) just before the CGT event, and the entity claiming the concession must be a CGT concession stakeholder in the company or trust, or CGT concession stakeholders in the company or trust must have a small business participation percentage in the entity of at least 90%.
Legislation currently before parliament proposes to amend s 152-5 of ITAA 1997 to reflect the fact that an entity must be what is known as a “CGT small business entity” to have access to the CGT small business concessions. Basic conditions for relief will not be affected. year exemption provides a total [11.340] 15-year exemption. The 15- exemption for any capital gain on the disposal of a CGT asset owned for at least 15 years where the taxpayer is 55 years of age or over and retiring or is permanently incapacitated. If this exemption applies, it is not necessary to consider any of the other exemptions as it will take priority.
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Example 11.21: 15 year-exemption Jo is 60 years old. He has owned the local news agency which he purchased in 1986 for $50,000. Jo decides to retire as he wants to travel the world. In March 2020, Jo sells the business for $250,000, making a capital gain of $200,000. Assuming Jo meets the three basic conditions to qualify for the small business exemptions, he will qualify for the 15-year exemption as he is over 55 years and has owned the business for more than 15 years. As this will exempt all capital gains made from the sale of the business, Jo will not need to consider any other exemptions or concessions nor will he need to consider indexation. [11.350] 50% reduction. The 50% reduction allows a qualifying taxpayer to reduce the amount of its capital gain by 50%. The 50% reduction may be used after the capital gain has been reduced by the general 50% discount percentage, giving a total discount of 75%. Further, the gain may also be reduced by the small business retirement exemption or a small business rollover.
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Example 11.22: 50% reduction Zara, who operates a small manufacturing business, disposes of a CGT asset. She owned the CGT asset for three years. It was used as an active asset of the business. Zara qualifies for the CGT general discount and for the small business 50% reduction. From the CGT event, she makes a capital gain of $20,000, and she sells another asset, which gives her an additional capital loss of $5,000 in the income year. Zara calculates her net capital gain for the year as follows: $20,000 –$5,000 = $15,000 $15,000 –(50% × $15,000) = $7,500 $7,500 –(50% × $7,500) = $3,750
Assuming the small business retirement exemption and the small business rollover do not apply, Zara’s net capital gain for the year is $3,750. If she chose the rollover or the retirement exemption, some or all of the remaining capital gain would be disregarded.
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Source: Adapted from ATO, Advanced Guide to Capital Gains Tax Concessions for Small Business available at https:// www.ato.gov.au/ uploadedFiles/Content/MEI/downloads/39821n33590614.pdf. [11.360] Retirement concession. A taxpayer may choose to disregard a capital gain arising from the sale of a CGT asset connected with a small business if the proceeds are used in connection with the taxpayer’s retirement. There is a lifetime limit of $500,000. However, the taxpayer may apply other concessions to reduce the amount before applying the retirement concession. If the taxpayer is under 55 years, the proceeds must be paid into a complying superannuation fund, approved deposit fund or retirement savings account. If a taxpayer is over 55 years, the concession is available automatically, and it is not necessary to rollover the capital gain to a complying superannuation fund. Example 11.23: Retirement concession Jack acquired a farm in 2013. In December 2019, at the age of 60 years, he retires and transfers the farm to his son for no consideration. The market value of the farm was $1 million, so the market value substitution rule applies. It deems that the capital proceeds equal the market value of the farm. The cost base of the farm was $600,000, so, assuming the other retirement exemption conditions are satisfied, Jack made a capital gain of $400,000.
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Jack reduces his capital gain twice: first, by the 50% CGT general discount to $200,000 and then further, by the 50% active asset reduction, to $100,000. Although he received no capital proceeds, and assuming the other retirement exemption conditions are satisfied, Jack may choose to apply the retirement exemption for the full amount of the remaining $100,000 capital gain. Source: Adapted from ATO, Advanced Guide to Capital Gains Tax Concessions for Small Business available at https:// www.ato.gov.au/ uploadedFiles/Content/MEI/downloads/39821n33590614.pdf. [11.370] Rollover relief. If a taxpayer chooses a rollover, all or part of the capital gain is not included in the taxpayer’s assessable income until circumstances change. A taxpayer may defer paying tax on a capital gain made from a CGT event in relation to a small business if the taxpayer acquires a replacement active asset and elects to obtain a rollover. The rollover relief may be applied after the CGT general discount and active asset reduction. Example 11.24: Partial rollover relief
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Jude’s small business has an original capital gain of $100,000. After Jude applies the CGT general discount and 50% active asset reduction, his original capital gain is reduced to $25,000. If we assume the first and second elements of the cost base of the business’ replacement asset total $20,000, this amount can be disregarded under the rollover, leaving Jude with a final capital gain of $5,000. Source: Adapted from ATO, Advanced Guide to Capital Gains Tax Concessions for Small Business available at https:// www.ato.gov.au/ uploadedFiles/Content/MEI/downloads/39821n33590614.pdf.
Main residence exemption [11.380] A capital gain or loss as a result of a CGT event happening to a taxpayer’s main residence is generally ignored. Specifically, subdiv 118-100 of Pt 3-1 of ITAA 1997 provides that you can disregard a capital gain or capital loss made from a CGT event that happens to a dwelling that is the taxpayer’s main residence. The full exemption on gains or losses on a main residence is known as the base case. However, this full exemption, or base case, will only apply where the residence was the main residence during the whole of the ownership period and it was not used for the purposes of producing assessable income.
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358 [11.390] PRINCIPLES OF TAXATION LAW 2020 There are some specific rules which may extend the exemption and other specific rules which may limit the exemption. Section 118-105 contains a map of subdiv 118-B as reproduced in Figure 11.3. Figure 11.3: Map of subdiv 118-B A CGT event happens to your dwelling
Event that may attract exemption
Basic case
The 2 different cases
You are an individual and did not acquire the interest as a beneficiary of a deceased estate
Extent of exemption Full exemption depends on whether dwelling is your main section 118-110 residence throughout ownership period (and on other factors for deceased estates)
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Deceased estates case
Partial exemption section 118–185
You acquire the interest as trustee or beneficiary of a deceased estate
Full exemption section 118–195
Partial exemption section 118–200
Adjust if dwelling used to produce assessable income section 118–190
Other rules that apply to both cases
Rules extending the exemption: sections 118–135 to 118–160
Rules limiting the exemption: sections 118–165 to 118–180
The government has previously proposed legislation to prevent foreign residents from claiming the main residence exemption with effect from 9 May 2017. This legislation has now lapsed and has not yet been reintroduced into parliament. [11.390] Basic case. The basic exemption provides that a capital gain or capital loss made from a CGT event that happens in relation to a CGT asset that is a dwelling is disregarded if:
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• the taxpayer is an individual; and • the dwelling was the taxpayer’s main residence throughout the whole of the ownership period: s 118-110(1) of ITAA 1997. A dwelling includes a unit of accommodation that is a building which consists wholly or mainly of residential accommodation, a caravan, houseboat or mobile home and the land immediately under the accommodation: s 118- 115(1). The exemption also applies to land that is adjacent to the dwelling, up to a maximum of two hectares, provided it is used for private or domestic purposes: s 118-120.
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The basic case applies where the taxpayer lives in the property for the whole of the ownership period. Where this is the case and the taxpayer sells the property, the capital gain or loss will be disregarded. There are instances where the taxpayer does not live in the property for the whole of the ownership period but can still disregard the capital gain or loss on disposal. These rules extend the exemption. Where a taxpayer is able to extend the exemption, it is not necessary to consider the partial exemption rules. [11.400] Rules that may extend the exemption. The following rules may extend the main residence exemption: • The main residence exemption extends to cover the period from the time of acquisition to the time when it is first practicable for the taxpayer to move into the dwelling: s 118-135 of ITAA 1997. • A taxpayer who acquires a new dwelling which is intended to be a main residence, but still holds an existing main residence, may treat both dwellings as a main residence for the six-month period before the disposal of the old dwelling or the period between the acquisition of the new dwelling and disposal of the old dwelling, whichever is the shorter: s 118-140(1). The extension only applies, however, if the original main residence was the taxpayer’s main residence for a continuous period of at least three months in the 12 months before it is disposed of and it was not used to produce income during any part of that 12-month period: s 118-140(2). • A taxpayer may be entitled to treat a dwelling as his or her main residence during a period of absence provided no other dwelling is treated as a main residence during the period of absence. If a dwelling that was the taxpayer’s main residence ceases to be the main residence, and the taxpayer uses the dwelling for the purposes of producing income, the taxpayer may choose to continue to treat the dwelling as his or her main residence for a maximum period of six years: s 118-145(2). If the dwelling is not used for the purposes of producing income, a taxpayer may treat the dwelling as a main residence indefinitely: s 118-145(3). • Where a taxpayer builds, repairs or renovates a dwelling, provided no other dwelling is treated as a main residence, a taxpayer may choose
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360 [11.410] PRINCIPLES OF TAXATION LAW 2020 to treat the dwelling as his or her main residence from the time of acquisition, provided it becomes the taxpayer’s main residence as soon as practicable after the work has finished: s 118-150(2). This extension can only operate for the shorter of four years before the dwelling becomes the taxpayer’s main residence or the period between the date of acquisition of the land the dwelling becoming the main residence: s 118-150(4). TD 2017/13 deals with the situation where you build a dwelling on land acquired pre-CGT and wish to claim the main residence exemption before it becomes your main residence. In that case, a choice needs to be made under s 118-150(2). • Where a dwelling that is a taxpayer’s main residence is accidentally destroyed and a CGT event happens in relation to the land, provided there is no other main residence, the taxpayer may choose to apply the exemption to the period after destruction until the land is sold: s 118-160.
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[11.410] Rules that may limit the exemption. The following rules may limit the main residence exemption: • The main residence exemption does not apply to a CGT event that happens in relation to land, or a garage, storeroom or other structure, to which the exemption can extend if the event does not also happen in relation to the dwelling: s 118-165 of ITAA 1997. • A taxpayer and his or her spouse will generally have the same main residence. Where the taxpayer and spouse have different main residences, the parties must choose one of the dwellings as the main residence of both or nominate the different dwellings as the main residences: s 118-170(1). If the parties nominate different residences, the entitlement to the main residence exemption is split between the two dwellings in accordance with s 118- 170(3) and (4). Where the taxpayer’s interest in his or her main residence is not more than half, the dwelling is taken to be the main residence during the period. Otherwise the dwelling is taken to be the taxpayer’s main residence for half of the period. The same principle applies to the main residence of the taxpayer’s spouse. • A taxpayer and his or her dependent child or children will generally have the same main residence. If another dwelling is the main residence of a dependent child under 18 years, the taxpayer must choose one main residence for both themselves and the dependant: s 118-175. • The main residence exemption will be limited where the dwelling is acquired by a taxpayer under the marriage breakdown rollover provisions. In these circumstances, the taxpayer’s exemption will be apportioned according to how the dwelling was used both before and after the rollover: s 118-178.
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[11.420] Partial exemption rules. In addition to the rules which extend or limit the main residence exemption, there are two situations where a taxpayer may be entitled to a partial exemption only. A taxpayer will only be entitled to a partial exemption for a CGT event that happens in relation to a main residence if the dwelling was the taxpayer’s main residence for part only of the ownership period. Where only a partial exemption is allowed, the capital gain is apportioned according to the days the dwelling was the taxpayer’s main residence: s 118-185 of ITAA 1997. Where a taxpayer is only entitled to a partial exemption because the property is used for income- producing purposes and that income-producing purpose first occurred after 20 August 1996, the partial exemption is calculated by reference to s 118-192. This section deems the taxpayer to have acquired the property at market value at the date it first produces income. Example 11.25: Partial exemption Rebecca bought a house in March 2010 for $200,000 and moved in immediately. In March 2013, she purchased another property, which she immediately began to treat as her main residence. She moved out of the first property and began to rent it out. At that time, it was valued at $350,000. She sold it in March 2020 for $360,000. The capital gain or capital loss will be calculated using s 118-192 to value the property. Rebecca will have made a capital gain of $10,000.
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Example 11.26: Partial exemption using s 118-145 to extend the exemption Connor bought a house in July 2009 for $200,000 and moved in immediately. In July 2012, he moved out and began to rent it out. At that time, it was valued at $350,000. He sold it in July 2019 for $360,000. Connor chooses to continue to treat the dwelling as his main residence under s 118-145 (about absences) for the first six of the seven years during which he rented the house out. The capital gain or capital loss (ignoring leap years as per the example provided in s 118-185) will be calculated using the following formula: Capital gain or capital loss amount
×
Non-main residence days Days in ownership period
Connor will be taken to have made a capital gain of: $10,000
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×
365 2,555
=
$1,429
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362 [11.425] PRINCIPLES OF TAXATION LAW 2020 A taxpayer will only be entitled to a partial exemption for a CGT event that happens in relation to a main residence if the dwelling was used for the purpose of producing assessable income during all or part of the period of ownership: s 118-190. The test to determine whether the property was used to earn assessable income is based on whether the interest is or would be deductible if incurred: s 118-190.
Example 11.27: Partial exemption Sandra’s house purchase contract was settled on 1 January 2016, and the house was her main residence for the entire four years she owned it, until she sold it under a contract entered into on 1 November 2019 and settled on 31 December 2019. From the time Sandra bought it until 31 December 2017 (75% of the ownership period), she used 25% of her house to run her photographic business. The rooms were modified for that purpose so were no longer suitable for private and domestic use. Sandra made a capital gain of $10,000 when she sold the house and used the following formula to calculate the taxable portion: Capital gain × % of floor area not used as main residence × % of period of ownership that that part of the home was not used as main residence = taxable portion $10,000 × 25% × 75% = $1,875
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Death [11.425] Division 128 of ITAA 1997 sets out what happens when a taxpayer dies and a CGT asset devolves to a legal personal representative or a beneficiary of the estate. The capital gain or capital loss made by the deceased from the CGT event is disregarded: s 128-10. There are, however, consequences for the beneficiary. The beneficiary will have acquired either a pre- CGT asset or a post-CGT asset. Where the beneficiary acquires a pre-CGT asset, he or she is deemed to have acquired the asset for the market value on the date of death: s 128-15(4). Where the beneficiary acquired a post-CGT asset, he or she is deemed to have acquired the asset for the deceased person’s cost base as at date of death: s 128-15(4). If, however, the CGT asset was the deceased’s main residence, the beneficiary is deemed to have acquired the asset for market value at the date of death: s 128-15(4).
Question 4: Can there be a rollover? [11.430] In certain specific situations, rollovers allow a taxpayer to defer or disregard a capital gain or loss from a CGT event. A rollover is either automatic
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or requires the taxpayer to make an election. Rollovers apply only to specific situations. Rollovers are divided into two categories: replacement asset rollovers and same asset rollovers. With a replacement asset rollover, the taxpayer is allowed the deferral of a capital gain or loss from one CGT event until a later CGT event happens where one CGT asset is replaced with another. Replacement asset rollovers are dealt with in subdiv 112-C of ITAA 1997. A replacement asset rollover involves one CGT asset ending and the taxpayer acquiring another. The consequence of a replacement asset rollover is that the cost base of the replacement asset is modified. If the taxpayer acquired the original CGT asset before 20 September 1985, the replacement asset is taken to have been acquired before that day. If a taxpayer acquired the original asset on or after 20 September 1985, the cost base of the replacement asset is modified. The first element of the replacement asset’s cost base (or reduced cost base) is replaced by the original asset’s cost base (or reduced cost base) at the time the replacement asset was acquired.
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All replacement asset rollovers are listed in a table in s 112-115. However, some common examples of replacement asset rollovers are as follows: • disposal of assets by an individual, trustee or partners to a wholly owned company; • where an asset is compulsorily acquired, lost or destroyed; • strata title conversion; • Crown leases; • scrip for scrip; and • demergers. With a same asset rollover, the taxpayer is allowed to disregard a capital gain or loss from a CGT event where the same CGT asset is involved. Same asset rollovers are dealt with in subdiv 112-D. A same asset rollover allows a taxpayer to disregard a capital gain or loss from the disposal or creation of a CGT asset to another taxpayer. The gain or loss is effectively transferred to the other taxpayer and deferred until there is a CGT event in the hands of that taxpayer. All same asset rollovers are listed in a table in s 112-150. However, some common examples of sale asset rollovers are as follows: • transfer of a CGT asset from one spouse to another because of a marriage breakdown; • transfer of a CGT asset to a wholly owned company; and • transfer of an asset between related companies.
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364 [11.440] PRINCIPLES OF TAXATION LAW 2020 From 1 July 2016, optional rollover relief is available where a small business undertakes a genuine restructure, but the ultimate legal ownership of the asset remains unchanged. This rollover extends beyond CGT assets to apply to gains and losses on trading stock, revenue assets and depreciating assets as well.
Step 2 –Work out amount of capital gain or loss [11.440] Once we have answered the four questions in Step 1 and determined that the taxpayer has made a capital gain or loss, it is necessary to work out the amount of that capital gain or loss. This requires us to consider two more questions: • What is a capital gain or loss for the particular CGT event? See [11.450]. • What factors come into calculating a capital gain or loss for the particular CGT event? See [11.460]. Columns 3 and 4 of the table contained in s 104-5 of ITAA 1997 provide a useful summary of when a capital gain or a capital loss arises for each CGT event.
What is a capital gain or loss?
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[11.450] For most CGT events the taxpayer makes a capital gain where the capital amount received (or that the taxpayer is entitled to receive) from a CGT event exceeds the total costs associated with that event and makes a capital loss where total costs associated with a CGT event exceed the capital amount received (or that the taxpayer is entitled to receive). CGT event A1, the disposal of a CGT asset, is the most common event. Section 104-10(4) of ITAA 1997 specifically provides: You make a capital gain if the capital proceeds from the disposal are more than the asset’s cost base. You make a capital loss if those capital proceeds are less than the asset’s reduced cost base.
If you re-examine the other CGT events, you will find a similar section for each. In each provision is the use of various terms which have specific legislative meaning. The terms are capital proceeds, cost base and reduced cost base. They are known as the factors which come into calculating a capital gain or loss.
What factors come into calculating a capital gain or loss? [11.460] The next question we ask is What factors come into calculating a capital gain or loss? The main factors are the capital proceeds, cost base and
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reduced cost base. Once we know these figures, we can calculate the capital gain or loss for most CGT events. Before considering the statutory meaning of these terms, note the calculations required to determine the gain or loss from a CGT event.
Figure 11.4: Calculating capital gain or loss
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Calculation 1
Work out your capital proceeds from the CGT event See [11.470]
Calculation 2
Work out the cost base for the CGT asset See [11.480]
Calculation 3
Subtract the cost base from the capital proceeds
Calculation 4
If the proceeds exceed the cost base, the difference is your capital gain
Calculation 5
If not, wok out the reduced cost base for the asset See [11.500]
Calculation 6
If the reduced cost base exceeds the capital proceeds, the difference is your capital loss
Calculation 7
If the capital proceeds are less than the cost base but more than the reduced cost base, you have neither a capital gain nor a capital loss
Capital proceeds [11.470] For most CGT events, the capital amounts that the taxpayer receives or is entitled to receive are the capital proceeds. Section 116-20 of
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366 [11.470] PRINCIPLES OF TAXATION LAW 2020 ITAA 1997 defines the capital proceeds from an event as the total amount of money the taxpayer has received or is entitled to receive in relation to a CGT event happening and the market value of any other property the taxpayer has received or is entitled to receive in respect of the event happening. The Full Federal Court has held that an entitlement to receive money is not affected even if the money is received from a third party: Quality Publications Australia Pty Ltd v FC of T [2012] FCA 256. For the purposes of determining the proceeds of a CGT event, any GST on the supply is disregarded: s 116-20(5). The definition in s 116-20 is known as the general rule about capital proceeds. In addition to this general rule, there are six modifications that may be relevant: 1. The first modification rule is the market value substitution rule, which is relevant if a taxpayer receives no capital proceeds from a CGT event or some or all of the capital proceeds cannot be valued, or the taxpayer did not deal at arm’s length with another entity in connection with the event: s 116-30. In other words, there is a connection between the parties, for example, they are related or good friends. The capital proceeds are deemed to be the market value determined at the time of the CGT event. “Market value” is determined by reference to its ordinary meaning and is generally understood to mean the price that a willing purchaser at that date would have had to pay: Spencer v Commonwealth (1907) 5 CLR 418 at 441 per Isaacs J.
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Example 11.28: Market value substitution rule Bill gives a rental property to his daughter and does not receive any consideration. Bill is taken to have received the market value of the property, which is a CGT asset. Source: Adapted from s 116-30 of ITAA 1997. 2. The second modification rule is an apportionment rule, which is relevant if a payment received by a taxpayer in connection with a transaction relates in part only to a CGT event: s 116-40. The capital proceeds from each event are so much of the payment as is reasonably attributable to that event.
Example 11.29: Apportionment rule Betty sells a block of land and a boat for a total of $100,000. This transaction involves two CGT events.
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The $100,000 must be divided among the two events. The capital proceeds from the disposal of the land are so much of the $100,000 as is reasonably attributable to it. The rest relates to the boat. Source: Adapted from s 116-40 of ITAA 1997.
3. The third modification rule is a non-receipt rule, which is relevant if the taxpayer does not receive or is not likely to receive, some or all of the capital proceeds from a CGT event: s 116-45. The capital proceeds are reduced by the amount not received.
Example 11.30: Non-receipt rule Lyn sells a painting to Mat for $5,000 (the capital proceeds). Lyn agrees to accept monthly instalments of $100. Lyn receives $2,000, but then Mat stops making payments. It becomes clear that Lyn is not likely to receive the remaining $3,000. The capital proceeds are reduced to $2,000. Source: Adapted from s 116-45 of ITAA 1997.
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4. The fourth modification rule is a repaid rule, which is relevant if the taxpayer is required to repay some or all of the capital proceeds from a CGT event: s 116-50. The capital proceeds are reduced by the amount repaid.
Example 11.31: Repaid rule Simon sells a block of land for $50,000 (the capital proceeds). Siobhan (the purchaser) later finds out that Simon misrepresented a term in the contract. Siobhan sues Simon, and the court orders him to pay $10,000 in damages to Siobhan. The capital proceeds are reduced by $10,000, to $40,000. Source: Adapted from s 116-50 of ITAA 1997. 5. The fifth modification rule is an assumption of liability rule, which is relevant if another entity assumes a liability in connection with a CGT event: s 116-55. The capital proceeds are increased by the amount of the liability.
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Example 11.32: Assumption of liability rule Olivia sells land for $150,000. She receives $50,000 (the capital proceeds), and Angus (the buyer) becomes responsible for a $100,000 liability under an outstanding mortgage. The capital proceeds are increased by $100,000, to $150,000. Source: Adapted from s 116-55 of ITAA 1997.
6. The sixth modification rule is a misappropriation rule, which is relevant if an employee or agent misappropriates all or part of the proceeds. The capital proceeds will be reduced by the amount misappropriated: s 116-60.
Cost base [11.480] For most CGT assets, the cost base is the total of the costs associated with the CGT asset. The cost base is used for the purpose of working out a capital gain. Where the taxpayer is registered for GST, the cost base will be net of any GST credits available. If, however, the taxpayer is not registered for GST, any GST paid will be included in the cost base of the asset.
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Subdivision 110-A of ITAA 1997 sets out the rules for determining the cost base of a CGT asset. The cost base of a CGT asset has five elements: • Element 1: The money paid by the taxpayer, or required to be paid, in respect of acquiring the asset and the market value of any other property given or required to be given in respect of acquiring the asset: s 110-25(2). • Element 2: The incidental costs incurred by the taxpayer. There are a number of incidental costs that a taxpayer may have incurred. The following nine categories of costs, the first eight of which must occur in relation to the acquisition or event, are listed in s 110-35 as incidental costs: – remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser; – cost of transfer; – stamp duty; – cost of advertising or marketing to find a buyer or seller; – costs for any valuation or apportionment; – search fees relating to a CGT asset; – cost of a conveyancing kit;
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–
borrowing expenses; and
– expenditure incurred by the head company of a consolidated group to an entity that is not a member of a group and the cost reasonably relates to a CGT asset held by the head company and is incurred because of a transaction between members of the group. • Element 3: The costs of owning the CGT asset (only if the asset is acquired after 20 August 1991) including the items listed in s 110-25(4): – interest on money borrowed to acquire the asset; – costs of maintaining, repairing or insuring it; – rates or land tax, if the asset is land; – interest on money borrowed to refinance the money borrowed to acquire the asset; and – interest on money borrowed to finance the capital expenditure incurred to increase the asset’s value. • Element 4: Expenditure incurred to increase or preserve the assets value or expenditure incurred to install or move the asset: s 110-25(5). • Element 5: Expenditure incurred to establish, preserve or defend the title to the asset or a right over the asset: s 110-25(6). Once the costs associated with a CGT event have been determined according to the five elements, it is necessary to determine those costs that do not form part of the cost base because they are specifically excluded. The following amounts are excluded from the cost base:
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• expenditure that does not form part of the second or third element of the cost base to the extent that you have deducted or can deduct it: ss 110-40(2)–110-45(1B); • expenditure that does not form part of any element of the cost base to the extent that it has been recouped unless the amount is included in assessable income ss 110-40(3) and 110-45(3); • expenditure that is prevented from being a deduction under s 26-54 (certain offences) s 110-38(1) or s 26-5 (penalties): s 110-38(4); • expenditure to the extent that it is a bribe to a public official: s 110-38(2); and
• expenditure to the extent that it is in respect of providing entertainment: s 110-38(3).
[11.490] In addition to the basic rules about cost base, there are cost base modification rules that need to be considered: • The first modification rule is the market value substitution rule. The first element of the cost base will be replaced with the market value if the taxpayer did not incur any expenditure to acquire the asset, some or all of the expenditure cannot be valued or the taxpayer did not deal
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370 [11.495] PRINCIPLES OF TAXATION LAW 2020
•
•
•
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•
at arm’s length in relation to the acquisition: s 112-20(1). Where it is the case that the parties did not deal at arm’s length with each other and the acquisition resulted from another entity doing something that did not constitute a CGT event happening, the market value will only be substituted where the taxpayer paid more than market value: s 112-20(2). However, there are circumstances where the market value substitution rule will not apply –for example, where CGT event D1 happens and the taxpayer did not pay anything for it. The second modification rule deals with split, changed or merged assets. If a CGT asset is split into two or more assets or a CGT asset changes into an asset of a different nature, the splitting or change is not a new CGT asset. However, the cost base needs to be worked out for the new assets. The cost base of each asset is a reasonable apportionment of the cost base of the original asset. If two or more assets are merged, the cost base of the new asset is the sum of the elements of each original asset: s 112-25. The third modification rule deals with the apportionment of expenditure where the expenditure relates in part only to the CGT asset. The expenditure allocated to the CGT asset is that which is reasonably attributable to each element: s 112-30. The fourth modification rule is the assumption of liability rule. If a taxpayer acquires a CGT asset from another taxpayer and that asset is subject to a liability, the first element of the asset’s cost base includes the amount of the liability: s 112-35. The fifth modification rule relates to put options and provides that the first element of the cost base of the right to dispose of a share in a company acquired as a result of CGT event D2 happening to the company is the amount included in the taxpayer’s assessable income as ordinary income as a result of the acquisition of the right, plus any amount paid to acquire the right: s 112-37.
Modification provisions are contained in the capital proceeds rules with each of the cost base modification rules discussed above having a mirror equivalent in relation to capital proceeds. [11.495] Indexation. A CGT asset acquired at or before 11.45 am on 21 September 1999 may have an indexed cost base. Indexation takes into account inflation up to September 1999. All of the elements, except for the third element, may be indexed. However, a taxpayer can only index the cost base of a CGT asset acquired at least 12 months before the CGT event. Where a taxpayer acquires an asset before 21 September, they will have a choice to use either indexation or the CGT general discount discussed below in Step 3 and may use whichever gives them the best result. Subdivision 960-M of ITAA 1997 shows how to apply indexation and calculate the indexation factor. The calculation involves multiplying the separate elements of the cost base by the
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indexation factor. The indexation factor is determined by dividing the index number for the quarter in which the CGT event occurred (or September 1999 if the CGT event occurred after that date) by the index number of the quarter in which the expenditure was incurred. Note that the indexation factor is always rounded to three decimal places. See [11.580] for a table of indexation figures. Example 11.33: Indexation and discounting Peter purchased a building as an investment on 1 January 1987 for $250,000. This amount forms the first element of his cost base. He sold the building on 1 February 2020 for $500,000. The cost base can only be indexed up to the September 1999 quarter. The indexation number for that quarter is 68.7. The index number for the quarter in which he purchased the building (the March quarter 1987) is 45.3. Applying s 960-275, work out the indexation factor as follows: 68.7 45.3
=
1.517
The indexed first element of Peter’s cost base is: 1.517 × $250,000 = $379,250 Assuming Peter has no other costs associated with the property, his capital gain under the indexation method would be:
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$500,000 –$379,250 = $120,750 Peter’s capital gain using the CGT general discount would be: $500,000 –$250,000 = $250,000 less 50% discount = $125,000
In this case, Peter would be advised to use the indexation method to determine his net capital gain from the sale of the property as it results in the least capital gain. Source: Adapted from s 114-1 of ITAA 1997.
Reduced cost base [11.500] For most CGT events, the reduced cost base is the total of the costs associated with the CGT event. The reduced cost base is used for the
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372 [11.510] PRINCIPLES OF TAXATION LAW 2020 purpose of working out a capital loss. The reduced cost base also consists of five elements. All the elements are the same as the cost base (see [11.480]) except for the third element. The third element of the reduced cost base is an amount included in the taxpayer’s assessable income because of certain balancing adjustments. Further, the elements of the reduced cost base cannot be indexed. The reduced cost base does not include any of the costs the taxpayer has previously claimed or can claim in the current year as a deduction. For example, the cost base must be reduced by any capital works deductions claimed for capital expenditure. Example 11.34: Capital works deduction –effect on reduced cost base Kate acquires a new income- producing asset on 1 January 2005 for $250,000. She sold it for $200,000 in May of the current tax year. While she owned it, she claimed capital works deductions of $30,000 for expenditure she incurred. Her capital loss is worked out as follows: Cost base
$250,000
Less capital works deductions
$30,000
Reduced cost base
$220,000
Less capital proceeds
$200,000
Capital loss
$20,000
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Step 3 –Work out your net capital gain or loss for the income year [11.510] Step 2 required calculations to be performed to determine the capital gain or loss from a CGT event. However, in an income year, a taxpayer may have more than one CGT event. Step 3 reconciles the gains or losses made from the individual events. It involves a determination of a taxpayer’s net capital gain or loss, that is, we need to calculate the amount of gain to be included in assessable income or the amount of loss to be carried forward to future years. This requires five calculations.
Calculation 1 [11.520] The first calculation involves reducing your capital gains for the income year by your capital losses for the income year. Taxpayers may reduce
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Figure 11.5: Five-step process to calculate net capital gain
Calculation 1
Reduce the capital gains for the income year, in the order you choose, by your capital losses for the income year from your assessable income See [11.520]
Calculation 2
Reduce any remaining capital gains, in the order you choose, by any unapplied net capital osses for previous income years See [11.530]
Calculation 3
Reduce any remaining discount capital gains by the discount percentage See [11.540]
Calculation 4
If you carry on a small business, apply the small business concessions in further reduction of your capital gains (whether or not the gains are discount capital gains) See [11.560]
Calculation 5
Add up: Any remaining capital gains that are not discount capital gains; and Any remaining discount capital gains: s 100–50
the capital gains in any order they choose. This allows taxpayers to maximise the value of any losses. At this stage, remember that there are special rules for collectables (see [11.180]) and personal use assets: see [11.190]. In particular, losses from personal use assets are disregarded and losses from collectables are quarantined to be used only against gains from collectables. Generally, a taxpayer will apply any losses against gains that cannot utilise the 50% general discount or indexation. It will then normally be a case of applying
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374 [11.530] PRINCIPLES OF TAXATION LAW 2020 losses against indexed capital gains and, finally, against gains which attract the 50% CGT general discount.
Calculation 2 [11.530] If a taxpayer still has capital gains after deducting the current year capital losses, he or she can then reduce those capital gains in the order he or she chooses by any losses of previous years. The losses, however, are applied in the order in which they were incurred. Example 11.35: Taking into account losses Lily has capital gains for the current income year of $1,000 and capital losses for the current income year of $600. Her capital losses are subtracted from her capital gains, to leave a balance of $400. If she also has net capital losses of $300 from the previous year and $200 from the year before that, she can reduce the current balance of $400 to nil. The net capital losses are applied in the order in which she made them. Therefore, the $200 will be used and $200 of the $300 will be used, leaving her with $100 to be carried forward. Source: Adapted from s 102-15 of ITAA 1997.
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Calculation 3 [11.540] Calculation 3 allows some taxpayers to reduce any discount capital gain by the discount percentage. Discount capital gains are dealt with in Div 115 of ITAA 1997. In certain circumstances, the cost base of a CGT asset may be indexed to take into account inflation: see [11.490] and Example 11.30. As of 21 September 1999, indexation was abolished and replaced with a CGT general discount. Individuals and trusts receive a 50% general discount on the capital gain from certain CGT events, while complying superannuation funds receive a one-third general discount. A taxpayer may apply the general discount where a CGT event occurs on or after 11.45 am on 21 September 1999 and he or she has held the asset for more than 12 months. Where a CGT asset is acquired before 21 September 1999 and the CGT event occurs after that date, the taxpayer may elect to use indexation or apply the general discount. Taxpayers cannot use both. There are also certain CGT events which do not attract the CGT general discount, generally because the 12-month rule is not satisfied. For example,
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the CGT general discount does not apply to any of the D category events. In certain circumstances, a discount capital gain may be recalculated without reference to indexation. Example 11.36: Recalculation without reference to indexation Maxine acquired land from her ex-husband under a court order made under the Family Law Act 1975 (Cth) in 1995. Her ex-husband’s indexed cost base for the land was $56,000, and Maxine was treated as having paid that amount for it. Her ex-husband’s cost base for the land then was $40,000. Maxine sold the land in the current tax year for capital proceeds of $150,000. Maxine’s discount capital gain on the land is calculated as: Capital proceeds –Cost base for the land without indexation $150,000 –$40,000 = $110,000
Source: Adapted from s 115-20(2) of ITAA 1997.
Calculation 4
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[11.550] Once any losses are taken into account, as well as any CGT general discount available, a taxpayer who is entitled to any of the small business concessions may apply them at this stage: see [11.320].
Calculation 5 [11.560] Calculation 5 requires a taxpayer to add up any remaining capital gains that are not discount capital gains and any remaining discount capital gains to determine the net capital gain to be included in assessable income. A net capital gain is included in a taxpayer’s assessable income as statutory income.
Capital losses [11.570] A net capital loss is determined via similar steps to determine a net capital gain. However, a taxpayer cannot deduct from his or her assessable income a net capital loss for any income: s 102-10(2) of ITAA 1997. Therefore, there is only a three-step process to follow to determine a taxpayer’s net capital loss. To the extent that a net capital loss cannot be applied in an income year, it can be carried forward to a later income year: s 102-15(1).
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376 [11.580] PRINCIPLES OF TAXATION LAW 2020
Indexation figures Current index reference base [11.580] Quarter ending
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Year
31 March
30 June
30 September
31 December
1985
37.9
38.8
39.7
40.5
1986
41.4
42.1
43.2
44.4
1987
45.3
46.0
46.8
47.6
1988
48.4
49.3
50.2
51.2
1989
51.7
53.0
54.2
55.2
1990
56.2
57.1
57.5
59.0
1991
58.9
59.0
59.3
59.9
1992
59.9
59.7
59.8
60.1
1993
60.6
60.8
61.1
61.2
1994
61.5
61.9
62.3
62.8
1995
63.8
64.7
65.5
66.0
1996
66.2
66.7
66.9
67.0
1997
67.1
66.9
66.6
66.8
1998
67.0
67.4
67.5
67.8
1999
67.8
68.1
68.7
N/A
Questions [11.590] 11.1 Anita is a client of yours. To fund her career as an artist, Anita sold some of her art collection by other artists. It consisted of: (a) An antique ceramic bowl purchased in February 1985 for $4,000. She sold the bowl on 1 December of the current tax year for $12,000. (b) A sculpture purchased in December 1993 for $5,500. She sold the sculpture on 1 January of the current tax year for $6,000. (c) A bronze figure purchased in October 1987 for $14,000. She sold the bronze figure on 20 March of the current tax year for $13,000. (d) A painting purchased in March 1987 for $470. She sold the painting on 1 July of the current tax year for $5,000. Consider the CGT consequences of the above transactions.
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11.2 Other than the examples provided in this chapter, provide an example for each of CGT events A1, B1, C1, C2, D1 and D2. 11.3 Are the following CGT assets, collectables or personal use assets: (a) An engagement ring which cost $5,000? (b) A second-hand car purchased for $2,000? (c) Shares in BHP? (d) Your home? (e) A painting hung in the foyer of your accounting firm? (f) A holiday house at Byron Bay? 11.4 List five things that you own that are considered personal use assets. Can you think of any collectables that you may own? 11.5 What CGT events apply to the following transactions: (a) You sell shares in BHP for $5,000. (b) You receive $100,000 in return for signing a three-year contract to play AFL with the Brisbane Lions. (c) You sell your holiday home at Byron Bay for $750,000. (d) You sell your hairdressing salon for $200,000 and receive an additional $20,000 for agreeing not to open another salon within a 10-km radius for the next three years. (e) You pay Shelby $50,000 for the option to purchase her hairdressing salon in three years time.
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(f) In three years time, you exercise the option to purchase Shelby’s salon for $300,000. (g) You sell a diamond ring for $20,000. You paid $12,000 for the ring in 1984. 11.6 Dave Solomon is 59 years of age and is planning for his retirement. Following a visit to his financial adviser in March of the current tax year, Dave wants to contribute funds to his personal superannuation fund before 30 June of the current tax year. He has decided to sell the majority of his assets to raise the $1,000,000. He then intends to rent a city apartment and withdraw tax-free amounts from his personal superannuation account once he turns 60 years in August of the next year. Dave has provided you with the following details of the assets he has sold: (a) A two-storey residence at St Lucia in which he purchased and has lived in since 1884. He paid $70,000 to purchase the property and received $850,000 on 27 June of the current tax year after the real estate agent deducted commissions of $15,000. The residence was originally sold at auction, and the buyer placed an $85,000 deposit on the property. Unfortunately, two weeks later, the buyer
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378 [11.590] PRINCIPLES OF TAXATION LAW 2020
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indicated that he did not have sufficient funds to proceed with the purchase, thereby forfeiting his deposit to Dave on 1 May of the current tax year. The real estate agents then negotiated the sale of the residence to another interested party. (b) A painting by Pro Hart that he purchased on 20 September 1985 for $15,000. The painting was sold at auction on 31 May of the current tax year for $125,000. (c) A luxury motor cruiser that he has moored at the Manly Yacht club. He purchased the boat in late 2004 for $110,000. He sold it on 1 June of the current tax year to a local boat broker for $60,000. (d) On 5 June of the current tax year, he sold for $80,000 a parcel of shares in a newly listed mining company. He purchased these shares on 10 January of the current tax year for $75,000. He borrowed $70,000 to fund the purchase of these shares and incurred $5,000 in interest on the loan. He also paid $750 in brokerage on the sale of the shares and $250 in stamp duty on the purchase of these shares. Dave has contacted the ATO, and they have advised him that the interest on the loan will not be an allowable deduction because the shares are not generating any assessable income. Dave has also indicated that his taxation return for the year ended 30 June of the previous year shows a net capital loss of $10,000 from the sale of shares. These shares were the only assets he sold in that year. (a) Based on the information above, determine Dave Solomon’s net capital gain or net capital loss for the year ended 30 June of the current tax year. (b) If Dave has a net capital gain, what does he do with this amount? (c) If Dave has a net capital loss, what does he do with this amount? 11.7 Your client is an investor and antique collector. You have ascertained that she is not carrying on a business. Your client provides the following information of sales of various assets during the current tax year. Based on this information, determine your client’s net capital gain or net capital loss for the year ended 30 June of the current tax year. (a) Block of vacant land. On 3 June of the current tax year, your client signed a contract to sell a block of vacant land for $320,000. She acquired this land in January 2001 for $100,000 and incurred $20,000 in local council, water and sewerage rates and land taxes during her period of ownership of the land. The contract of sale stipulates that a deposit of $20,000 is payable to her when the contract of sale is signed and the balance is payable on 3 January of the next tax year, when the change of ownership will be registered.
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(b) Antique bed. On 12 November of the current tax year, your client had an antique four-poster Louis XIV bed stolen from her house. She recently had the bed valued for insurance purposes and the market value at 31 October of the current tax year was $25,000. She purchased the bed for $3,500 on 21 July 1986. Although the furniture was in very good condition, the bed needed alterations to allow for the installation of an innerspring mattress. These alterations significantly increased the value of the bed, and cost $1,500. She paid for the alterations on 29 October 1986. On 13 November of the current tax year, she lodged a claim with her insurance company seeking to recover her loss. On 16 January of the current tax year, her insurance company advised her that the antique bed had not been a specified item on her insurance policy. Therefore, the maximum amount she would be paid under her household contents policy was $11,000. This amount was paid to her on 21 January of the current tax year. (c) Painting. Your client acquired a painting by a well-known Australian artist on 2 May 1985 for $2,000. The painting had significantly risen in value due to the death of the artist. She sold the painting for $125,000 at an art auction on 3 April of the current tax year. (d) Shares. Your client has a substantial share portfolio which she has acquired over many years. She sold the following shares in the relevant year of income:
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(i) 1,000 Common Bank Ltd shares acquired in 2001 for $15 per share and sold on 4 July of the current tax year for $47 per share. She incurred $550 in brokerage fees on the sale and $750 in stamp duty costs on purchase. (ii) 2,500 shares in PHB Iron Ore Ltd. These shares were also acquired in 2001 for $12 per share and sold on 14 February of the current tax year for $25 per share. She incurred $1,000 in brokerage fees on the sale and $1,500 in stamp duty costs on purchase. (iii) 1,200 shares in Young Kids Learning Ltd. These shares were acquired in 2005 for $5 per share and sold on 14 February of the current tax year for $0.50 per share. She incurred $100 in brokerage fees on the sale and $500 in stamp duty costs on purchase. (iv) 10,000 shares in Share Build Ltd. These shares were acquired on 5 July of the current tax year for $1 per share and sold on 22 January of the current tax year for $2.50 per share. She incurred $900 in brokerage fees on the sale and $1,100 in stamp duty costs on purchase.
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380 [11.590] PRINCIPLES OF TAXATION LAW 2020 (e) Violin. Your client also has an interest in collecting musical instruments. She plays the violin very well and has several violins in her collection, all of which she plays on a regular basis. On 1 May of the current tax year, she sold one of these violins for $12,000 to neighbour who is in the Queensland Symphony Orchestra. The violin cost her $5,500 when she acquired it on 1 June 1999. Your client also has a total of $8,500 in capital losses carried forward from the previous tax year, $1,500 of which are attributable to a loss on the sale of a piece of sculpture which she sold in April of the previous year. 11.8 Scott is an accountant who purchased a vacant block of land in Brisbane on 1 October 1980. On 1 September 1986, Scott built a house on the land. At the time, the land was valued at $90,000 and the cost of construction was $60,000. The property has been rented out since construction was completed. On 1 March of the current tax year, Scott sold the property at auction for $800,000. (a) Based on the information above, determine Scott’s net capital gain or net capital loss for the year ended 30 June of the current tax year. (b) How would your answer to (a) differ if Scott sold the property to his daughter for $200,000?
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(c) How would your answer to (a) differ if the owner of the property was a company instead of an individual? 11.9 On 1 July 1986, Sophia acquires an office block under a contract of purchase for $750,000. She also incurred stamp duty associated with the purchase of $25,000 as well as conveyancing and legal costs incidental to the purchase of $15,800. These costs were incurred on the date of settlement, which was 1 September 1986. Sophia was immediately sued and incurred $50,000 in legal costs defending her right to the office block against a person challenging the legal validity of her title. These costs were paid on 15 February 1987. Ongoing expenses during the ownership period were interest totalling $120,000, deductible repairs to the property of $50,000 and rates and taxes totalling $85,000. On 7 April 1991, Sophia made capital improvements to the building totalling $75,000. On 1 September 2019, Sophia sold the office block under a contract of sale for $1,200,000. In doing so, she spent $7,500 in advertising costs in relation to the sale and paid sales commission to the real estate agent of $48,000. The four offices in the block had been rented out to tenants for the period of ownership.
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Sophia wants to know whether she is better off using the indexation method for calculating her capital gain or the discount method. Based on your calculations, advise her. 11.10 Discuss the capital gains tax consequences of the following in relation to the main residence exemption: (a) Your client purchases a property to live in and does so for four months. They are then sent overseas by their employer for 12 months during which time the residence is rented out.
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(b) Your client purchases a new home and moves in immediately. Four months later, their previous main residence is sold. (c) Your client purchases a new home and moves in immediately. Nine months later, their previous main residence is sold. (d) Your client decides to make extra income by renting out their spare bedroom in their main residence on Airbnb.
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Part 3 Deductions and Offsets
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Taxpayers can reduce their income tax payable by taking into account certain deductions and offsets. Once assessable income is determined, as discussed in Part 2, deductions are subtracted to determine taxable income. Deductions consist of what are commonly referred to as general deductions and specific deductions. Not all expenses incurred by a taxpayer are deductible and it is necessary to comply with a provision of the legislation before deducting an expense. Chapter 12 begins by explaining how all of the deductions available to a taxpayer fit within the legislative regime. It then concentrates on the general deduction provision, s 8-1 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997). The chapter explains that s 8-1 provides taxpayers with a deduction for expenses incurred in gaining or producing assessable income or necessarily incurred in carrying on a business. However, s 8-1 also provides that expenses are not deductible under that section where they are capital or capital in nature, private or domestic, incurred in gaining exempt or non-assessable non-exempt income or prevented from being deducted by a specific provision of the legislation. Finally, Chapter 12 discusses the deductibility of some commonly incurred expenses, such as expenses incurred in gaining employment, relocation expenses, child care, travel, self-education, home office, clothing, interest and legal expenses. Some expenses, which may or may not be deductible under the general deduction provision, may fall within a specific deduction provision. There are two categories of specific deductions: those which are immediately deductible and those which can be deducted over a number of years. Chapter 13 examines deductions which are immediately deductible and allowed because the legislation specifically provides a deduction for a
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384 PRINCIPLES OF TAXATION LAW 2020
specific type of expense. Examples of specific deductions discussed are the cost of managing tax affairs, gifts and donations, repairs, bad debts, memberships, travel and tax losses from previous years. Chapter 14 examines deductions available for capital expenditure. While not immediately deductible, these expenses are deductible over a number of years under the capital allowances regime. The most common deductible capital expenditure is the cost of acquiring a depreciating asset which is used for income-producing purposes. Other business expenses which are not normally deductible may also be allowed over a period of time.
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In addition to being able to deduct certain expenses, a taxpayer may also reduce his or her income tax payable through various tax offsets (often known as rebates and credits). Tax offsets are more limited than deductions as a taxpayer needs to meet certain criteria to qualify. However, where a taxpayer does qualify for a tax offset, it is substantially more valuable than a deduction. This is because a deduction reduces taxable income, whereas a tax offset is deducted directly from income tax payable. Chapter 15 explains how tax offsets work and then explains the concepts relating to the largest group of offsets, known as concessional offsets.
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12 General deductions Key points.................................................................................................... [12.00] Introduction................................................................................................ [12.10] General deduction rule............................................................................... [12.20] Loss or outgoing......................................................................................... [12.30] The nexus test –positive limbs of s 8-1.................................................... [12.40] Judicial tests......................................................................................... [12.50] Is the nexus sufficiently direct or too remote to satisfy the positive limbs of s 8-1?................................................................. [12.70]
Expenses involving alleged or actual wrongdoing by taxpayer....................................................................................... [12.80] Expenses to reduce future expenditure................................................ [12.100] Involuntary losses or outgoings............................................................ [12.110]
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Is there a sufficient temporal nexus or connection to satisfy the positive limbs of s 8-1?......................................................... [12.120]
Expenses related to the production of assessable income in future years.................................................................................... [12.130] Expenses related to the production of assessable income in prior years...................................................................................... [12.140] Summary............................................................................................ [12.150] Non-deductible expenses –the negative limbs of s 8-1........................ [12.160] Capital or capital in nature................................................................. [12.170] Judicial tests........................................................................................... [12.180] Form and substance.............................................................................. [12.200] Summary................................................................................................ [12.210] Private or domestic............................................................................ [12.220]
Incurred in gaining or producing exempt or non-assessable non-exempt income.................................................................... [12.230] Denied deductions............................................................................. [12.240]
Entertainment expenses........................................................................ [12.250] Reimbursed expenditure....................................................................... [12.260]
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386 PRINCIPLES OF TAXATION LAW 2020
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Apportionment –deductibility of dual purpose expenses.................... [12.270] Amount of deduction............................................................................... [12.290] Reasonable vs actual expense.......................................................... [12.300] Tax minimisation situations –purpose............................................. [12.310] Substantiation of deductions.................................................................. [12.320] Application of s 8-1 to commonly incurred expenses........................... [12.330] Expenses incurred in gaining employment............................................ [12.340] Business taxpayers............................................................................ [12.350] Relocation expenses................................................................................. [12.360] Child care expenses.................................................................................. [12.370] Travel expenses........................................................................................ [12.380] Travel between home and work........................................................ [12.390]
Itinerant workers.................................................................................... [12.410] Transportation of bulky items................................................................ [12.420] Alternative workplace............................................................................ [12.430] Travel between two places of work.................................................. [12.440] Car expenses...................................................................................... [12.450] “Cents per kilometre” method............................................................... [12.460] “Logbook” method................................................................................. [12.550] Self-education expenses.......................................................................... [12.580] Positive limbs of s 8-1........................................................................ [12.590] Self-education expenses relate to taxpayer’s current career................................................................................. [12.600] Current career requires taxpayer to stay up to date........................................................................................ [12.630] Self-education expenses not related to employment income...................................................................... [12.640] Negative limbs of s 8-1...................................................................... [12.650] Capital expenses.................................................................................... [12.660] Private or domestic expenses............................................................... [12.670] Non-deductible self-education expenses.............................................. [12.680] Apportionment................................................................................... [12.690] Home office expenses.............................................................................. [12.700] Genuine home office.......................................................................... [12.710] Home office for convenience only.................................................... [12.720] Apportionment and capital expenses............................................... [12.730] Clothing and dry-cleaning expenses....................................................... [12.740] Conventional clothing and related items.......................................... [12.750] Abnormal expenditure on conventional clothing................................. [12.760] Expenditure caused by taxpayer’s work conditions............................. [12.780]
Occupation-specific clothing, protective clothing and uniforms............................................................................... [12.790] Capital expenses................................................................................ [12.800] Interest expenses...................................................................................... [12.810] Gearing............................................................................................... [12.820] Capital expenses................................................................................ [12.830]
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12: General DeDUctions [12.00] 387
Legal expenses.......................................................................................... [12.840] Questions................................................................................................... [12.860]
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Key points [12.00] • Expenses incurred by taxpayers in gaining or producing assessable income may be deducted against that income to reduce the taxpayer’s final tax liability. • Expenses may be immediately deductible under the general deduction provision in s 8-1 of ITAA 1997 or under a specific deduction provision. • Expenses that are deductible under a specific deduction provision should be deducted under that provision as it is the most appropriate provision. • Expenses must be incurred by the taxpayer in gaining or producing assessable income or necessarily incurred in carrying on a business to gain or produce assessable income to be deductible under s 8-1 of ITAA 1997. • An expense that is capital or capital in nature, private or domestic, incurred in gaining or producing exempt or non- assessable non- exempt income, or specifically denied by another provision in the income tax legislation, cannot be deducted under s 8-1 of ITAA 1997. • Capital expenses that are not immediately deductible may be deductible over a period of years. • Taxpayers may claim a deduction for a part of an expense where only a part of the expense satisfies the requirements of s 8-1 of ITAA 1997, for example, an expense partly incurred to gain or produce assessable income and partly incurred for private purposes. • Taxpayers are required to maintain adequate records when claiming a deduction for an expense. • Common expenses that may or may not be deductible under s 8-1 of ITAA 1997 include: – expenses incurred in gaining employment; – relocation expenses; – child care expenses; – travel expenses; – self-education expenses; – home office expenses; – clothing expenses; – interest expenses; and – legal expenses.
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388 [12.10] PRINCIPLES OF TAXATION LAW 2020
Introduction [12.10] Recall from Chapter 3 that the basic formula in s 4-10 of ITAA 1997 which determines the amount of tax that a taxpayer has to pay for a particular year is: Tax payable = (Taxable income × Tax rate) –Tax offsets
Section 4-15 provides that: Taxable income = Assessable income –Deductions
Part 2 considered when an amount will be assessable income of the taxpayer. In this and subsequent chapters, we consider when an amount will be a deduction to the taxpayer. Broadly, a deduction is an expense of the taxpayer which is deductible for tax purposes as it is incurred in gaining or producing income that is assessable for tax purposes. The deduction is applied against the taxpayer’s assessable income to determine “taxable income” upon which the taxpayer’s tax liability is calculated. “Taxable income” is considered a better reflection of the taxpayer’s taxable capacity or ability to pay. Deductions are set out in Div 8 of ITAA 1997 and are divided into two categories:
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• general deductions: s 8-1; and • specific deductions: s 8-5. General deductions are discussed in this chapter, while specific deductions are discussed in Chapter 13. Expenses may be deductible under both the general deduction provision and a specific deduction provision. In this case, s 8-10 provides that the expense should be deducted under the “most appropriate” section. As a general rule of statutory construction, the specific rule (the specific deduction provision) should apply over the general rule (the general deduction provision). In any case, s 8-10 makes it clear that an expense can only be deducted once. There are also some expenses that may not be immediately deductible under either a specific deduction provision or the general deduction provision but which may nonetheless be deductible over a period of years. These expenses are discussed in Chapter 14. Figure 12.1 illustrates the approach to determining when an expense is deductible for tax purposes.
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Figure 12.1: Deductions overview
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General deduction rule [12.20] The main provision that gives taxpayers a deduction for an expense is s 8-1 of ITAA 1997, which is known as the general deduction provision. It is a “general” deduction provision as it has the potential to apply to any expense of the taxpayer. Section 8-1(3) states that a loss or outgoing that is deductible under s 8-1 is called a “general deduction”. Note that s 8-1 of ITAA 1997 was formerly s 51(1) of ITAA 1936. Case law or rulings which refer to s 51(1) are equally applicable to s 8-1. Section 8-1(1) of ITAA 1997 provides that a taxpayer can deduct from his or her assessable income a loss or outgoing to the extent that it is: • incurred in gaining or producing assessable income; or • necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. These two elements of s 8-1 are commonly known as the “positive limbs” of s 8-1 as an expense must satisfy one of these elements to be deductible. However, s 8-1(2) stipulates that an expense that satisfies the positive limbs of s 8-1 may nonetheless not be deductible under s 8-1 to the extent that it is: • capital or capital in nature: see [12.170]; • private or domestic: see [12.220];
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• incurred in gaining exempt or non-assessable non-exempt income: see [12.230]; or • prevented from being deducted by a specific provision of the income tax legislation: see [12.240]. These four elements are commonly known as the “negative limbs” of s 8-1 as an expense which satisfies any one of these elements will not be deductible. Note that the deductibility of an expense is determined from the taxpayer’s perspective in accordance with the requirements of s 8-1 and the treatment of the amount in the recipient’s hands (ie, whether or not it is assessable) is generally not relevant. Figure 12.2 provides a guide to determining when an expense would be deductible under the general deduction rule.
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Figure 12.2: General deduction rule in s 8-1
Loss or outgoing [12.30] The first thing to note about s 8-1 of ITAA 1997 is that it applies to both losses and outgoings. As a result, s 8-1 is not limited to direct expenses of the taxpayer and can provide a deduction for a loss. The ability to deduct losses under s 8-1 was confirmed by the High Court in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (see Case Study [12.1]), which considered the predecessor to s 8-1.
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Example 12.1: Outgoings Sarah paid her office phone bill of $220. The payment of $220 is an outgoing which is deductible under s 8-1 if all of the other requirements of the section are satisfied.
Example 12.2: Losses Sarah undertook a profit-making land development scheme as in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 (see Chapter 8). She purchased the land for $1 million, spent $1 million on development of the land and sold the land for $1.5 million. Sarah has a net loss of $500,000 from the scheme, which is deductible under s 8-1 if all of the other requirements of the section are satisfied: see Ruling TR 92/4. The existence of a “loss or outgoing” is generally not an issue in claiming a deduction under s 8-1, and it is the positive and negative limbs of s 8-1 which require detailed consideration when determining the deductibility of a loss or outgoing.
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The nexus test –positive limbs of s 8-1 [12.40] The first hurdle for a loss or outgoing to be deductible under s 8-1 of ITAA 1997 is the nexus requirement. Under s 8-1(1), the loss or outgoing must be: • incurred in gaining or producing assessable income; or • necessarily incurred in carrying on a business to gain or produce assessable income. There is some uncertainty as to whether the second positive limb (“necessarily incurred in carrying on a business to gain or produce assessable income”) adds in any way to the first positive limb since a loss or outgoing which satisfies the second positive limb is likely to also satisfy the first. There is potentially an argument that the first positive limb requires a direct connection between the expense and the production of assessable income, whereas the second positive limb ensures that expenses that are necessary for the operation of a business that produces assessable income are deductible even though the expenses may not have a direct connection to the production of assessable income. This distinction is rarely focused on in practice. In essence, the first positive limb requires a connection between the expense and the production of assessable income, while the second positive limb
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requires a connection between the expense and the carrying on of a business to produce assessable income. Note that s 8-1(1) provides that an expense is deductible “to the extent that” it satisfies one of the positive limbs. This means that an expense may be partially deductible under s 8-1 where the expense only partially satisfies the positive limbs of s 8-1. Apportionment and the deductibility of dual purpose expenses are considered further at [12.270]. The courts have long accepted that when looking at the positive limbs of s 8-1, the phrase “in gaining or producing assessable income” is to be interpreted as “in the course of gaining or producing assessable income”: Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295; Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; FCT v Day (2008) 70 ATR 14. In Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 at 57, the High Court stated that: to come within the initial part of [s 8-1] it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.
In other words, the connection between the expense and the production of assessable income is determined in the context of the taxpayer’s overall activities and not by narrowly looking at the direct impact of the expense on the taxpayer’s production of assessable income.
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Case study 12.1: Losses incurred in the course of gaining or producing assessable income In Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344, the taxpayer was a retail company, the normal operations of which included an employee taking the day’s earnings to the bank daily. The employee was robbed while on the way to the bank. The taxpayer’s claim for a deduction for the loss was denied by the Commissioner, who argued that the loss was not sufficiently connected to the production of assessable income by the taxpayer. In concluding that the loss was deductible, the Full High Court stated that “in gaining or producing assessable income” should be interpreted as “in the course of gaining or producing assessable income”. In this case, the taxpayer’s normal business operations included banking the daily earnings and, as the loss had been incurred as part of that normal business operation, the loss was incurred in the production of assessable income and satisfied the positive limbs of the predecessor to s 8- 1.
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Judicial tests [12.50] The determination as to whether an expense is incurred in the course of gaining or producing a taxpayer’s assessable income is not straightforward, and the courts have adopted a number of approaches in addressing this issue. The key tests that have been utilised by the courts are: • the incidental and relevant test; • the essential character test; and • the occasion of the expenditure test. There was also an attempt to develop a “condition of employment test” under which expenses would satisfy the positive limbs of s 8-1 where the expense arose as a result of the taxpayer’s conditions of employment. This test was specifically rejected by the court in FCT v Wilkinson (1983) 14 ATR 218 as it could be easily manipulated –taxpayers would simply need to include the expenses in their employment contracts and the expenses would be deductible under such a test. In applying the tests listed above, the courts have consistently stated that no single test can be applied to the positive limbs of s 8-1 and a case-by-case approach is appropriate. This point was reiterated by the High Court in FCT v Day (2008) 70 ATR 14 (see Case Study [12.2]) where the High Court stated (at [30]) that:
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Section 8-1(1)(a) is couched in terms intended to cover any number of factual and legal situations in which expenditure is incurred by a taxpayer. Its language and breadth of application do not make possible a formula capable of application to the circumstances of each case.
Earlier cases, such as W Nevill & Co Ltd v FCT (see Case Study [12.7]), Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 (see Case Study [12.18]) and Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (see Case Study [12.1]) adopted the incidental and relevant test in determining whether a loss or outgoing had the necessary connection to the production of assessable income. As stated by Dixon J in W Nevill, a loss or outgoing would be sufficiently connected to the production of assessable income where “the expenditure … is incidental and relevant to the operations or activities regularly carried on for the production of income” (at 305). In Charles Moore, the High Court stated (at 351) that phrases such as: “incidental and relevant” when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income.
[12.60] In later cases, such as Lunney v FCT; Hayley v FCT (1958) 100 CLR 478, the courts looked at the essential character of an expense in determining
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whether the expense was sufficiently connected to the production of assessable income. In Lunney v FCT; Hayley v FCT, the High Court denied the taxpayers a deduction for expenses incurred in travelling from home to work on the basis that the “essential character” of the expenses was to put the taxpayers in a position to gain or produce assessable income rather than being incurred in the production of assessable income. More recently, the High Court in FCT v Payne (2001) 202 CLR 93 and FCT v Day (2008) 70 ATR 14 suggested that, in determining whether an expense is incurred in the course of gaining or producing assessable income, it is necessary to consider whether the occasion of the expenditure arises out of the taxpayer’s income- producing activities. Expenses will be sufficiently connected to the production of assessable income where they arise out of the taxpayer’s income- producing activities. Utilising this approach therefore requires an assessment as to what is productive of the taxpayer’s assessable income, which is determined in accordance with the taxpayer’s individual circumstances. On the application of the “relevant and incidental test” and the “essential character test”, the High Court in FCT v Day (2008) 70 ATR 14 at 26 stated:
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Expressions used in the cases, such as “incidental and relevant”, as referable to a business, should not be thought to add more to the meaning of provisions such as s 8-1(1)(a) of the ITAA, or to narrow its operation. They should be taken to describe an attribute of an expenditure in a particular case, rather than being an exhaustive test for ascertaining the limits of the operation of the provision. Reference in some cases to the expenditure having an “essential characteristic” must likewise be treated with some care. As Gaudron and Gummow JJ observed in Payne, the use of the term may avoid the evaluation which the section requires. It is perhaps better understood as a statement of conclusion than of reasoning.
Following the High Court’s comments in FCT v Payne and FCT v Day, it would appear that the “incidental and relevant” and “essential character” tests are not as relevant in determining whether the positive limbs of s 8-1 are satisfied, and it is necessary to focus on whether the loss or outgoing arises out of the taxpayer’s income-producing activities. However, as cautioned by the High Court, this should not be considered the determinative test as to whether an expense satisfies the positive limbs of s 8-1, and a case-by-case approach is to be adopted. Note that the courts have consistently rejected any consideration of the taxpayer’s subjective purpose or intention in incurring an expense in determining whether the positive limbs of s 8-1 are satisfied. This was reiterated by the High Court in FCT v Anstis (2010) 76 ATR 735 (see Case Study [12.34]). However, a taxpayer’s subjective purpose may be relevant in certain limited situations: see [12.310]. We will now look at some of the key cases that considered whether the positive limbs of s 8-1 (or its predecessors) were satisfied.
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Is the nexus sufficiently direct or too remote to satisfy the positive limbs of s 8-1? [12.70] There are two aspects to the nexus or connection issue as to whether a loss or outgoing is incurred in the course of gaining or producing assessable income. The first is the question of direct or remote connection. If the link between an expense and the production of assessable income is too remote, it will not be deductible. The second is the question of a link in time or temporal nexus. The necessary connection between the expense and the production of assessable income may be broken where the expense is incurred too far in advance of, or too long after, the production of assessable income. Cases related to the temporal connection will be examined at [12.120]. In the vast majority of cases, it is generally simple to see whether an expense is directly related to the production of assessable income or so remote from the production of income that it would not satisfy the positive limbs of s 8-1. For example, the cost of a taxi trip to visit a client’s premises would generally be related to the production of assessable income, whereas the cost of a taxi trip to visit a friend would not be connected to the production of assessable income. There are, however, a number of cases where there was some question as to whether the expenses were sufficiently connected to the taxpayer’s income-producing activities. These cases are considered in the following paragraphs.
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Expenses involving alleged or actual wrongdoing by taxpayer [12.80] A number of cases have considered whether expenses arising due to alleged or actual wrongdoing by the taxpayer can satisfy the positive limbs of s 8-1. As the expenses related to the taxpayer’s conduct, they were arguably “quasi-personal” (ie, incurred in a personal rather than professional or business capacity) and the question arose as to whether the expenses were incurred in the production of the taxpayer’s assessable income or necessarily incurred in carrying on a business for the production of assessable income. In each of the cases, the Court took a broad approach and found that the positive limbs of s 8-1 (or its predecessors) were satisfied. Case study 12.2: Legal expenses incurred in defending improper conduct charges In FCT v Day (2008) 70 ATR 14, the taxpayer was a customs officer who was charged with failing to fulfil his duties as an officer under the Public Service Act 1922 (Cth). The taxpayer incurred legal expenses in defending
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the charges, which involved a variety of allegations, including improper use of his position, assisting with an improper diesel fuel rebate claim, improper use of a work vehicle and improper attempts to conceal his absences from work. The taxpayer successfully defended himself against some of the charges, but not others. The Commissioner denied the taxpayer’s deduction for the legal expenses on the basis that the expenses related to conduct unconnected to the performance of the taxpayer’s income-producing activities and, therefore, the nexus requirement in s 8-1 was not satisfied as the expenses were not “incurred in gaining or producing … assessable income”. The Full High Court found that the legal expenses were incurred by the taxpayer in gaining or producing assessable income as the occasion of the expenditure arose out of his income-producing activities. The taxpayer was subject to the Public Service Act 1922 (Cth) because of his employment as a customs officer and the legal expenses related to defending himself against charges under that Act. In reaching its conclusion, the Court distinguished the legal expenses in this case to expenses which may be incurred by a taxpayer in general civil or criminal proceedings. The key factor here was that it was the taxpayer’s employment that exposed him to the charges that resulted in the legal expenses being incurred.
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The courts have also accepted that expenses resulting from the taxpayer’s alleged or actual wrongdoing can satisfy the second positive limb despite the requirement that the expense be “necessarily incurred” in the carrying on of the taxpayer’s business. Case study 12.3: Necessarily incurred in carrying on a business In Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113, the taxpayer was a newspaper publisher that incurred expenses in the form of damages with respect to libel claims made against it. The Full High Court considered the deductibility of the compensatory damages. The majority of the Court accepted that the libel or alleged libel was published with the sole purpose of selling newspapers. Therefore, the liability to damages was incurred because of the publishing of the newspaper, which was “the thing which produced assessable income”. In reaching its conclusion that the damages were deductible, the Court noted that the potential for libel claims was a regular and almost unavoidable incident of publishing, which meant that there was sufficient connection between the cause of the expense and the taxpayer’s business.
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Case study 12.4: Necessarily incurred in carrying on a business
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In FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431, the taxpayer was a building company that was the subject of a number of complaints and at the centre of investigations. The complaints and investigations were public knowledge, and the taxpayer incurred expenses on advertising and legal fees in defending its reputation. The taxpayer sought to deduct these expenses on the basis that they were ordinary business expenses, while the Commissioner sought to deny a deduction on the basis that the expenses were not necessarily incurred by the taxpayer in the carrying on of its business. In concluding that the expenses were deductible, the Full High Court found that an expense is necessarily incurred where the expenditure is dictated by business purposes, those purposes being part of or incidental to the business itself. In this case, the expenses were incurred in defending the taxpayer’s reputation and in enabling the continued operation of the business to gain or produce assessable income, which was clearly a legitimate business purpose. In reaching its conclusion, the Court appears to suggest that allegations of wrongdoing are an ordinary incident of business and expenses incurred in defending the taxpayer against such allegations are necessary for the continued operation of the business and therefore appropriate (and deductible). The taxpayer’s guilt or innocence in relation to the allegations is irrelevant. [12.90] In the cases of Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 (see Case Study [12.3]) and FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 (see Case Study [12.4]), the taxpayers’ alleged or actual wrongdoing was related to their business activities and the allegations of wrongdoing were considered by the courts to be an ordinary incident of the particular business. In FCT v Day, the charges against the taxpayer arose under the Public Service Act 1922 (Cth), to which the taxpayer was only subject due to the nature of his employment. As such, the connection between the expenses and the production of assessable income may seem more apparent. The following cases considered the deductibility of expenses related to criminal or illegal behaviour, which potentially suggests a personal element. Both cases considered whether expenses related to criminal or illegal behaviour were “necessarily incurred” in carrying on a business, thereby satisfying the second positive limb. Case study 12.5: Legal expenses incurred in defending criminal charges In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276, the taxpayer incurred legal expenses in defending itself and its directors in
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criminal proceedings. The taxpayer was accused of paying illegal secret commissions to boost sales of its products. The proceedings against the taxpayer were subsequently dropped and the legal expenses primarily related to the directors’ defence. The Commissioner denied the deduction on the basis that the legal expenses were primarily for the directors’ personal benefit. The Full Federal Court found that the legal expenses were necessarily incurred in carrying on a business to gain or produce assessable income. The Court noted that “necessary” does not mean that the expense has to be unavoidable or essential. The Court also stated (at 293) that “it is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically”.
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The Court concluded that the expenses were deductible as the taxpayer was inextricably involved in the proceedings and its reputation and interests were tied to the directors. It was therefore in the taxpayer’s interests to pay for the legal expenses to defend the directors. The Court suggested that the directors knew that the legal expenses were incurred not only in their own interests but also to protect the taxpayer’s business. The Court articulated what has become known as the “business judgment rule” –that is, an expense will be necessarily incurred in carrying on a business to gain or produce assessable income where the persons who run the business consider the expense desirable and appropriate in achieving business ends.
Case study 12.6: Expenses related to illegal business In FCT v La Rosa (2003) 53 ATR 1, the taxpayer was a convicted drug dealer who was robbed of cash during an intended drug purchase. The Commissioner sought to assess the taxpayer on the income he had earned from drug dealing. The taxpayer claimed a deduction for the loss incurred in the robbery per Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344: see Case Study [12.1]. The Commissioner argued that the taxpayer should be denied a deduction for the loss on public policy grounds, while including the gross proceeds from the sale as assessable income. The Full Federal Court confirmed that proceeds from an illegal business or activity may be assessable and corresponding expenses or losses deductible. The Court did not accept the Commissioner’s public policy argument for denying the deductions as there was no legal basis for doing so. The loss was deductible as it was necessarily incurred in carrying on the taxpayer’s business to gain or produce assessable income.
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Not surprisingly, the case attracted widespread publicity and the government responded by introducing s 26-54, which denies a deduction for “a loss or outgoing to the extent that it was incurred in the furtherance of, or directly in relation to, a physical element of an offence against an Australian law of which you have been convicted if the offence was, or could have been, prosecuted on indictment”: see [12.240]. The decisions in Magna Alloys & Research Pty Ltd v FCT and FCT v La Rosa further support a broad approach in determining the connection between a loss or outgoing and the production of assessable income. It should be noted that a deduction is available in these situations regardless of the taxpayer’s guilt or innocence in relation to the allegations: FCT v Snowden & Willson Pty Ltd and Magna Alloys & Research Pty Ltd v FCT.
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Expenses to reduce future expenditure [12.100] The deductibility of expenses incurred in improving business efficiency which will result in a reduction of future expenditure is an interesting issue. Strictly speaking, such expenses increase “taxable income” (by reducing deductions) and not assessable income as required by s 8-1. The Full High Court considered whether such expenses were “necessarily incurred” in carrying on a business and satisfied the second positive limb of the predecessor to s 8-1 in W Nevill & Co Ltd v FCT (1937) 56 CLR 290. The Court held that an expense that improves the taxpayer’s business overall and reduces future expenses, although not directly incurred in gaining or producing assessable income, is not too remote and satisfies the second positive limb of the predecessor to s 8-1.
Case study 12.7: Necessarily incurred in carrying on a business In W Nevill & Co Ltd v FCT (1937) 56 CLR 290, the taxpayer was a company that had two managing directors. The joint management system was found not to be working and therefore it was decided that the contract of one of the managing directors would be terminated and a compensation payment made. Among other things, the Commissioner argued that the compensation payment was not deductible as it was not incurred in gaining or producing assessable income. The taxpayer argued that the amount was deductible as it was saving on future salary costs, which would have been deductible, and that terminating the managing director would improve the efficiency of the business, which would increase assessable income.
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The Full High Court found that the payment satisfied the positive limbs of the predecessor to s 8-1 and was therefore deductible. In reaching this conclusion, the Court noted that no expense directly increases a taxpayer’s assessable income and therefore an overall approach is appropriate. Here, the Commissioner erred in looking at the compensation payment in isolation. The Court held that the compensation payment must be viewed in context with the original agreement with the managing director, which was clearly entered into in the production of assessable income. The compensation payment, which resulted from an amendment to the original agreement, must therefore also be for the purpose of gaining or producing assessable income. Therefore, an expense which improves the taxpayer’s overall business efficiency and operation would be incurred in gaining or producing assessable income. Further, the Court also found that an expense that reduces a taxpayer’s future deductible expenditure is incurred in gaining or producing assessable income.
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Involuntary losses or outgoings [12.110] As discussed at [12.30], s 8-1 of ITAA 1997 contemplates that a “loss” may be deductible. However, the question arises as to whether a loss or outgoing is sufficiently connected to the production of assessable income where the taxpayer has not chosen to incur the loss or outgoing and it is involuntary or unforeseen, or unavoidable. In these situations, the loss or outgoing may be too remote to the production of assessable income. The issue was considered by the High Court in Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (see Case Study [12.1]) where the taxpayer suffered a loss due to theft. The Full High Court found that an involuntary loss or outgoing may be sufficiently connected to the production of assessable income where it arises out of the taxpayer’s income-producing activities.
Is there a sufficient temporal nexus or connection to satisfy the positive limbs of s 8-1? [12.120] In the cases considered so far, the loss or outgoing was incurred in the same income year as the production of assessable income. The question in those cases was whether the loss or outgoing was sufficiently connected to or too remote from the production of assessable income. A separate question arises as to whether expenses incurred prior to or after the production of assessable income are sufficiently connected to the production of assessable income.
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Expenses related to the production of assessable income in future years [12.130] The courts (eg, in Steele v DCT (1999) 41 ATR 139) have accepted that an expense incurred to gain or produce assessable income in future income years may satisfy the positive limbs of s 8-1 of ITAA 1997 in certain circumstances. Case study 12.8: Expenses related to income gained or produced in future years In Steele v DCT (1999) 41 ATR 139, the taxpayer was an individual who had obtained a loan to purchase property for use in a business venture. For various reasons, the venture did not go ahead and the taxpayer did not gain or produce assessable income in relation to the property as intended.
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The taxpayer sought a deduction for the interest expenses incurred on the loan to purchase the property on the basis that the expenses were incurred to gain or produce future assessable income. The Commissioner sought to deny the taxpayer’s claim on the basis that there was no connection between the interest expenses and the production of assessable income – that is, the positive limbs of the predecessor to s 8-1 were not satisfied. The Full High Court held that such expenses would be deductible if the taxpayer could demonstrate that the expenses were incurred in order to gain or produce assessable income. The factual question was remitted back to the AAT, which found that the evidence showed that the taxpayer had no other purpose in incurring the interest expense other than for the production of assessable income. The expenses were thus deductible under the predecessor to s 8-1. Despite the High Court’s decision in Steele v DCT, the deductibility of expenses related to the production of future assessable income can be a tricky issue and should be decided on a case-by-case basis. It is important to note that Steele v DCT considered a deduction for interest expenses associated with the acquisition of an income-producing asset. A deduction for such expenses may be considered desirable from a policy perspective as it promotes investment in income-producing assets, such as shares and property. In a business context, expenses incurred in anticipation of future assessable income may not be deductible on the basis that the business has not actually commenced at that time: see [8.110]–[8.120]. In an employment context, the courts may find that the expenses are incurred to put the taxpayer in a position to gain or produce assessable income, rather
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than being incurred in the production of assessable income: see [12.340], [12.360]–[12.370], [12.390]. While the Full High Court’s decision in Steele v DCT stands for the proposition that expenses incurred in anticipation of future income may be deductible, this is more likely to be the case where the expenses relate to the acquisition of an income-producing asset, and such expenses may still be considered to be “too soon” in an employment or business context.
Expenses related to the production of assessable income in prior years [12.140] A question also arises as to whether an expense is incurred “in gaining or producing assessable income”, where the expense relates to the production of income in previous years. In particular, there is an issue as to whether a sufficient connection continues to exist between the expense and the income where the taxpayer has ceased to carry on its previous income- producing activities.
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In Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295, the Full High Court denied the taxpayer deductions for expenses that related to its past business activities, which it no longer carried on at the time the expenses were incurred. Although this case has not been expressly overturned by subsequent cases, it is no longer considered good authority on the issue. A number of subsequent cases have permitted the taxpayer a deduction for expenses relating to past business activities provided that the expense was caused by the past income-producing activities of the taxpayer. In AGC (Advances) Ltd v FCT (1975) 132 CLR 175, the Full High Court allowed the taxpayer a deduction for expenses that related to past business activities. However, the difference between this case and Amalgamated Zinc v FCT was that, in AGC (Advances) Ltd v FCT, the taxpayer had restarted its business at the time of claiming the deduction. The Full Federal Court subsequently applied AGC (Advances) Ltd v FCT to permit taxpayers a deduction for expenses relating to past business activities, even where the business activities have ceased at the time of incurring the expense: see, for example, FCT v EA Marr and Sons (Sales) Ltd (1984) 15 ATR 879; Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253. Case study 12.9: Expenses related to the production of assessable income in prior years In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer incurred expenses in satisfying obligations arising out of its previous
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business of manufacturing conveyor belts. At the time of incurring the expenses, the taxpayer was only involved with the investment and management of related companies. The taxpayer sought a deduction for the expenses on the basis that they were incurred in producing assessable income. The Commissioner argued that the nexus between the taxpayer’s income-producing activities and the expense was broken by the fact that the taxpayer had ceased carrying on the business of manufacturing conveyor belts. The Full Federal Court allowed the taxpayer a deduction for the expenses on the basis that they arose out of or were caused by the taxpayer’s past activities of manufacturing conveyor belts, from which it produced assessable income. The fact that the business had since ceased was therefore irrelevant. The Commissioner’s application for special leave to appeal was refused by the High Court. More recent cases, such as FCT v Brown (1999) 43 ATR 1 and FCT v Jones (2002) 49 ATR 188, have also permitted taxpayers a deduction for interest expenses on loans related to prior business activities which have since ceased.
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The key to determining whether an expense incurred in producing assessable income in prior years satisfies the positive limbs of s 8-1 of ITAA 1997 is to establish whether the expense was caused by the taxpayer’s prior income- producing activities. If the expenses have been caused by the taxpayer’s previous income-producing activities, then they will be deductible.
Summary [12.150] The above discussion and case studies indicate that a broad approach is to be adopted when determining whether an expense is incurred in the production of assessable income, or is necessarily incurred in carrying on a business for the production of assessable income. This broad approach is supported by the fact that courts have accepted that the phrase “in gaining or producing assessable income” is to be interpreted as “in the course of gaining or producing assessable income”: FCT v Day (2008) 70 ATR 14; Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344. In the context of an individual, it is necessary to consider whether the expenditure arises out of the taxpayer’s income-producing activities (ie, the “occasion of the expenditure”): see FCT v Payne (2001) 202 CLR 93; FCT v Day (2008) 70 ATR 14.
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In a business context, the courts have not applied a narrow interpretation to “necessarily incurred” and have concluded that involuntary, unavoidable, unforeseen or even apparently illogical outgoings may be incurred in gaining or producing assessable income: Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344; Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276. The determination as to whether an expense is desirable and appropriate towards business ends is a decision for the directors or persons responsible for carrying on the business: Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276. Further, the connection between an expense and the production of assessable income cannot be made in isolation and an overall approach should be adopted: W Nevill & Co Ltd v FCT (1937) 56 CLR 290. Finally, the courts have accepted that expenses may be deductible even where they relate to assessable income gained or produced in future or prior years. Expenses in anticipation of future assessable income will be deductible if it can be shown that the expenses were incurred in order to gain or produce assessable income. However, it may be necessary to consider whether the expenses were incurred to put the taxpayer in a position to gain or produce assessable income, or prior to the commencement of a business. Expenses related to the production of prior year assessable income will be deductible where the expenses were caused by the taxpayer’s prior income-producing activities.
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Non-deductible expenses –the negative limbs of s 8-1 [12.160] An expense that satisfies the positive limbs of s 8-1 of ITAA 1997 may nevertheless not be deductible under s 8-1 if it satisfies any one of the elements of s 8-1(2). Note that s 8-1(2) provides that an expense is not deductible “to the extent that” it satisfies any one of the negative limbs. This means that an expense may be partially deductible under s 8-1 where it only partially satisfies one of the negative limbs of s 8-1. Apportionment and deductibility of dual purpose expenses are considered further at [12.270].
Capital or capital in nature [12.170] The first of the negative limbs in s 8-1 of ITAA 1997 is often the main issue in determining whether an expense is deductible under s 8-1, particularly in a business context. Under s 8-1(2)(a), a loss or outgoing that is capital or capital in nature will not be deductible under s 8-1. Expenses that are not capital or capital in nature are often termed “revenue expenses”, although this expression does not appear in the legislation. Unfortunately, there is no clear test in the legislation as to when an expense will be a capital expense or a revenue expense. Broadly, an expense that relates
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406 [12.180] PRINCIPLES OF TAXATION LAW 2020 to the taxpayer’s income-producing process will be a revenue expense, while an expense that relates to the taxpayer’s income-producing structure will be a capital expense (this distinction is sometimes known as the “business entity” test or “business structure or process” test or “profit-yielding structure” test). Revenue expenses generally provide the taxpayer with benefits in the current year, while capital expenses generally provide the taxpayer with benefits over a period of years. Although capital expenses are not immediately deductible under s 8-1, the taxpayer may be entitled to deduct a portion of the expenses over a number of years to correspond with the expected benefits from the expense: see Chapter 14. In other cases, the taxpayer may be able to recognise the expense upon disposal of the asset or some other event under the provisions regarding the taxation of capital gains: see Chapter 11.
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Judicial tests [12.180] One of the earliest attempts to distinguish between capital and revenue expenses occurred in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529. In that case, Lord Dunedin stated that “capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year” (at 536). The test merely required an examination of the form of the expense. While such a test had the advantage of simplicity, in practice, it soon proved to be inadequate. In British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213–214, Viscount Cave LC suggested that “where an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is a very good reason … for treating such an expenditure as properly attributable not to revenue but to capital”. This became known as the “enduring benefit test” and focused on the effect of the expense in determining its character. This test is often still referred to, and while it can be useful in distinguishing between revenue and capital expenses, it is sometimes difficult in practice to determine the expected benefit from an expense when it is incurred. The courts continued to apply various tests in characterising expenses with no definitive guidance emerging from the cases until Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, one of the most important cases in income tax. In Sun Newspapers, Dixon J (as he then was) set out the distinction between expenses related to business processes (revenue expenses) and expenses related to business structure (capital expenses), mentioned above. This distinction was not new and had been variously argued and applied in previous cases, but Dixon J’s clear articulation of the test has resulted in the case being the leading precedent for distinguishing between capital and revenue expenses.
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Case study 12.10: Capital expenses In Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, the taxpayer was a newspaper publisher. The taxpayer’s principal competitor was the World published by Sydney Newspapers Ltd. Sydney Newspapers proposed to introduce a rival paper, the Star, which would sell for two-thirds of the price of the Sun, published by the taxpayer. The taxpayer made a payment to Sydney Newspapers for the right to use its plant and equipment for a period of three years and for an agreement that it would not establish a new newspaper, the Star, for the same period. The taxpayer immediately ceased publication of the World once it took over the plant and equipment. In effect, the payment resulted in Sun Newspapers shutting down an existing rival newspaper (the World) and preventing the publication of a new rival (the Star) for a period of three years.
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The taxpayer tried to claim a deduction for the payment over a period of three years, but there was no provision in the income tax legislation which would allow it to do so. The taxpayer then claimed an immediate deduction for the payment on the basis that the expenses would safeguard and increase the taxpayer’s revenue (ie, its assessable income). The Commissioner argued that as the payment resulted in an addition to the goodwill of the business, benefited the business as a whole and was a monopoly for a capital asset, the payment was therefore capital in nature. A majority of the High Court concluded that the payment was a non- deductible capital expense as the taxpayer had acquired a non-wasting capital benefit (ie, an “enduring benefit”) by effectively shutting down its competitor. Dixon J reached the same conclusion by distinguishing between expenses related to the taxpayer’s income-producing process and expenses related to the taxpayer’s income-producing structure. The payment strengthened or preserved the taxpayer’s business structure and, as such, was capital in nature. In applying the distinction between business structure and business process, Dixon J suggested that the following three factors should be considered: • Character of the advantage sought. This requires a consideration as to whether the expense results in a lasting or a temporary benefit for the taxpayer. An expense that results in the taxpayer receiving a lasting benefit is more likely to be a capital expense, whereas an expense that results in the taxpayer receiving a temporary benefit is less likely to be a capital expense. • Manner in which the benefit is to be used, relied upon or enjoyed. This is similar to the first factor and requires a consideration as to whether
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408 [12.180] PRINCIPLES OF TAXATION LAW 2020 the benefit received by the taxpayer is a single, substantial, enduring benefit upon which the taxpayer relies in a constant way, or rather a benefit that is relied upon, or enjoyed, in a short-term sense, though recurrently. A benefit received once and for all is more likely to be a capital expense, whereas a benefit that is received recurrently, for short-term periods, is more likely to be a revenue expense. • Means adopted to obtain the benefit. This looks at whether the taxpayer acquired the benefit through recurrent payments or a one-off payment. A recurrent payment is less likely to be capital expense, while a lump sum payment is more likely to be a capital expense. In discussing these three factors, Dixon J clearly stated that none of the factors is definitive and all three factors are to be considered together in reaching a conclusion as to whether an expense is a capital expense. With modern financing practices, the third factor has become much less useful as it is possible for taxpayers to purchase capital assets through instalment payments, rather than lump sum amounts. Since Sun Newspapers, courts generally conclude that a capital expense is the acquisition of a means of production (related to the income-producing structure), whereas a revenue or non-capital expense would be for the use of the means of production (related to the income-producing process). Example 12.3: Capital expenses Dominic owns a pizza-making business. He incurs an expense of $3,000 to purchase an oven which he uses to make pizzas and approximately $100 in monthly electricity expenses. Copyright © 2019. Thomson Reuters. All rights reserved.
Applying Dixon J’s three factors to the two expenses: Character of the advantage sought
• The pizza oven will provide Dominic with a long-lasting benefit and is therefore more likely to be a capital expense.
• The monthly electricity expenditure is for a short-term, one-month benefit (albeit a benefit that could continue, provided Dominic pays the next monthly bill) and is therefore more likely to be a revenue expense.
Manner in which the benefit is to be used or enjoyed • The pizza oven will provide Dominic with a benefit that he can rely on once and for all and is therefore more likely to be a capital expense. • The electricity is a recurring benefit (in that he uses it by the month, on a recurring basis) and is therefore more likely to be a revenue expense.
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Means adopted to obtain the benefit • Dominic paid for the pizza oven in one lump sum payment of $3,000, which indicates that the expense is more likely to be capital. • The electricity bills are recurrent monthly expenses, which are more likely not to be capital. Looking at the three factors overall, it is likely that the payment for the pizza oven would be a capital expense, whereas the electricity payments would not be. Further, the acquisition of the pizza oven is the acquisition of a means of production (to make pizzas), which relates to Dominic’s income- producing structure, whereas the electricity payments are for the use of that means of production, which relates to Dominic’s income- producing activities or process.
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[12.190] Although there is a clear articulation of the distinction between capital and revenue expenses and three factors which can be looked at to make that determination, the characterisation of capital and revenue expenses is not quite so straightforward in practice. In fact, the Commissioner and the taxpayer often apply these same tests in reaching opposite conclusions. As observed by Green MR in IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482 at 488, “in many cases it is almost true to say that a spin of the coin would decide the matter almost as satisfactorily as an attempt to find reasons”. The following cases illustrate the difficulty in characterising expenses as revenue or capital, even when applying Dixon J’s test and factors to the same or similar facts. Case study 12.11: Exclusivity payments not capital in nature In BP Australia Ltd v FCT (1965) 112 CLR 386, the taxpayer was a petrol wholesaler. The taxpayer entered into “tied house” agreements with several service stations. Under the agreements, the service stations agreed to sell the taxpayer’s petrol exclusively for an average period of just under five years in return for a lump sum payment. Prior to the agreement, the service stations sold petrol from several different wholesalers. The Privy Council considered the application of Dixon J’s test and factors in characterising the payments. As to the first factor, the character of the advantage sought, the Privy Council suggested that it is necessary to consider the lasting qualities of the benefits, the recurrence of the benefits and the reasons for the expenditure. Looking at the facts that the expenses came about because of a change in marketing practices in 1951, the relatively short exclusivity period and the lack of a permanent solution, their Lordships suggested that the payments were a revenue expense. As to the second factor, their Lordships concluded that “the
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benefit was to be used in the continuous and recurrent struggle to get orders and sell petrol” and were part of the ordinary process of selling, which made them revenue in nature. Their Lordships did not find the third factor particularly useful as it did not point clearly in either direction. Their Lordships stated that “the case is not easy to decide” but “an allocation to revenue is slightly preferable”. In concluding that the payments were revenue expenses, the Privy Council reversed the decision of the High Court of Australia in BP Australia Ltd v FCT (1964) 110 CLR 387. The majority of the High Court (Dixon CJ dissenting) applied the same test and factors to conclude that the payments were capital in nature.
Case study 12.12: Exclusivity payments capital in nature
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In Strick v Regent Oil Co Ltd [1966] AC 295, the taxpayer secured exclusive sales ties through a lease premium arrangement. Under the arrangement, the retailers leased their stations to the taxpayer for between 10 and 20 years in exchange for a lump sum lease premium. The taxpayer then sublet the stations back to the retailers at nominal rent on condition that the retailer sold the taxpayer’s oil exclusively. The House of Lords found that the lease premium payments were capital in nature. An important element in this case was the fact that the lease premium arrangements provided the taxpayer with a substantially longer benefit than the taxpayer in BP Australia. Lord Reid stated: “I would have great difficulty in regarding a payment to cover 20 years as anything other than a capital outlay”.
Form and substance [12.200] BP Australia Ltd v FCT (1965) 112 CLR 386 (see Case Study [12.11]) and Strick v Regent Oil Co Ltd [1966] AC 295 (see Case Study [12.12]) suggest that the frequency of payments may be relevant in characterising an expense as capital or revenue. Other cases indicate that the courts will examine the substance of a payment and not just its form in determining whether an expense is capital or revenue in nature. Case study 12.13: Lump sum payment held to be revenue expense In National Australia Bank Ltd v FCT (1997) 37 ATR 378, the taxpayer made a large lump sum payment to the Commonwealth Government. In return, the taxpayer became the exclusive lender under a Commonwealth
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subsidised home loan scheme for members of the defence force for a period of 15 years. The taxpayer sought a deduction for the lump sum payment on the basis that it was akin to a marketing expense or minimum royalty payment. The Commissioner argued that the payment was a capital expense as it resulted in the taxpayer having a monopoly over a particular class of taxpayers and therefore provided the taxpayer with an enduring benefit. The Full Federal Court concluded that the lump sum payment was a deductible revenue expense. In applying Dixon J’s test and factors, the Court held that the character of the advantage sought was the expansion of its customer base and the potential increase in its income from loan activities. Importantly, the payment was not considered to create a monopoly or add to the structure of the taxpayer’s business as defence force members were not required to obtain their home loan from the taxpayer and could go to other banks.
Case study 12.14: Monthly “rental” payments held to be capital expense
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In Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428, the taxpayer purchased a block of land. The consideration for the transfer was a “rent charge” to be paid monthly for a period of 50 years. The “rent charge” was equal to 90% of the annual rents on three shops and a basement on the transferred land. Payment of the “rent charge” was conditional on the rents being received. The Full High Court concluded that the “rent charge” was a capital expense. The so-called rental payments were in effect consideration for the acquisition of the land. Fullager J stated that “the documents make it quite clear that these payments constitute the price payable on the purchase of land, and that appears to me to be the end of the matter. It does not matter how they are calculated, or how they are payable, or when they are payable, or whether they may for a period cease to be payable. If they are paid as parts of the purchase price of an asset forming part of the fixed capital of the company, they are outgoings of capital or of a capital nature”.
The examination of the substance of an expense is not limited to the frequency of the payments. In FCT v Star City Pty Ltd (2009) 72 ATR 431, the Full Federal Court looked beyond the contract documents to additional background information in concluding that the substance of a payment was capital in nature although the form of the payment suggested otherwise.
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Case study 12.15: Payment held to be capital based on substance rather than form In FCT v Star City Pty Ltd (2009) 72 ATR 431, the taxpayer had an exclusive licence to operate a casino in Sydney. Under the terms of its agreement with the NSW Government, the taxpayer was granted a 99-year lease over the land where the casino was located and a 12-year exclusive licence to operate the casino. The taxpayer was required to make an upfront payment for the licence plus a payment of $120 million, which was described as prepaid “rent” for the first 12 years of land rental. The Full Federal Court examined the background documentation, which clearly indicated that the value of the rent was related to the benefits that would be enjoyed by the taxpayer in operating the casino under an exclusive licence, and held that the “rent” was a capital expense. The High Court refused the taxpayer special leave to appeal from the decision of the Full Federal Court.
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A similar conclusion was reached by the Full Federal Court in Jupiters Ltd v DCT (2002) 50 ATR 236. The taxpayer entered into an agreement with the Queensland Government under which, in return for “special rent” payments, the Government would not permit the operation of another casino within 60 km of the taxpayer’s casino. The “rent” payments were frequent and regular, but the Court concluded that they were capital in nature as the benefit acquired was “to secure the advantage of exclusivity and freedom from competition”, which relates to the taxpayer’s income-producing structure.
Summary [12.210] As illustrated by the cases discussed here, the characterisation of an expense as capital or revenue is not an easy issue. It is necessary to apply the three factors from Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (see Case Study [12.10]) to the expense and consider whether the expense relates to the taxpayer’s income- producing process (revenue expense) or income-producing structure (capital expense). In some cases, it may be necessary to look beyond the form of the transaction or payment and examine its substance to determine its character. Remember that although capital expenses are not immediately deductible under s 8-1, the expenses may be deductible over a period of years (see Chapter 14) or taken into account when an event, such as a disposal, happens to the relevant asset: see Chapter 11. The distinction between capital and revenue expenses will be considered further when we look at some commonly incurred expenses: see [12.330]. The
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distinction can be particularly difficult to apply in the case of legal expenses: see [12.840].
Private or domestic [12.220] Under s 8-1(2)(b) of ITAA 1997, losses or outgoings of a private or domestic nature will not be deductible under s 8-1. There is some question as to whether the second negative limb is strictly necessary, as expenses which are private or domestic in nature are unlikely to be incurred in gaining or producing assessable income and therefore would not satisfy either of the positive limbs of s 8-1. Nonetheless, the second negative limb ensures that such expenses would not be deductible under s 8-1. There is no clear test as to whether an expense is private or domestic in nature. In broad terms, private or domestic expenses are those which are incurred to put the taxpayer in a position to gain or produce assessable income, as opposed to expenses incurred in gaining or producing assessable income. Another way of looking at it is that private or domestic expenses are incurred regardless of the taxpayer’s income-producing activities (eg, food and shelter). But it does not necessarily follow that an expense will not be private or domestic in nature simply because it has some connection to the taxpayer’s income-producing activities. This was made clear by the Full Federal Court in FCT v Cooper (1991) 21 ATR 1616.
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Case study 12.16: Private or domestic expenses In FCT v Cooper (1991) 21 ATR 1616, the taxpayer was a professional rugby player who received instructions from his coach requiring him to eat more meat and potatoes and drink more beer, in addition to his normal meals, to improve his fitness for the following season. The taxpayer sought a deduction for the additional food and alcohol costs on the basis that the expenses were incurred in gaining or producing his assessable income. The Commissioner denied the taxpayer a deduction on the basis that the expenses were private or domestic in nature. The Full Federal Court agreed with the Commissioner’s argument, finding that the expenses were incurred in putting the taxpayer in a position to carry out his income-producing activities, rather than being incurred in the carrying on of those activities. Therefore, the expenses did not satisfy the positive limbs of the predecessor to s 8-1 and were specifically excluded from being deductible as they were private or domestic in nature. The fact that the taxpayer was instructed by his coach to consume the additional food and drink, and therefore incur the additional expenditure, did not change the character of the expenditure, which was for food and drink to sustain life.
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414 [12.230] PRINCIPLES OF TAXATION LAW 2020 In FCT v Cooper, the Full Federal Court also stated that the taxpayer’s income- producing activities did not include the consumption of food and drink and, as such, the expenditure on food and drink was not related to the production of the taxpayer’s assessable income. Where the consumption of food and drink is incurred in the course of gaining or producing the taxpayer’s assessable income, expenditure on food or drink will be sufficiently connected to the production of assessable income and not constitute a private or domestic expense. For example, a food critic incurs expenditure on food or drink in the course of gaining or producing their assessable income. Similarly, expenditure on food or drink incurred while a taxpayer is required to travel overnight for work purposes is incurred in the course of gaining or producing assessable income: see Ruling TR 98/9.
Case study 12.17: Expenses not private or domestic
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In FCT v Day (2008) 70 ATR 14 (see Case Study [12.2]), the Commissioner also argued that the legal expenses were not deductible as they were a private or domestic expense. The High Court rejected this argument and found that the legal expenses were not private or domestic in nature. Crucial to the taxpayer’s success on this issue were the facts that the taxpayer was exposed to the action because of his employment and the charges were brought against him by his employer.
Several other cases regarding private or domestic expenses will be considered later in the chapter when we consider the application of s 8-1 to some commonly incurred expenses: see [12.330].
Incurred in gaining or producing exempt or non- assessable non-exempt income [12.230] As with the second negative limb, there is some question as to whether the third negative limb is strictly necessary, as expenses that are incurred in gaining or producing exempt or non- assessable non- exempt income would not satisfy either of the positive limbs of s 8-1 of ITAA 1997 as they would not be incurred in gaining or producing assessable income. Nevertheless, s 8-1(2)(c) ensures that such expenses would not be deductible under s 8-1 since the income to which the expense relates is not subject to tax in Australia. To allow a deduction for such expenses would inappropriately reduce the taxpayer’s tax payable on any other unrelated income.
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Example 12.4: Expenses incurred in gaining or producing exempt income Leela is a primary school teacher who is a resident of Australia for income tax purposes. She has taken a five-year leave of absence from her job and is currently teaching English in Africa. She is employed by a charitable institution that is exempt from income tax under s 50-50(1)(c) of ITAA 1997. Leela incurred annual membership fees of $200 for the Teaching Institute of Australia. She is required to be a member of the Institute to be employed by the charity. Leela’s salary for teaching in Africa is exempt from tax in Australia under s 23AG of ITAA 1936. Leela will not be able to claim a deduction for her membership fees as they relate to the production of exempt income.
Denied deductions
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[12.240] The last of the negative limbs in s 8-1 of ITAA 1997 provides that an expense will not be deductible under s 8-1 where another section in the income tax legislation states that the expense is not deductible for tax purposes. The provisions that operate to deny a deduction are mainly contained in Div 26, but there are also a number of other provisions scattered throughout both ITAA 1936 and ITAA 1997. The provisions may operate to deny a deduction for an expense either in whole or in part. The expenses that are denied deductions are generally not deductible for policy reasons, such as where the government does not want to reward or promote certain types of behaviour. Some examples of expenses that are not deductible for tax purposes are: • Penalties – All forms of penalties, whether or not they are described as penalties, imposed under Australian or foreign laws are not deductible under s 26-5(a). Any court-ordered amounts payable in respect of a conviction under an Australian or foreign law are also not deductible: s 26-5(b). – Disallowing a tax deduction for penalties preserves the policy intent of the penalty, which is generally to discourage taxpayers from undertaking certain behaviour. – Note that the penalty must be imposed under a government law and therefore s 26-5 only applies to government penalties and not to penalties arising in a private context (eg, penalties imposed by sporting clubs or libraries).
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416 [12.240] PRINCIPLES OF TAXATION LAW 2020 – Note also that penalties are different to damages. Penalties are “imposed as a punishment of the offender considered as a responsible person owing obedience to the law”: Gavin Duffy CJ and Dixon J in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 at 120. Damages, on the other hand, are an attempt to compensate a plaintiff (the victim) in financial terms for harm suffered due to the actions of the defendant (the alleged wrongdoer). As we have seen in cases such as Herald and Weekly Times (see Case Study [12.3]), payments for damages may be deductible where the requirements of s 8-1 are satisfied. • Expenditure related to rebatable benefits – In response to FCT v Anstis (2010) 76 ATR 735 (see Case Study [12.34]), the government introduced s 26-19 which denies taxpayers a deduction for losses or outgoings incurred in gaining or producing a rebatable benefit (eg, Youth Allowance, Austudy).
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• Assistance to students – As discussed in Chapter 3, the government provides financial assistance in the form of loans to people undertaking higher education, trade apprenticeships and other training programs. Repayments of some of these debts or student contributions under the Higher Education Support Act 2003 (Cth) are not deductible due to s 26-20. – The non-deductibility of such expenses ensures that taxpayers do not get an additional benefit in relation to their higher education fees in the form of a reduction to their tax payable as the system already provides for financial assistance and/or subsidised higher education. – However, such expenditure is deductible when provided as a fringe benefit: s 26-20(2). – Note that s 26-20 does not prevent a deduction for full course fees where the requirements of s 8-1 are satisfied. This is the case even where the fees have been funded by the Higher Education Loan Programme (FEE-HELP): see, for example, ATO ID 2005/26. • Gifts or donations – Section 26-22 denies business taxpayers a deduction for political gifts and donations: see [13.150]. Individuals can claim a maximum deduction of $1,500 for political gifts or donations but not if the gift or donation is made in the course of carrying on a business: ss 30-242 and 30-243. Where an individual makes a political gift or contribution in the course of carrying on a business, the amount is not deductible due to s 26-22.
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– Section 26- 55 stipulates that a taxpayer is not entitled to a deduction for a gift or donation where the deduction would result in the taxpayer incurring or increasing a tax loss for the year: see [13.140]. – A deduction for a gift or donation may also be denied due to s 78A of ITAA 1936: see [13.140]. • Relative’s travel expenses – Under s 26-30, expenses incurred by a taxpayer attributable to a relative’s travel, so that the relative can accompany the taxpayer on a work-related trip, are not deductible. “Relative” is defined in s 995- 1 as (a) the person’s spouse; or (b) parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of that person or of that person’s spouse; or (c) the spouse of a person referred to in paragraph (b). “Spouse” is defined in s 995- 1 to include a person in a de facto relationship with the taxpayer, including same-sex relationships. – In Re WTPG v FCT [2016] AATA 971, the Administrative Appeals Tribunal denied a deduction for a disabled taxpayer’s wife’s travel costs where she accompanied him to overseas conferences because he required a carer. The deduction was denied on the basis that the expenditure was private or domestic in nature and because of s 26-30. The AAT held that it was not possible to read into s 26-30 an exception for a relative accompanying a taxpayer as a carer. – The relative’s travel expenses will be deductible where the relative accompanies the taxpayer in his or her own capacity as an employee and would have done so regardless of the personal relationship (s 26-30(2)) or where the travel expenditure is provided as a fringe benefit: s 26-30(3). • Amounts paid to related entities – Section 26-35 provides that taxpayers can only deduct so much of an expense paid to a related entity as the Commissioner considers reasonable. – “Related entities” are defined in s 26-35(2) as the taxpayer’s relative or a partnership in which the taxpayer’s relative is a partner. – Note that under s 26-35(4), any excess payment that is not deductible is treated as non-assessable non-exempt income of the recipient. Therefore, any amount in excess of what the Commissioner considers to be reasonable is effectively treated as a gift from the taxpayer to the related entity. This is an unusual situation where the assessability of an amount for one taxpayer is determined by the deductibility of the amount for another taxpayer.
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Example 12.5: Payments to related entities Linda is a lawyer with her own successful legal practice. She recently employed her son Scott, a university student, to work in her practice three days a week as a receptionist. The market rate for receptionists is $20 per hour, but Linda decided to pay Scott $40 an hour so that he does not need to get a second job and can concentrate on his university studies. Generally, salary and wages are fully deductible under s 8-1 as an ordinary business expense. In this case, however, Linda’s deduction in relation to the salary and wages paid to Scott is likely to be limited to $20 per hour (or some other amount the Commissioner considers reasonable) as Scott is Linda’s son and is therefore a “related entity”: s 26-35. Under s 26-35(4), Scott is only required to include the amount that is deductible to Linda in his assessable income and not the $40 per hour which he actually receives.
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• Recreational club expenses – Membership fees or other related payments for a recreational club are not deductible under s 26-45. – “Recreational clubs” are defined in s 26-45(2) as companies providing their members with facilities for drinking, dining, recreation or entertainment. – However, under s 26-45(3), such expenses would be deductible where provided as a fringe benefit. • Bribes to foreign public officials and public officials – Sections 26- 52 and 26- 53 prevent taxpayers from claiming a deduction for bribes to foreign public officials and public officials, respectively. Such expenses are not deductible for policy reasons as the government seeks to discourage such behaviour. • Expenditure relating to illegal activities – Under s 26-54, taxpayers cannot claim a deduction for a loss or outgoing incurred in the furtherance of, or directly in relation to, a physical element of an offence against an Australian law of which the taxpayer has been convicted if the offence was, or could have been, prosecuted on indictment. The section was introduced in direct response to FCT v La Rosa (2003) 53 ATR 1 (see Case Study [12.6]), where the Full Federal Court permitted the taxpayer, a convicted drug dealer, a deduction under s 8-1 for losses related to his drug-dealing operations.
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• Travel expenses related to earning assessable income from residential premises – Under s 26-31, taxpayers are denied a deduction for travel expenses incurred in earning assessable income from residential premises. Examples of such expenses include travel expenses to collect rent or to inspect or maintain the property. The relevant travel expenses could relate to motor vehicle expenses, taxi or hire car costs, airfares, public transport costs, and any meals or accommodation related to the travel. The deductibility of expenses incurred in engaging third parties, such as a real estate agent, to manage investment properties is not affected by the provision. – The restriction on deducting travel expenditure does not apply if the expenditure is: a) necessarily incurred in carrying on a business; b) incurred by a corporate tax entity; c) incurred by a superannuation fund that is not a self-managed fund, a managed investment trust or a public unit trust; or d) incurred by a unit trust or partnership, provided each member of the trust or partnership is one of the entities described in (b) or (c). – Law Companion Ruling LCR 2018/ 7 provides guidance on the meaning of “residential premises” and the meaning of “carrying on a business” for the purposes of s 26-31. The Ruling also addresses the application of s 26-31 to travel expenditure that serves more than one purpose. Copyright © 2019. Thomson Reuters. All rights reserved.
• Non-compliant payments for work and services – From 1 July 2019, non-compliant payments for work and services will not be deductible under s 26-105. A non-compliant payment arises where the payment is subject to the withholding provisions in Sch 1 of the Taxation Administration Act 1953 (Cth) (eg, payments to employees or payments to contractors where a valid ABN is not provided) and the payer does not comply with those provisions.
Entertainment expenses [12.250] One of the main types of expenses that is not deductible is entertainment expenses: Div 32 of ITAA 1997. Section 32- 5 is the key provision and states that entertainment expenses are not deductible under s 8-1. “Entertainment” is defined in s 32-10(1) as entertainment by way of food, drink or recreation, or accommodation or travel related to the provision of entertainment by way of food, drink or recreation. The expenses are
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420 [12.250] PRINCIPLES OF TAXATION LAW 2020 considered to be “entertainment” even if business discussions or transactions take place: s 32-10(2). The note to s 32-10(2) suggests that business lunches and social lunches will constitute entertainment, but meals on business travel overnight, theatre attendance by a critic or a restaurant meal consumed by a food writer are not considered to be entertainment. The legislation thus takes a broad-brush approach to the denial of deductions for entertainment expenses through ss 32-5 and 32-10. A number of exceptions are then created in subdiv 32-B. The main exception to the non-deductibility of entertainment expenses is for entertainment provided by way of a fringe benefit: s 32-20. The amount of the deduction in this case will depend on how the taxpayer has treated the expenditure for fringe benefits tax purposes: see Chapter 7. Example 12.6: Entertainment expenses provided as fringe benefit Michael is a senior manager at a large accounting firm. He recently took one of his key clients to lunch to discuss the upcoming audit process. The lunch cost $200.
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Prima facie, the firm cannot claim a deduction for the $200 as it constitutes an entertainment expense. This is despite the fact that the purpose of the lunch was to discuss the upcoming audit and therefore relates to the production of assessable income by the firm. However, as Michael is an employee, the firm may be entitled to a deduction for a portion of the lunch cost as the cost of providing a fringe benefit. The amount of the deduction will depend on how the firm treats meal entertainment expenses for fringe benefits tax purposes. For example, if the firm elects to apply Div 9A of FBTAA to meal entertainment expenses and uses the 50/50 method to calculate taxable value, the taxable value in this example would be $100 (50% of total meal entertainment expenses). The firm would be entitled to a deduction of $100 in relation to the meal expense: s 51AEA of ITAA 1936. In this situation, the $100 is treated as the cost of providing a fringe benefit (a deductible expense), rather than as an entertainment expense. Subject to the prescribed conditions being satisfied, some other expenses that are excepted from the operation of s 32-5 and may be deductible under s 8-1 include: • expenses incurred in providing food or drink in an in-house dining facility: s 32-30, items 1.1–1.3; • provision of food or drink to an employee under industrial arrangements relating to overtime: s 32-30, item 1.4;
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• an allowance to an employee that is included in the employee’s assessable income: s 32-30, item 1.8; • expenses on food, drink, accommodation or travel that are incidental to the attendance at a seminar that lasts for at least four hours: s 32-35, item 2.1; • the ordinary course of the taxpayer’s business or duties that include the provision of entertainment (eg, a restaurant providing meals to customers): s 32-40; and • promotion and advertising expenses: s 32-45.
Reimbursed expenditure [12.260] Finally, s 51AH of ITAA 1936 prevents taxpayers from claiming a deduction for reimbursed expenditure. The denial of a deduction for reimbursed expenditure is logical as the taxpayer is not actually out-of-pocket as a result of the expense. In other words, they are in the same economic position despite the expense. Further, a double deduction could result if the entity making the reimbursement is entitled to a deduction (eg, the employer) as well as the taxpayer who incurred the original expense which has been reimbursed (eg, the employee). Example 12.7: Reimbursed expenditure
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Sarah is a tax accountant. She paid a fee of $440 for her membership of the Taxation Institute of Australia. Her employer subsequently repaid Sarah for the expense. Sarah cannot claim a deduction for the $440 membership fee as she has been reimbursed for the expense by her employer.
Apportionment –deductibility of dual purpose expenses [12.270] The phrase “to the extent that” appears twice in s 8-1 of ITAA 1997 and has important consequences. The phrase ensures that a loss or outgoing may still be partially deductible even though: • some portion of the loss or outgoing does not satisfy either of the positive limbs of s 8-1; or • some portion of the loss or outgoing does satisfy one of the negative limbs of s 8-1.
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422 [12.270] PRINCIPLES OF TAXATION LAW 2020 The fact that a loss or outgoing may be partially deductible where the taxpayer has a dual purpose in relation to the expense has long been accepted: see, for example, Ronpibon Tin No Liability v FCT (1949) 78 CLR 47. The difficulty with regard to dual purpose expenses is in determining the extent to which the expense may be deductible. The High Court in Ronpibon Tin considered the appropriate apportionment formula for a partially deductible expense and found that there can be no precise formula and the apportionment is to be done on a case-by-case basis depending on individual circumstances.
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Case study 12.18: Dual purpose expenses In Ronpibon Tin No Liability v FCT (1949) 78 CLR 47, the taxpayer produced income from mines in Thailand (then Siam) which was exempt income in Australia. The taxpayer also produced investment income in Australia, which was subject to tax. During World War II, the taxpayer’s Siamese mines were confiscated by the Japanese and the taxpayer did not receive any income from the mines. The taxpayer incurred administrative and management expenses which related to its production of Australian-sourced investment income and its Siamese mining operations. The investment income was only a small percentage of the taxpayer’s total income. Prior to the confiscation of the Siamese mines, the Commissioner permitted the taxpayer a deduction for only a small portion of the taxpayer’s expenses relating to the production of Australian-sourced investment income. Following the confiscation of the mines, the Commissioner continued to only permit a deduction for a small percentage of the taxpayer’s expenses. The taxpayer argued that apportionment was not required as it was no longer gaining or producing exempt income from the overseas mines. Its only income was the investment income, which was fully assessable. This argument was rejected by the Full High Court. The expenses were not incurred solely in relation to the investment income and continued to relate to the halted overseas operations (eg, the taxpayer made some support payments to the families of employees who had been in Siam at the time of the invasion). As such, apportionment was required and allowed for by the predecessor to s 8-1 of ITAA 1997. As to how much of the expenses should be apportioned to the taxpayer’s overseas activities and the investment income, the High Court concluded that this was a question of fact that must be based on the taxpayer’s actual expenditure and activities. The Court stated that “it is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent”. This is similar to the “business judgment rule” later espoused by the Court in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276: see Case Study [12.5].
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[12.280] Where the portion of the expense that relates to the production of income is distinct and severable from the portion that is not related to the production of income, the expense is apportioned between the two activities accordingly. However, where the expense serves both an income-producing purpose and some other purpose indifferently, it may be necessary to examine the taxpayer’s purpose in incurring the expenditure to determine the appropriate amount that is deductible. The High Court in Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 recognised that there can be no precise formula for apportionment in such cases and it will be necessary to determine a fair and reasonable division based on the taxpayer’s particular circumstances. Example 12.8: Dual purpose expenses Hoong is a lawyer at a large firm. His mobile phone expenses for the previous income year totalled $2,200. Hoong estimates that 70% of his mobile phone use is for work purposes. Hoong is entitled to a deduction for a portion of his mobile phone expenses as he uses his phone for income-producing activities and therefore the expense is incurred in gaining or producing Hoong’s assessable income. The amount of the deduction should be a fair and reasonable estimate which, in this case, is likely to be $2,200 × 70% based on Hoong’s estimated use of his mobile phone.
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Example 12.9: Dual purpose expenses Leela is a primary school teacher who is a resident of Australia for income tax purposes. She recently taught English in Africa for six months. She was employed to teach in Africa by a charitable institution, which is exempt from income tax under s 50-50(1)(c) of ITAA 1997. Leela incurred expenses of $200 for her annual membership fees of the Teaching Institute of Australia. Leela is required to be a member of the Institute in order to teach in Australia and with the charitable institution. Leela’s salary for teaching in Africa is exempt from tax in Australia under s 23AG of ITAA 1936. The $200 membership fees are deductible under s 8- 1 as they are incurred in the production of Leela’s assessable income. However, some portion of the $200 may not be deductible if it relates to Leela’s overseas income, which is not assessable in Australia. Leela will need to make a fair and reasonable estimate of the portion of the expense that relates to her Australian assessable income. This may be done, for example, on the basis of the percentage of assessable teaching income over total teaching income.
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424 [12.290] PRINCIPLES OF TAXATION LAW 2020 The apportionment of expenses incurred for income-producing and private purposes is discussed in more detail later in this chapter when we consider the application of s 8-1 to some commonly incurred expenses: see, in particular, [12.690].
Amount of deduction [12.290] As a general rule, taxpayers are entitled to deduct the full amount of an expense or loss once it is determined that the requirements of s 8-1 of ITAA 1997 are satisfied. However, the question has arisen in some situations as to whether the full amount or some lesser amount is deductible. In particular, the courts have considered whether a taxpayer’s expense needs to be “reasonable” to be deductible and whether consideration should be given to the taxpayer’s subjective purpose in incurring an expense.
Reasonable vs actual expense
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[12.300] The courts have consistently stated that the deductibility of a loss or outgoing does not depend on whether it is commercially realistic or reasonable but that it is a question of judgment to be made by the taxpayer based on their individual circumstances. As stated by Ferguson J in Tooheys Ltd v Commissioner of Taxation for NSW (1922) 22 SR (NSW) 432 at 440–441: A taxpayer is liable to be taxed on the income he has made, not on what he might have made. It is nothing to the point that if he had been more capable, more experienced or more prudent, he might have cut down his expenses. The question is what he did in fact spend on his business. If he chooses to employ a hundred men where twenty would have been ample, that is his own affair. Of course, it may still be a matter for enquiry whether these men were really employed in the business, or were merely put on the pay-roll as a device to swell the apparent expenses of the business; but that is another matter.
In Tweedle v FCT (1942) 7 ATD 186 at 190, Williams J stated: It is not suggested that it is the function of income tax Acts or those who administer them to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically. The Act must operate upon the results of a taxpayer’s activities as it finds them. If a taxpayer is in fact engaged in two businesses, one profitable and the other showing a loss, the Commissioner is not entitled to say he must close down the unprofitable business and cut his losses even if it might be better in his own interest and although it certainly would be better in the interests of the Commissioner if he did so.
Similar comments were made by the Full High Court in Ronpibon Tin No Liability v FCT (1949) 78 CLR 47 at 60 (see Case Study [12.18]), where it was stated that “it is not for the Court or the commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has
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spent”. In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276 (see Case Study [12.5]), Deane and Fischer JJ articulated the “business judgment rule” – that it is for the people who run the business to determine what is desirable and appropriate for that business. The courts’ comments in these and other cases are generally well accepted and, as a result, taxpayers are entitled to deduct the full amount of any expenses incurred if the requirements of s 8-1 are satisfied. For example, a first-class airfare or the cost of designer (eg, Prada) sunglasses incurred in gaining or producing assessable income will be deductible under s 8-1, as long as the requirements of the section are met. The amount of the expense cannot be limited to an economy-class airfare or a non-designer pair of sunglasses. However, note that a statutory provision may apply in certain circumstances to limit the amount of a deduction to a reasonable amount. As we have seen at [12.240], s 26-35 operates to limit the amount of a deduction for a payment made to a related entity to what is considered reasonable by the Commissioner. In other situations, the Commissioner could potentially seek to apply the general anti-avoidance provision in Pt IVA of ITAA 1936 (see Chapter 23) to deny a deduction. In an international context, Div 815 of ITAA 1997 permits the Commissioner to substitute the “transfer price” (ie, the price at which related parties transact) with an arm’s length amount (see Chapter 22).
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Tax minimisation situations –purpose [12.310] As mentioned at [12.60], a taxpayer’s subjective purpose or intention in incurring an expense is generally not relevant in determining deductibility. Traditionally, the courts have adopted a legal rights approach in determining whether the elements of s 8-1 are satisfied. Under this approach, courts have only considered the objective circumstances of a loss or outgoing in determining its deductibility under s 8-1 and not the taxpayer’s subjective purpose or intention in incurring the expense. The leading case on the legal rights doctrine is Europa Oil (NZ) Ltd v CIR (NZ) (No 2) (1976) 5 ATR 744, where the Privy Council only looked at the actual legal rights acquired as a result of an expense without considering any related benefits or arrangements which were not set out in the contract itself. The Privy Council’s precedent was followed in several Australian cases in the 1970s. For example, in FCT v South Australian Battery Makers Pty Ltd (1978) 14 CLR 645, a majority of the High Court permitted the taxpayer a deduction for the full amount of rental payments on a property even though the rental payments in effect reduced the purchase price of the property for a related company. The Commissioner had sought to argue that a portion of the rental payments should be attributable to the purchase price of the property and thus a capital expense, but this argument was not accepted by the Court. Applying the legal rights approach, the majority concluded that the only benefit acquired
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426 [12.310] PRINCIPLES OF TAXATION LAW 2020 from the rental payments was the rental of the property and the entire payment was therefore deductible as an ordinary business expense. By the 1980s, however, Australian courts sought to move away from the traditional legal rights approach and considered the taxpayer’s purpose or intention in incurring an expense in certain circumstances. Broadly, the taxpayer’s subjective purpose or intention in incurring an expense may be relevant where the taxpayer is in a loss position for tax purposes (ie, deductions exceed assessable income) and the taxpayer’s purpose in incurring a particular expense appears to be one of tax minimisation: Ure v FCT (1981) 11 ATR 484; Fletcher v FCT (1991) 173 CLR 1. In such cases, the amount of the deduction may be limited to the amount of income produced by the expense, even though the elements of s 8-1 are satisfied. Case study 12.19: Expenses incurred with a tax minimisation purpose
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In Ure v FCT (1981) 11 ATR 484, the taxpayer borrowed money at interest rates ranging from 7.5% to 12.5%. He then on-lent the borrowed money to his wife and a family trust at an interest rate of 1%, thereby producing assessable income from the funds and making the interest payable on the original loans deductible for tax purposes. The wife and the family trust directly and indirectly invested the funds in debt instruments paying competitive market rates. Although the Full Federal Court did not expressly rest its decision on the taxpayer’s purpose in incurring the expenditure, that is essentially what it did in finding that most of the interest expense was not deductible as it was a private or domestic outgoing. The Court concluded that the only explanation for the 1% interest rate was that it was a private or domestic arrangement. As a result, the Court limited the amount of the taxpayer’s deduction for the interest expenditure to the amount of interest income gained or produced under the on-lending arrangement, that is, 1%.
Case study 12.20: Expenses incurred with a tax minimisation purpose Fletcher v FCT (1991) 173 CLR 1 involved a complex arrangement whereby the taxpayer effectively incurred substantial interest expenses with little or no actual outlay. The interest expenses related to the purchase of an annuity. Under the applicable tax accounting rules, the interest payments substantially exceeded the assessable annuity amounts in the early years of the arrangement. This resulted in a tax loss that could be applied to reduce the taxpayer’s overall tax liability. The annuity amounts would in
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later years exceed the interest payments, but the taxpayer had the option of ending the arrangement prior to that time. The Commissioner argued that the taxpayer did not intend to continue the arrangement until it generated assessable income in excess of the interest deductions. Therefore, the interest expenses should not be deductible under s 8-1 taking into account the taxpayer’s subjective purpose or intention in incurring the expense since the taxpayer’s purpose was not to gain or produce assessable income. The High Court found that the taxpayer’s subjective purpose or intention was relevant in these circumstances. If it could be shown that, at the outset, the taxpayer intended to end the arrangement prior to it being profitable, the interest expenses would not be deductible under s 8-1. The High Court remitted the matter back to the AAT for a factual determination of purpose. In AAT Case 5489A (1992) 23 ATR 1068, the AAT found that the taxpayer’s dominant purpose in incurring the expense was to minimise tax and not to gain assessable income. The taxpayer’s appeal to the Full Federal Court from the AAT’s decision was dismissed in Fletcher v FCT (1992) 92 ATC 4611. The decisions in Ure and Fletcher endorse the view that a taxpayer’s subjective purpose or intention may be relevant where the taxpayer incurs the expenses in such a way as to only generate a small amount of assessable income which results in a tax loss. The expenses that are deductible under s 8-1 may be limited in these circumstances. Note that these situations are different to negative gearing, which is discussed at [12.820]. Here, the taxpayers never intended for the arrangements to be profitable, whereas in a negative gearing arrangement, the taxpayer generally intends that the arrangement will be profitable overall. The Commissioner’s guidance on the relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings is contained in Ruling TR 95/33. Note also that in these situations, the Commissioner could apply the general anti-avoidance provision in Pt IVA of ITAA 1936 (see Chapter 23) to deny the deduction.
Substantiation of deductions [12.320] In order to claim a deduction for tax purposes, taxpayers must be able to substantiate the deduction by maintaining proper records and documentation. The substantiation requirements are outlined in Div 900 of ITAA 1997 and taxpayers are generally expected to keep evidence and records relating to the expense for a period of five years under s 900-165.
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428 [12.330] PRINCIPLES OF TAXATION LAW 2020 For most expenses, taxpayers should obtain a document from the supplier containing the following information (s 900-115): • name or business of the supplier; • amount of the expense; • nature of the goods and services; • date expense incurred; and • date of document. Specific substantiation rules may apply in relation to certain expenses, such as car expenses: see [12.450]–[12.570]. To reduce the compliance burden, taxpayers may deduct up to $300 of work expenses and $150 of laundry expenses without written evidence: ss 900-35 and 900-40. Where a taxpayer receives a travel or overtime meal allowance, the taxpayer is exempted from the substantiation rules where the amounts claimed in relation to the allowance do not exceed the Commissioner’s reasonable limits: ss 900-50, 900-55, 900-60. The Commissioner’s reasonable limits are set out in Determination TD 2019/11 for the 2019–2020 income year. The Determination should be read in conjunction with Ruling TR 2004/6, which discusses the substantiation exception for reasonable travel and overtime meal allowance expenses.
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Application of s 8-1 to commonly incurred expenses [12.330] We have now examined the key issues in relation to deducting an expense under s 8-1 of ITAA 1997. In the rest of this chapter, we will apply these rules to consider the deductibility under s 8-1 of the following commonly incurred expenses:
• • • • • • • • •
expenses incurred in gaining employment: see [12.340]; relocation expenses: see [12.360]; child care expenses: see [12.370]; travel expenses: see [12.380]; self-education expenses: see [12.580]; home office expenses: see [12.700]; clothing expenses: see [12.740]; interest expenses: see [12.810]; and legal expenses: see [12.840].
Many of these expenses may be considered quasi-personal, and the courts have had to consider whether the expenses are sufficiently connected to the
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production of assessable income or whether they could be considered private or domestic. In other situations, such as with legal expenses, the issue is generally whether the expenses are capital or revenue in nature.
Expenses incurred in gaining employment [12.340] As discussed at [12.130], expenses related to gaining or producing future assessable income can sometimes satisfy the positive limbs of s 8-1. However, in the case of expenses incurred in gaining employment (eg, travel expenses to attend an interview or legal expenses to review an employment contract), the expenses are generally considered to be too early for the production of assessable income. The expenses are considered to have been incurred to put the taxpayer in a position to gain or produce assessable income, not in gaining or producing assessable income: FCT v Maddalena (1971) 2 ATR 541.
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Case study 12.21: Expenses incurred in gaining employment not deductible In FCT v Maddalena (1971) 2 ATR 541, the taxpayer was an electrician who was also a rugby player. The taxpayer incurred travel and legal expenses in considering whether to change rugby clubs, which he sought to deduct under the predecessor to s 8-1. The Full High Court agreed with the Commissioner in concluding that the expenses were not deductible under the predecessor to s 8-1 as they were not sufficiently connected to the taxpayer’s production of assessable income. The expenses were incurred in putting the taxpayer in a position to produce assessable income, rather than in producing assessable income. As such, the positive limbs of the predecessor to s 8-1 were not satisfied.
Business taxpayers [12.350] In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148, with regard to expenses incurred in gaining employment, the High Court drew a distinction between taxpayers who are carrying on a business and those who are not. Case study 12.22: Expenses incurred in gaining employment – business taxpayers In Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148 (see Case Study [8.9]), the taxpayers were a professional football player and a professional
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rugby player, respectively. The taxpayers incurred management fees, and the deductibility of these fees was in dispute. It was accepted by all parties that the management fees were in fact incurred in the negotiation of employment contracts.
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Following FCT v Maddalena (1971) 2 ATR 541 (see Case Study [12.21]), the Full Federal Court denied the taxpayers a deduction for the management fees on the basis that they were incurred in negotiating employment contracts and were therefore incurred in putting the taxpayers in a position to gain or produce assessable income, rather than in the course of gaining or producing assessable income. It was not in dispute that the non- playing activities of the taxpayers constituted a business for tax purposes. The Full High Court found that the negotiated contracts were employment contracts, but that they were not solely employment contracts as they included terms and conditions regarding promotional activities to be carried on independently of the players’ clubs. This meant that the employment contracts also related to the production of the taxpayers’ business income. As such, the Court found that all of the taxpayers’ activities (playing and non-playing) constituted a business for tax purposes. The Court rejected the Commissioner’s argument that it was necessary to separate the taxpayers’ playing activities (employment) from their non-playing activities (business). The Court noted that taxpayers can have different income-producing activities and even different businesses, but that was not the case here. Looking at the relevant indicia for a business, the Court found that the taxpayers were engaged in the business of commercially exploiting their sporting prowess and associated celebrity for a limited period. Following the conclusion that all of the taxpayers’ activities amounted to a business, the Court found that the management fees were incurred in gaining or producing assessable income as there was sufficient connection between the management fees and the production of business income. The Court held that FCT v Maddalena was distinguishable from the present case as there was no evidence as to any of the indicia for business in that case. It could not be said that the taxpayer in FCT v Maddalena was carrying on a business, a part of which included the taxpayer’s employment as a rugby player. Following the High Court’s decision in Spriggs v FCT; Riddell v FCT, it would appear that expenses incurred in gaining employment may be deductible where the taxpayer is carrying on a business and the employment contract contributes towards the production of business income (ie, the employment contract is not solely an employment contract). This is likely to be the case for elite sportspeople and celebrities, such as television or radio personalities.
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In such cases, it will be necessary to examine the contractual framework and connection between the taxpayer’s various activities. In all other cases, the precedent set by FCT v Maddalena remains unchanged and expenses incurred in gaining employment are unlikely to be deductible as they are incurred in putting the taxpayer in a position to produce assessable income, rather than in gaining or producing assessable income.
Relocation expenses [12.360] Expenses incurred by a taxpayer in relocating his or her home have similarly been held to be non-deductible under s 8-1 of ITAA 1997 as they are incurred in putting the taxpayer in a position to produce assessable income, rather than being incurred in gaining or producing assessable income: Fullerton v FCT (1991) 22 ATR 757. As a result, such expenses would not satisfy the positive limbs of s 8-1. In addition, the expenses are likely to fall foul of the second negative limb of s 8-1 in that they are private or domestic expenses. This would be the case even where the taxpayer is required to relocate by the employer.
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Case study 12.23: Relocation expenses not deductible In Fullerton v FCT (1991) 22 ATR 757, the taxpayer was a professional forester who had to accept a transfer or be retrenched. His employer reimbursed him for a portion of his relocation costs and the taxpayer sought a deduction for the expenses incurred by him which were not reimbursed. The Federal Court held that the expenses were not deductible as they were incurred in putting the taxpayer in a position to produce assessable income, rather than incurred in gaining or producing assessable income (ie, the positive limbs of the predecessor to s 8-1 were not satisfied). Further, the expenses were a private or domestic outgoing, which meant that the expenses were also not deductible under the second negative limb of the predecessor to s 8-1.
Child care expenses [12.370] Child care expenses have long been held to be non-deductible under s 8-1 of ITAA 1997 (and its predecessors) as they are incurred in putting the taxpayer in a position to gain or produce assessable income and are not incurred in the production of assessable income: Lodge v FCT
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432 [12.380] PRINCIPLES OF TAXATION LAW 2020 (1972) 3 ATR 254; Martin v FCT (1984) 15 ATR 808. Again, the expenses do not satisfy the positive limbs of s 8-1 and are also likely to not be deductible due to the second negative limb as they are private or domestic expenses. This is the case regardless of whether the taxpayer is self-employed or an employee. However, the Federal Government does provide some assistance in relation to child care expenses through rebates for taxpayers and exemptions for employers from fringe benefits tax on qualifying child care facilities.
Travel expenses [12.380] The deductibility of travel expenses will depend on the type of travel undertaken, which could be: • travel between home and work: see [12.390]–[12.430]; and • travel between two workplaces: see [12.440]. Where the travel expenses are car expenses (ie, the taxpayer owns or leases a car during the year and the car is used in gaining or producing the taxpayer’s assessable income), Div 28 of ITAA 1997 sets out the rules for calculating the amount of the deduction: see [12.450]–[12.570]. Travel expenses that relate to recreation and income-producing activities are a tricky issue and are discussed at [12.620] in the context of self-education travel expenses.
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Travel between home and work [12.390] As a general rule, expenses incurred in travelling between a taxpayer’s ordinary home and his or her regular work location are not deductible under s 8-1 of ITAA 1997: Lunney v FCT; Hayley v FCT (1958) 100 CLR 478; Draft Ruling TR 2017/D6. As with the other expenses discussed so far, expenses on travel between a taxpayer’s ordinary home and regular work location are considered to be incurred in putting the taxpayer in a position to gain or produce assessable income, rather than in the production of assessable income. As such, these expenses do not satisfy the positive limbs of s 8-1 and are further prevented from being deductible under the second negative limb as private or domestic expenses. This travel is required for an employee to commence work or to depart after work is completed. In some situations, the determination as to whether the travel between home and work relates to private travel or work travel may not be straightforward and it is necessary to examine all relevant factors.
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Case study 12.24: Travel to work site on “fly in-fly out” basis
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In John Holland Group Pty Ltd v FCT (2015) FCAFC 82, the Full Federal Court considered the deductibility of airfares paid by an employer of “fly in-fly out” employees for travel from Perth airport to Geraldton, Western Australia, where the employees worked. The Commissioner argued that the expenses were not deductible as they were incurred in putting the taxpayers in a position to gain or produce assessable income rather than being incurred in gaining or producing assessable income. The Full Federal Court found that the expenses were deductible on the basis that under their employment contracts, the employees commenced their employment duties from the time they arrived at Perth airport (ie, they were paid for their travel time from Perth airport to Geraldton); all travel between Perth airport and Geraldton was controlled, arranged and paid for by the employer; and the employer paid for the employees’ transportation from Geraldton airport to their accommodation in Geraldton, which was also paid for and funded by the employer. Given these factual circumstances, the employees could not be said to be travelling to work when flying from Perth to Geraldton but rather were travelling on work. In Draft Ruling TR 2017/D6, the Commissioner highlights that a relevant factor here in finding that the travel was “work travel” was that the employees were subject to their employer’s direction and control during the period of travel. Note that this case concerned the fringe benefits tax implications of the airfares paid by the employer and the deductibility of the airfares was considered by the Court in the context of the “otherwise deductible rule” (see Chapter 7).
Case study 12.25: After-hours travel from home to work In FCT v Collings (1976) 6 ATR 476, the taxpayer was a computer consultant who generally worked in her employer’s offices. She was required to be “on call” after work hours and deal with any queries from her home. However, when she was unable to resolve the queries from home, she was required to go into the office to deal with them. The Court permitted the taxpayer a deduction for the travel expenses on the basis that the taxpayer commenced working at home and therefore the travel expenses were incurred in the course of gaining or producing assessable income, rather than in putting the taxpayer in a position to gain or produce assessable income. The positive limbs of the predecessor to s 8-1 were satisfied and the expenses did not fall within any of the negative limbs.
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The case does not create a general exception for all after-hours travel, but is limited to taxpayers in similar situations. The key factor here was that the taxpayer had commenced working at home prior to undertaking the travel and was not simply “on call”, but rather was required to work wherever she was located. In Draft Ruling TR 2017/D6, the Commissioner notes that travel between home and work is not in the performance of an employee’s work activities merely because an obligation to travel has been contrived to create the appearance of work travel. In determining whether a travel arrangement is genuine or contrived, it is necessary to consider whether the work involves special demands such as in John Holland Group Pty Ltd v FCT or FCT v Collings. [12.400] A number of exceptions to the general rule that travel from home to work is not deductible have arisen through case law, as follows.
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Itinerant workers [12.410] Taxpayers who do not have a fixed place of work, such as travelling salespeople, are known as itinerant workers. In their case, travel between home and work is deductible under s 8-1 as they are considered to have commenced work from the time they leave home and, as such, the travel expenses are incurred in the course of gaining or producing assessable income: FCT v Wiener (1978) 8 ATR 335; Ruling TR 95/34. The key factor is that the travel must be a fundamental part of the taxpayer’s employment. In Hill v FCT (2016) AATA 514, the Tribunal held that a taxpayer with multiple unrelated jobs was not an itinerant worker as he was not required to travel to different locations in the course of his employment.
Case study 12.26: Travel expenses of itinerant workers In FCT v Wiener (1978) 8 ATR 335, the taxpayer was a teacher who was required to teach at a minimum of four schools each day. The Court permitted the taxpayer a deduction for expenses incurred on travel from home to work on the basis that the travel was a fundamental part of the taxpayer’s employment and therefore the taxpayer commenced working from the time she left home. As a result, the travel expenses were incurred in the course of gaining or producing assessable income, rather than in putting the taxpayer in a position to gain or produce assessable income. The positive limbs of the predecessor to s 8-1 were satisfied and the expenses did not fall within any of the negative limbs.
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Transportation of bulky items [12.420] Taxpayers who are required to carry bulky items to perform their employment duties are permitted a deduction under s 8- 1 for expenses incurred in travelling between home and work: FCT v Vogt (1975) 5 ATR 274. In this case, the taxpayer was a professional musician who was required to carry a large musical instrument between home and work. In this situation, the travel expenses are attributable to transportation of the equipment and not the taxpayer’s travel between home and work. As such, they are considered to be incurred in the course of gaining or producing assessable income. The expenses are sufficiently connected to the production of the taxpayer’s assessable income and the positive limbs of s 8-1 are satisfied. Further, the expenses are not considered a private or domestic outgoing and therefore do not fall within any of the negative limbs of s 8-1. However, the expenses would not be deductible where the taxpayer carries the items between home and work as a matter of convenience only. In this situation, the travel expenses are not attributable to the transportation of the items and, as such, are not incurred in the course of gaining or producing assessable income. The positive limbs of s 8-1 are not satisfied. Further, the expenses are considered a private or domestic outgoing and are not deductible due to the second negative limb of s 8-1.
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Case study 12.27: Travel expenses not deductible where bulky item transported for convenience only In Brandon v FCT (2010) 2010 ATC 10-143, the AAT denied the taxpayer a deduction for travel expenses from home to work as the transportation of the bulky item was for the taxpayer’s convenience only. The taxpayer was a soldier in the Australian Defence Force who took his deployment kit home. While it was accepted that the deployment kit was a bulky item, the AAT found that the taxpayer only took it home as a matter of convenience as the kit could be stored securely at the taxpayer’s barracks. As such, the “essential character” of the taxpayer’s expenses was a private or domestic outgoing and the travel expenses were not attributable to the transportation of the deployment kit. The expenses were not sufficiently connected to the production of the taxpayer’s assessable income so the positive limbs of s 8-1 were not satisfied. Further, the expenses were not deductible due to the second negative limb of s 8-1 as they were considered a private or domestic expense. In Ford v FCT (2014) AATA 361, the AAT denied the taxpayer a deduction for work-related car expenses to transport essential equipment from his home to work on the basis that the equipment could be stored in a locker
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provided by the employer and the taxpayer took the equipment home as a matter of personal choice. See also Reany v FCT (2016) AATA 672; Rafferty v FCT (2017) AATA 636.
Alternative workplace [12.430] Taxpayers are permitted a deduction under s 8- 1 for expenses incurred on travel between home and an alternative workplace as the travel is considered to be incurred in gaining or producing assessable income: FCT v Ballesty (1977) 7 ATR 411; Draft Ruling TR 2017/D6. Here, the travel is attributable to the employee having to work in more than one place, rather than their choice about where to live. However, a deduction would not be permitted for such expenses where the taxpayer is employed to work at different workplaces on a fixed or regular basis. Example 12.10: Travel between alternative workplace and home deductible Sarah is an accountant with a large accounting firm. She is occasionally required to attend client premises as part of her employment duties and travels directly home from the client’s offices.
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Any expenses incurred by Sarah in travelling from the client’s premises to her home will be deductible under s 8-1 of ITAA 1997 as the expenses are incurred in the course of gaining or producing assessable income.
Example 12.11: Travel between alternative workplace and home not deductible Sarah is an accountant with a large accounting firm. Under the terms of her employment contract, she works in the firm’s city office on Mondays, Tuesdays and Thursdays and at a suburban branch office on Wednesdays and Fridays. Sarah is not under her employer’s direction and control for the period when she is travelling to either workplace and she does not receive any extra compensation for having two workplaces. Any expenses incurred by Sarah in travelling between her home and either of her employer’s offices are not deductible under s 8-1 of ITAA 1997. The offices are not an alternative workplace and Sarah simply has two different workplaces.
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Travel between two places of work [12.440] The deductibility of expenses incurred in travelling between two places of work will depend on whether the two places relate to the same income-producing activity. Where the two places of work relate to the same income-producing activity, any expenses incurred in travelling between the two places of work are deductible under s 8-1 of ITAA 1997 as the travel is undertaken in gaining or producing assessable income. Example 12.12: Travel between two workplaces deductible Sarah is an accountant with a large accounting firm. Under the terms of her employment contract, she works in the firm’s city office on Mondays, Tuesdays and Thursdays and at a suburban branch office on Wednesdays and Fridays. On occasion, Sarah is required to travel between the two offices.
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Any expenses incurred by Sarah in travelling between the two offices would be deductible under s 8-1 of ITAA 1997 as they relate to the same income-producing activity and are therefore incurred in the course of gaining or producing assessable income. However, where the two places of work relate to different income-producing activities, the High Court in FCT v Payne (2001) 202 CLR 93 held that expenses incurred on such travel are not deductible under s 8- 1 as the expenses are incurred in putting the taxpayer in a position to produce assessable income, rather than in gaining or producing assessable income. As such, the positive limbs of s 8-1 are not satisfied. Case study 12.28: Travel between two workplaces not deductible In FCT v Payne (2001) 202 CLR 93, the taxpayer was a Qantas pilot who also owned a deer-farming property. The taxpayer sought a deduction for expenses incurred in travelling between the airport and the deer-farming property. The Full High Court found that the expenses were not deductible under the predecessor to s 8-1 of ITAA 1997 as the positive limbs of the predecessor to s 8-1 were not satisfied and the expenses were not sufficiently connected to the production of the taxpayer’s assessable income. The taxpayer’s travel between the airport and the deer farm was not related to the production of income from his deer-farming activities
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or his occupation as a pilot. As such, the expenses were not incurred in the course of his income-producing activities and were instead incurred in putting him in a position to gain or produce assessable income. Following FCT v Payne, the government inserted s 25-100 into ITAA 1997, which provides taxpayers with a deduction for expenses incurred in travelling between two unrelated workplaces: see [13.110]. Therefore, travel expenses incurred in travelling between two unrelated workplaces will not be a general deduction (per FCT v Payne) but may be a specific deduction if the requirements of s 25-100 are satisfied.
Car expenses [12.450] Where the travel expenses relate to a car, special rules govern the amount of the car expenses that are deductible under s 8-1. Division 28 of ITAA 1997 sets out the rules for calculating the amount of a deduction for car expenses where a taxpayer owns or leases a car during the year and the car is used in the production of the taxpayer’s assessable income. It is important to note that Div 28 does not provide a specific deduction for car expenses. Rather, it provides two methods for determining the amount of the deduction under another section. Consequently, the deductibility of car expenses is generally determined under s 8-1, with the amount of the deduction determined by reference to Div 28.
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Example 12.13: Deductibility of car expenses Rebecca is a florist’s assistant. As part of her employment duties, she is required to deliver flowers to clients. Rebecca uses her own car for this purpose. The car was purchased with a bank loan of $50,000. Each month, Rebecca makes repayments of principal and payments of interest. The repayments of principal are not deductible under s 8-1 as they are capital expenses. The interest payments are deductible under s 8-1, but the amount of the deduction will depend on Rebecca’s choice of method for car expenses under Div 28. Source: Adapted from the Example in s 28-90(2) of ITAA 1997. It is also important to note that Div 28 only applies to individuals and partnerships that include at least one individual: s 28-10. The Division provides taxpayers with the following two methods for calculating car expense deductions: • “cents per kilometre” method: see [12.460]; or • “logbook” method: see [12.550].
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Taxpayers may choose which method to use in a particular income year, but the choice of one method precludes the use of the other method: s 28-20(1). However, taxpayers are entitled to change their choice of method for a particular income year: s 28-20(2). Further, taxpayers may use different methods for different cars in one income year and different methods for the same car in different income years: s 28-20(3). A taxpayer’s choice of method will depend on their individual circumstances as the two methods involve different substantiation requirements. Example 12.14: Choice of method Ivana claimed a deduction of $3,000 for car expenses using the “logbook” method. However, on audit, the Commissioner determines that her deduction should be reduced to $500. She would be entitled to a deduction of $1,000 under the “cents per kilometre” method. Ivana can change her choice and deduct $1,000. Source: Adapted from the Example in s 28-20(2) of ITAA 1997. Figure 12.3 provides an overview of the application of Div 28 on calculating deductions in relation to car expenses.
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Figure 12.3: Overview of the application of Div 28 of the ITAA 1997
“Cents per kilometre” method [12.460] Under the “cents per kilometre” method (s 28-25 of ITAA 1997), the deduction for car expenses is equal to:
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440 [12.470] PRINCIPLES OF TAXATION LAW 2020 Number of business kilometres the car travelled in the income year
×
Number of cents per kilometre
The number of business kilometres is the number of kilometres the car travelled in the course of the taxpayer’s production of assessable income or between workplaces. The taxpayer must calculate the number of business kilometres by making a reasonable estimate. The number of cents per kilometre is 68 for the 2019–2020 income year: Income Tax Assessment Act 1997 –Cents per Kilometre Deduction Rate for Car Expenses 2018. This rate applies to subsequent income years until the Commissioner varies the rate, as permitted by s 28-25(4). [12.470] Advantages. The advantage of the “cents per kilometre” method is that the taxpayer is not required to substantiate the car expenses: s 28-35 of ITAA 1997. [12.480] Limitations. The significant limitation of the “cents per kilometre” method is that it can only be used for the first 5,000 business kilometres travelled by the car. Any business travel in excess of 5,000 kilometres is disregarded in calculating the taxpayer’s deduction for car expenses under this method: s 28-25(2).
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Example 12.15: Cents per kilometre method Gregor and Barkly are partners in their own suburban medical practice. They sometimes make house calls to visit patients who are unable to visit the practice. They use their own cars when travelling to see patients. For the year ended 30 June 2020, Gregor travelled a total of 6,000 km to see patients and Barkly travelled 4,000 km. Using the “cents per kilometre” method, they would each claim a deduction for car expenses as follows: • Gregor: 5,000 × 0.68 = $3,400 (the excess 1,000 km is disregarded); • Barkly: 4,000 × 0.68 = $2,720.
“Logbook” method [12.550] Under the “logbook” method, the amount of the deduction for car expenses is calculated as follows under s 28-90 of ITAA 1997: Amount of each car expense × Business use percentage
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A “car expense” is defined in s 28-13 as a loss or outgoing to do with a car, including a loss or outgoing to do with operating a car and the decline in value of a car. Examples of car expenses include petrol costs, repairs, registration, insurance and depreciation or leasing costs. The business use percentage is calculated as follows: Number of business kms the car travelled in the period when n the taxpayer held the car × 100% Total number of kms travelled by the car in that period
The taxpayer is taken to hold the car while he or she owned or leased it and the car was used in gaining or producing assessable income, regardless of any other use of the car during the period: s 28-90(6). The number of business kilometres is the number of kilometres the car travelled in the course of the taxpayer’s production of assessable income or in travelling between workplaces: s 28-90(4). Although the number of business kilometres is calculated by making a reasonable estimate, the estimate must take into account all relevant matters, including (s 28-90(5)): • any logbooks, odometer records or other records maintained by the taxpayer; • any variations in the pattern of use of the car; and • any changes in the number of cars used by the taxpayer in the course of gaining or producing assessable income.
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Section 28- 90(2) makes it clear that the car expenses must qualify for a deduction under some other provision of the income tax legislation (eg, s 8-1) in order to be deductible. [12.560] Advantages. With the “logbook” method, the deduction for car expenses takes into account the taxpayer’s actual expenditure and the extent to which the car is used in gaining or producing assessable income. [12.570] Limitations. The “logbook” method is only available where the taxpayer “held” a car during the income year, that is, the taxpayer owned or leased a car that was used in gaining or producing the taxpayer’s assessable income. The taxpayer is required to substantiate all car expenses in accordance with the requirements in subdiv 900-C of ITAA 1997: see [12.320]. This generally requires the taxpayer to maintain written records of all expenses. In addition, the taxpayer must maintain a logbook. Subdivision 28-G explains how and how often the taxpayer needs to keep a logbook. Broadly, the taxpayer is required to maintain a logbook for a period of 12 continuous weeks. The taxpayer can choose the relevant period subject to certain legislative requirements, but must record the following information in the logbook:
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• • • •
when the logbook period begins and ends; the car’s odometer readings at the start and end of the period; the total number of kilometres the car travelled during the period; and the number of kilometres the car travelled, in the course of gaining or producing the taxpayer’s assessable income, on journeys recorded in the logbook. In order to record a journey undertaken by the taxpayer in gaining or producing his or her assessable income, the taxpayer must specify: • the day the journey began and the day it ended; • the car’s odometer readings at the start and end of the journey; • how many kilometres the car travelled on the journey; and • the reason for the journey.
Example 12.16: Logbook method Malik is a health and safety inspector for the local government. He is required to travel to at least three sites per day to conduct inspections. He leases a car for $2,000 per month. He has had the car for the whole income year. Malik has maintained written records of all expenses, and his car expenses for the year were: • Oil and fuel costs = $3,000; • Registration = $2,000;
• Insurance = $700.
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Malik maintained a logbook for a 12-week period and determined his business use percentage to be 95%. Under the “logbook” method, Malik’s deduction for car expenses would be: ($24,000 + $3,000 + $2,000 + $700) × 95% = $28,215
Note that the car expenses would be deductible under s 8-1 as they are incurred in gaining or producing assessable income and are not capital in nature.
Self-education expenses [12.580] Expenses incurred by a taxpayer on self- education are another example of a potentially quasi- personal expense. While the expense may relate to the taxpayer’s income-producing activities, they may also relate to
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the personal development of the taxpayer and thus be considered private or domestic. Self-education includes undertaking a course at an education institution, attending a work-related conference or seminar, completing a self- study course or going on a study tour in Australia or overseas. Examples of self-education expenses that may be deductible under s 8-1 include course fees, books, stationery and travel to attend conferences or seminars. Meals and accommodation expenses may be deductible where the taxpayer is away from home overnight. As with all other expenses, self-education expenses must satisfy the positive limbs of s 8-1 and not fall within any of the negative limbs of s 8-1 to be deductible.
Positive limbs of s 8-1 [12.590] Generally, self-education expenses will be sufficiently connected to the taxpayer’s production of assessable income where: • the education will improve the taxpayer’s prospects of promotion or earning a higher income in the taxpayer’s current career: FCT v Hatchett (1971) 2 ATR 557; FCT v Studdert (1991) 22 ATR 762; Ruling TR 98/9 (see [12.600]); or • the taxpayer works in an occupation which requires them to be constantly up to date: Ruling TR 98/9 (see [12.630]).
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However, this general rule has been called into question where the expenses relate to non-employment income: see [12.640].
Self-education expenses relate to taxpayer’s current career [12.600] Self-education expenses related to the taxpayer’s current career will be sufficiently connected to the production of the taxpayer’s assessable income where the expenses will improve the taxpayer’s prospects of promotion or earning a higher income in their existing career. Case study 12.29: Deductibility of self-education expenses In FCT v Hatchett (1971) 2 ATR 557, the taxpayer was a primary school teacher who incurred expenses in obtaining a Teacher’s Higher Certificate and in completing an Arts degree at university. The Teacher’s Higher Certificate would enable the taxpayer to be promoted and was required for certain teaching positions. The Arts degree, while recommended by the Education Department, would not lead directly to a promotion or higher income for the taxpayer in his current job.
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The High Court permitted the taxpayer a deduction for the expenses incurred in relation to the Teacher’s Higher Certificate as it had a sufficient nexus to his income-producing activities (ie, the positive limbs of the predecessor to s 8-1 were satisfied and the expenses did not fall within the negative limbs of the predecessor to s 8-1). However, the expenses in relation to the Arts degree were not deductible as the positive limbs of the predecessor to s 8-1 were not satisfied. There was an insufficient connection between the expenses and the taxpayer’s current income- producing activities.
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Case study 12.30: Deductibility of self-education expenses In FCT v Studdert (1991) 22 ATR 762, the taxpayer was a flight engineer who incurred expenses in undertaking flying lessons. The taxpayer argued that the expenses were deductible as the flying lessons would improve his skills as a flight engineer and lead to a promotion and higher income. The Commissioner argued that the flying lessons were not deductible as they related to a new career as a pilot and not the taxpayer’s current income-producing activities as a flight engineer. In the Federal Court, Hill J allowed the taxpayer a deduction for the flying lessons on the basis of the evidence presented that the flying lessons would improve the taxpayer’s skills as a flight engineer and lead to a promotion and higher income in his current career. As such, the expenses were sufficiently connected to the taxpayer’s current income-producing activities and satisfied the positive limbs of the predecessor to s 8-1. The expenses were not private or domestic in nature and did not satisfy any of the other negative limbs of the predecessor to s 8-1. The Court noted that self-education expenses relating to a new career are not deductible under the predecessor to s 8-1 as they are incurred in putting the taxpayer in a position to gain or produce assessable income. However, although the flying lessons may lead to the taxpayer obtaining a new career as a pilot, the expenses remained deductible as they were sufficiently connected to the taxpayer’s current income- producing activities as a flight engineer. The taxpayer’s ulterior purpose in incurring the expenses on flying lessons (to retrain as a pilot) was not considered relevant as it was a subsidiary purpose and there was sufficient connection to the production of the taxpayer’s current assessable income. As discussed at [12.310], a taxpayer’s purpose in incurring an expense is not generally relevant in determining its deductibility. As noted by the court in FCT v Studdert, self-education expenses relating to a new career are not deductible. In this situation, the expenses are not incurred in
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gaining or producing assessable income, but rather in putting the taxpayer in a position to gain or produce assessable income. Such expenses are considered to have been incurred too early and do not satisfy the positive limbs of s 8-1. Example 12.17: Self-education expenses relate to new career Jenna works as a receptionist at an accounting firm. Her employer encouraged her to study accounting and suggested that she would be able to get an accounting position with the firm at the end of her studies. Jenna undertakes a course in accounting while continuing to work as a receptionist at the firm. The cost of the accounting course is not deductible as it relates to a new career and is incurred at a point too soon to be regarded as incurred in gaining or producing Jenna’s assessable income. The positive limbs of s 8-1 are therefore not satisfied. [12.610] Establishing the nexus. Where self- education expenses directly relate to the taxpayer’s income-producing activities (eg, a particular skill or specific knowledge), the connection between the expenses and the taxpayer’s income-producing activities may be easy to identify. However, where the self- education expenses are general in nature, it will be necessary to examine the taxpayer’s particular circumstances to determine whether a sufficient connection exists.
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Example 12.18: Self-education expenses directly related to taxpayer’s income-producing activities Ricco is working as a trainee bookkeeper. He undertakes a course at a local educational institution related to bookkeeping. The course will improve his skills and knowledge and increase his income-producing prospects in his current career. The cost of the bookkeeping course will be deductible under s 8-1 as it is sufficiently connected to his income-producing activities and will increase his prospects in his current occupation. The positive limbs of s 8-1 are satisfied.
Example 12.19: Self-education expenses indirectly related to taxpayer’s income-producing activity Maxine is a journalist. Her employment duties include conducting interviews and making presentations. Maxine incurs expenses on a speech course to improve her ability to conduct interviews and make presentations.
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Although the speech course is not directly related to Maxine’s income- producing activities as a journalist, the course will improve her skills in her current occupation and are thus deductible under s 8-1. The positive limbs of s 8-1 are satisfied and the expenses are not considered private or domestic in nature so the negative limbs of s 8-1 are not met. Source: Adapted from Case Z42 (1992) 24 ATR 1183.
Example 12.20: Self-education expenses not related to taxpayer’s income-producing activity Hasmin is a company director. She is struggling to cope with work due to stress caused by a family situation. She attended a stress-management course after hours, which she paid for herself. The cost of the course is not deductible as it is not related to her income- producing activities or skills or knowledge and is private or domestic in nature. The positive limbs of s 8-1 are not satisfied and the expense falls within the scope of the second negative limb of s 8-1.
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Source: Adapted from the example in Ruling TR 98/9. [12.620] Travel expenses. The deductibility of travel expenses related to self- education is often a tricky issue, particularly where the travel has a recreational element. For the expenses to be deductible, it is necessary to show that the travel relates to the taxpayer’s income-producing activities and that the travel would increase the taxpayer’s income-producing prospects in their current career. The High Court in FCT v Finn (1961) 106 CLR 60 (see Case Study [12.31]) suggested that the following factors may be relevant in determining the deductibility of travel expenses related to self-education: • whether the employer supports the taxpayer’s travel (although this will depend on the exact circumstances of a particular situation); • whether the taxpayer is able to show clear evidence that the travel was devoted to the collation of information that is related to their income- producing activities; and • whether the application of such information to the taxpayer’s income- producing activities will improve their opportunities for promotion and/ or more income. Courts will look at these factors in determining whether self-education travel expenses are deductible, but, to be deductible, it is not necessarily the case that the expenses must satisfy each of these factors or that expenses that do satisfy all of these factors will automatically be deductible. The ultimate determination will depend on the taxpayer’s individual circumstances.
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Case study 12.31: Recreational travel expenses including a work purpose deductible
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In FCT v Finn (1961) 106 CLR 60, the taxpayer was an architect with the West Australian Government who had accumulated both annual and long service leave. The taxpayer planned to use the leave to travel to the UK and Europe to study current architectural trends. The taxpayer’s employer asked him to extend his trip to include South America and the employer agreed to cover the taxpayer’s costs of the additional travel. The taxpayer sought a deduction for his non-reimbursed travel expenses on the basis that all of his time while travelling was devoted to the study of architecture. The evidence showed, and the Commissioner accepted, that all of the taxpayer’s activities while overseas were devoted to the study of architecture. The Commissioner’s contention was that the expenses were not incurred in gaining or producing assessable income as it was not certain that the taxpayer’s improved knowledge would result in increased pay or chances of a promotion. The Full High Court permitted the taxpayer a deduction for the travel expenses on the basis of the factors discussed above: the employer had endorsed the taxpayer’s travel; the taxpayer had extensive evidence of the information collated while travelling and the fact that the information would improve the taxpayer’s income-producing capacity in his current career. As such, the expenses were incurred in gaining or producing assessable income and satisfied the positive limbs of the predecessor to s 8- 1.
Case study 12.32: Recreational travel expenses including a work purpose partially deductible In Peter Lenten v FCT (2008) 71 ATR 862, the taxpayer was a secondary school teacher who incurred expenses in travelling throughout Asia, the UK and Europe with his wife while on long service leave. The taxpayer described his trip as a “self-guided educational discovery tour” which consisted primarily of general package tours and self-guided expeditions to places of historical interest and significance. He did not attend any professional conferences or lectures or visit any educational institutions during the trip, but he did attend lectures at museums. The taxpayer claimed a portion of his travel expenses as a deduction on the basis that it was incurred in gaining or producing his assessable income. The taxpayer pointed to the fact that he had been promoted to head of faculty after the trip as evidence of the impact of the trip on his production of assessable income. While the trip was not a condition of the promotion, the taxpayer argued that it had certainly been a factor and
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that it was important for him to demonstrate initiative as he felt that his age may have hampered his chances of being promoted. Noting that the deductibility of travel expenses in these circumstances depends on the individual facts of the case, the AAT found that the taxpayer was entitled to a deduction for 75% of the travel expenses incurred. The remaining 25% was attributable to inevitable recreational portions of the trip and thus not deductible as a private or domestic expense under the second negative limb of s 8-1. In this case, the AAT was satisfied that the taxpayer’s dominant purpose in undertaking the overseas travel was to improve his knowledge and skill levels as a teacher, which would (and, in fact, did) enhance his promotional opportunities. As such, the expenses were sufficiently connected to the taxpayer’s income-producing activities and the positive limbs of s 8-1 were therefore satisfied.
Case study 12.33: Recreational travel expenses including a work purpose partially deductible In Carlos Sanchez v FCT (2008) 73 ATR 650, the taxpayer was a travel agent employed by STA Travel. The taxpayer undertook a number of overseas holidays while on annual leave and claimed a portion of the expenses incurred on the trips as a deduction.
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The taxpayer argued that it was necessary for him to travel as the motto of STA is “we know because we go”. The taxpayer also presented evidence showing the importance of travel by sales consultants to the STA business model and the taxpayer’s success as a travel consultant as a result of his trips. The AAT allowed the taxpayer a deduction for a portion of his overseas travel expenses. On the basis of the evidence presented, the AAT found that the trips were not just holidays and were clearly related to the taxpayer’s production of assessable income as a sales consultant employed to sell holiday- related travel products. In fact, there was evidence that his sales increased following the trips and therefore the positive limbs of s 8-1 were satisfied. The expenses were not considered private or domestic outgoings and therefore did not fall foul of the second negative limb of s 8-1. The AAT rejected the Commissioner’s argument that a sufficient nexus was not established because the taxpayer did not visit a single travel agency during his trips. The AAT concluded that this was not relevant as the taxpayer did not run a travel agency business and therefore it was unnecessary for him to see how they were run overseas.
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In order to claim a deduction for travel expenses related to self-education, taxpayers should maintain complete records of the trips (such as a travel diary detailing the taxpayer’s activities each day of the trip) which evidence a connection between the trips and the taxpayer’s income-producing activities. It is also important for a taxpayer to show that the trips have or could have increased the taxpayer’s assessable income or promotional opportunities in the taxpayer’s existing career.
Current career requires taxpayer to stay up to date [12.630] Self-education expenses will also be deductible where the taxpayer works in an occupation that requires the taxpayer to be constantly up to date, and the expenses are incurred for that purpose: Ruling TR 98/9. Example 12.21: Self-education expenses deductible Sarah is an accountant with a large accounting firm. Due to the nature of her work, Sarah is required to stay up to date with the latest changes in accounting standards. Sarah pays $700 a year to attend weekly update seminars held by a professional accounting organisation.
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The $700 paid by Sarah would be deductible self-education expenses under s 8-1 of ITAA 1997 as Sarah works in an occupation which requires her to stay up to date and, as such, the expenses are incurred in gaining or producing her assessable income.
Self-education expenses not related to employment income [12.640] The general rule that self-education expenses will only be sufficiently connected to the taxpayer’s production of assessable income where the expenses will increase the taxpayer’s prospects of promotion and/or earning a higher income in their current career, or the taxpayer is in a career which requires them to stay up to date, has been found not to apply where the self- education expenses do not relate to employment income: FCT v Anstis (2010) 76 ATR 735 (see Case Study [12.34]). Case study 12.34: Self-education expenses related to non-employment income In FCT v Anstis (2010) 76 ATR 735, the taxpayer was enrolled as a full-time student in a teaching degree at the Australian Catholic University. The taxpayer included in her assessable income wages earned as a part-time
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sales assistant in a clothing store and Youth Allowance of $3,622. The taxpayer claimed a deduction of $920 for self-education expenses related to her teaching degree, although she did not declare any income from teaching. The expenses primarily related to computer depreciation, textbooks and stationery.
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The taxpayer claimed a deduction for the expenses on the basis that a condition of receiving Youth Allowance is that the recipient must be enrolled in and make satisfactory progress in an acceptable course of study and the expenses were incurred by the taxpayer in meeting those requirements. The Commissioner denied the taxpayer’s deductions on the basis that self-education expenses are only deductible if they would lead to an increase in income from the taxpayer’s current income-producing activities. Here, the amount of Youth Allowance received by the taxpayer was constant. The taxpayer sought to distinguish existing case law on the basis that the cases related to the production of income through labour or employment, not from study. In the Federal Court, Ryan J held that the expenses were deductible as the expenditure was incurred because of the requirements of the Youth Allowance, which is assessable income. His Honour noted that the expenses were not incurred in putting the taxpayer in a position to receive Youth Allowance, but rather were incurred in satisfactorily completing her course of study. Therefore, they were incurred in gaining or producing assessable income. The fact that the amount of the Youth Allowance did not vary based upon the course of study or the expenses incurred by the taxpayer was held to be irrelevant. As in FCT v Studdert (1991) 22 ATR 762 (see Case Study [12.30]), the Court found that the taxpayer’s purpose in undertaking the course (to become a teacher) was irrelevant. The Full Federal Court rejected the Commissioner’s arguments that the primary judge had erred in his reasoning. As to the Commissioner’s argument that the self-education expenses were incurred “too soon”, the Full Federal Court held that that would be correct if the expenses were only referable to the production of income in future when the taxpayer was a teacher. However, that was not the case here as the expenses were referable to the production of Youth Allowance, which is assessable income. The Full High Court confirmed that Youth Allowance is assessable as ordinary income. The Court found that the taxpayer’s expenses were deductible against that income as they were “productive of the assessable income”. The taxpayer’s reasons or motives in incurring those expenses were found not to be relevant. The High Court also held that the expenses were not private or domestic in nature.
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The fact that the taxpayer may have been studying for reasons other than to maintain her entitlement to Youth Allowance did not sever the necessary connection between the expenses and her assessable Youth Allowance income. As discussed at [12.240], the Government has introduced s 26- 19 to deny a deduction for expenses related to rebatable benefits. Self-education expenses related to the production of Youth Allowance income (and similar Government payments) are therefore not deductible from 1 July 2011. However, the principle in FCT v Anstis is potentially relevant in determining the deductibility of self-education expenses related to the production of assessable study income received in a private context. The deductibility of such expenses will depend on the particular circumstances such as whether a condition of the receipt of such income is that the recipient must make satisfactory progress in their educational pursuits.
Negative limbs of s 8-1 [12.650] Self- education expenses that are sufficiently connected to the taxpayer’s production of assessable income may nonetheless not be deductible if any one of the negative limbs of s 8-1 is satisfied.
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Capital expenses [12.660] A self-education expense may not be deductible under s 8-1 if it is a capital expense: see [12.170]–[12.210]. Examples of self-education expenses that may be capital include the cost of personal computers, laptops, calculators, professional libraries, furniture such as desks and filing cabinets, technical instruments and equipment. These expenses result in the acquisition of assets which provide the taxpayer with a lasting benefit and are generally considered capital expenses. While such expenses may not be immediately deductible under s 8-1, they may be deductible over a period of years under the capital allowances regime: see Chapter 14. Note that the courts in FCT v Finn (1961) 106 CLR 60 and FCT v Hatchett (1971) 2 ATR 557 expressly rejected any argument that self-education expenses are generally capital in nature because the improvement to the taxpayer’s skills or knowledge provides an enduring benefit.
Private or domestic expenses [12.670] Self-education expenses will not be deductible where they are private or domestic in nature. For example, self-education travel expenses may relate
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452 [12.680] PRINCIPLES OF TAXATION LAW 2020 to a conference, but the taxpayer may also at the same time have a holiday or visit family, which are private pursuits. In this situation, the taxpayer may be entitled to a partial deduction for the self-education expenses. Apportionment of self-education expenses is discussed at [12.690].
Non-deductible self-education expenses [12.680] Any payments made under the government assistance schemes such as under the Higher Education Support Act 2003 (Cth) that are not deductible under s 26-20 (see [12.240]) remain non-deductible even where they qualify as self-education expenses. However, the prohibition on deductibility does not apply where the payments are incurred in the provision of a fringe benefit: s 26- 20(2) of ITAA 1997. As discussed at [12.240] and [12.640], expenses related to rebatable benefits are not deductible under s 26-19.
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Further, s 82A of ITAA 1936 prevents the first $250 of self-education expenses incurred by a taxpayer from being deductible. In this context, self-education expenses are defined as expenses necessarily incurred by the taxpayer for or in connection with a course of education provided by a school, college, university or other place of education and undertaken by the taxpayer for the purpose of gaining qualifications for use in the carrying on of a profession, business or trade or in the course of employment: s 82A(2). The section was introduced due to the availability of a tax offset for self-education expenses, which has since been abolished. Although s 82A continues to operate, the impact of the provision has been diminished by the fact that the $250 threshold may be applied to any non-deductible expenses incurred by the taxpayer which are necessarily incurred in relation to the education course: Ruling TR 98/9. In addition, taxpayers are not required to substantiate any self-education expenses disallowed under s 82A: Determination TD 93/97. Example 12.22: Application of s 82A to self-education expenses Sarah is tax consultant with a large accounting firm. She is currently enrolled in a Masters of Tax degree at the local university. Sarah paid $3,000 to enrol in a subject to complete her degree. The classes are held after hours. Sarah had to employ a babysitter so that she could attend the course, which cost her $100. The $3,000 course fees incurred by Sarah are deductible under s 8-1 of ITAA 1997 as they are sufficiently connected to her income-producing activities because Sarah works in an occupation which requires her to be up to date. However, the first $250 of self-education expenses would not be deductible under s 82A of ITAA 1936. However, Sarah can apply the $250 exemption towards her child care costs as the expenses are necessarily incurred by her to enable her to
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attend the course. It does not matter that child care expenses are a non- deductible expense (see [12.370]): Ruling TR 98/9. Therefore, Sarah can claim a deduction of $2,850 for self- education expenses under s 8-1. The $250 s 82A exemption is first applied towards her child care costs, thereby reducing the exemption amount to $150. The remaining $150 s 82A exemption is applied towards the course fees of $3,000.
Apportionment [12.690] As discussed at [12.270], dual purpose expenses are partially deductible under s 8-1. Where self-education expenses relate to both income- producing and private purposes, the taxpayer may be required to apportion the expenses and only a partial deduction will be allowed under s 8-1. In Ruling TR 98/9, the Commissioner suggests that, if the income-producing purpose is merely incidental to the main private purpose, only the expenses that relate directly to the income-producing purpose will be deductible. However, where the private purpose is merely incidental to the main income-producing purpose, apportionment is not required and the expenses will be fully deductible under s 8-1. Example 12.23: Apportionment not required for incidental private pursuits
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Roger, a dermatologist, attends an eight-day work-related conference in Aruba. One day of the conference involves sightseeing. As Roger’s main purpose in attending the conference was related to his income-producing activities, the total cost of the conference (airfares, accommodation and meals) will be deductible under s 8-1. The day of sightseeing is incidental to the main purpose and does not affect the characterisation of the self-education expenses. Source: Adapted from the Example in Ruling TR 98/9.
Example 12.24: Direct self-education expenses deductible where primary purpose is private Stacey, a lawyer, was holidaying in Cairns when she became aware of a work-related seminar on mediation. The cost of the seminar was $300. Stacey can claim a deduction for the cost of attending the seminar as a self- education expense. However, her airfare to Cairns and holiday
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accommodation are not deductible as her primary purpose in going to Cairns was private. Source: Adapted from the Example in Ruling TR 98/9.
Example 12.25: Apportionment of self-education expenses required where dual purpose Luthor, a scientist, has two equal purposes when he decides to attend a five-day international conference in France to be followed by a five-day holiday in London. Luthor is entitled to a deduction for the conference fees, meals and accommodation costs in France. He is required to apportion his airfare as he has two equal purposes in incurring the expense. Any expenses incurred in London are not deductible as they are private or domestic in nature. Source: Adapted from the Example in Ruling TR 98/9.
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In Determination TD 93/195, the Commissioner provides some guidance as to the deductibility of registration fees for continuing professional development seminars where the fee includes the cost of food and drink to be provided at the seminar. The deductibility of the registration fee will depend on whether the food and drink is considered “entertainment”. See [7.230] as to when food and drink will be considered “entertainment”.
Home office expenses [12.700] Generally, expenses incurred by a taxpayer in relation to his or her home are not deductible under s 8-1 of ITAA 1997 as they constitute private or domestic outgoings. However, such expenses may be deductible where the taxpayer uses a part of the home as an office in relation to the taxpayer’s income-producing activities. Expenses incurred by a taxpayer in running a home office generally fall into two categories: • running expenses, which relate to the use of facilities within the home and are affected by the use of the home for income-producing activities (eg, electricity, cleaning costs, depreciation); and • occupancy expenses, which relate to ownership or use of the home and are not affected by the taxpayer’s income-producing activities (eg, rent, interest on a mortgage, insurance, rates).
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The deductibility of expenses falling into each category depends on whether the taxpayer uses the home office as a genuine home office or as a matter of convenience only.
Genuine home office [12.710] Where the taxpayer’s home office is a genuine home office, that is, a part of the home is set aside for use in the taxpayer’s income-producing activities only, a portion of both running and occupancy expenses incurred by the taxpayer will be deductible under s 8-1 of ITAA 1997. In Ruling TR 93/30, the Commissioner suggests that the following factors will be relevant when determining whether the home office is a “genuine home office” or “place of business”: • the area is clearly identifiable as a place of business; • the area is not readily suitable or adaptable for use for private or domestic purposes in association with the home generally; • the area is used exclusively or almost exclusively for carrying on a business; or • the area is used regularly for visits from clients or customers.
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The absence of an alternative place for conducting income-producing activities may also be relevant in determining whether an area is a genuine home office. In Swinford v FCT (1984) 15 ATR 1154, the Court was influenced by this fact in concluding that a self-employed scriptwriter who used one room of a flat for writing purposes and for meeting with television station staff had a “place of business” at her home.
Example 12.26: Running and occupancy expenses deductible for genuine home office Lara has her own accounting practice, which she runs out of her own home. She has set aside one room in her house, which she uses exclusively as an office for her business. Lara’s use of one room in her house as an office is a genuine home office rather than being for convenience only. As such, Lara will be entitled to deduct a portion of her running and occupancy costs under s 8-1 of ITAA 1997 as the expenses are incurred in gaining or producing her assessable income. The expenses satisfy the positive limbs of s 8-1 and are not considered private or domestic outgoings and therefore do not satisfy any of the negative limbs of s 8-1.
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Home office for convenience only [12.720] Where the taxpayer uses an area of the home for income-producing activities but the area does not constitute a “genuine home office” or “place of business”, the home office is considered to be for the taxpayer’s convenience only. In such situations, the courts have suggested that some portion of the taxpayer’s running expenses will be deductible as they relate to the taxpayer’s production of assessable income, but any occupancy-related expenses will not be deductible as they remain a private or domestic expense: FCT v Faichney (1972) 3 ATR 435; Handley v FCT (1981) 11 ATR 644; FCT v Forsyth (1981) 11 ATR 657. Case study 12.35: No deduction for occupancy expenses related to home office used for convenience only In FCT v Faichney (1972) 3 ATR 435, the taxpayer was a scientist who used his study at home for work-related activities, such as reading, writing reports and so on. The High Court permitted the taxpayer a deduction for a portion of his running expenses, but not for any occupancy expenses, as the taxpayer used the study for work purposes as a matter of convenience only.
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Case study 12.36: No deduction for occupancy expenses related to home office used for convenience only In Handley v FCT (1981) 11 ATR 644, the taxpayer was a barrister who used his study at home for work-related activities. The Commissioner had allowed the taxpayer deductions for a portion of electricity and cleaning expenses, but not for a portion of the occupancy expenses (interest on a mortgage, rates and insurance premiums). The High Court agreed with the Commissioner and did not permit a deduction for the occupancy expenses as the taxpayer used his study for work purposes as a matter of convenience only. As stated by Murphy J (at 198): Acceptance of the taxpayer’s claim could lead to curious or even absurd results. Many lawyers, to the annoyance of their domestic partners, do a lot of legal reading in the bedroom. Also there is much scientific and anecdotal evidence in favour of the view that intellectual work goes on subconsciously as well as consciously, even during sleep. Perhaps the next claim would be for deducting part of the upkeep of the bedroom, or even a claim for part of the upkeep of the garden in which a barrister thinks about the conduct of cases whilst resting or strolling.
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In FCT v Forsyth (1981) 11 ATR 657, the High Court denied the taxpayer a deduction for rental payments on his home as the taxpayer, a barrister, used his home study for work purposes for convenience only. The key element in all three of these cases was that the taxpayers had an alternative workplace (ie, an office or barristers’ chambers) and the use of the home as an office was for convenience only.
Apportionment and capital expenses [12.730] The quantum of home office expenses that is deductible under s 8-1 will depend on the taxpayer’s individual circumstances. In Ruling TR 93/30, the Commissioner suggests that, in the case of occupancy expenses, it may be appropriate to apportion the expenses in accordance with floor area. The expenses may also need to be apportioned on a time basis where the taxpayer did not use the area as a home office for the entire year. In the case of running expenses, one possible method is to apportion the expenses based on hours of usage. Practice Statement PS LA 2001/6 provides guidance on calculating and substantiating home office running expenses.
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Home office expenses that are capital in nature (see [12.170]–[12.210]) will not be deductible under s 8-1, but the taxpayer may be entitled to deduct the expenses over a period of time: see Chapter 14. Examples of home office expenses which are capital in nature include furniture, such as a desk or filing cabinet, a home library, a computer or a printer.
Clothing and dry-cleaning expenses [12.740] The deductibility of expenses on clothing depends on the type of clothing worn by the taxpayer in relation to his or her income-producing activities: Ruling TR 97/ 12. The deductibility of dry- cleaning expenses is determined in accordance with the same tests as for the deductibility of clothing expenses.
Conventional clothing and related items [12.750] Conventional clothing refers to ordinary clothing that is not a uniform or specific to the taxpayer’s occupation. Such clothing can be worn in day-to- day living and is considered a natural part of living in society and is private or domestic in nature. As such, expenses incurred by a taxpayer on conventional
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458 [12.760] PRINCIPLES OF TAXATION LAW 2020 clothing are not deductible under s 8-1 of ITAA 1997 as they are not incurred in gaining or producing assessable income. The positive limbs of s 8-1 are not satisfied, and, further, the second negative limb will operate to deny a deduction as the expenses are private or domestic in nature. This would be the case even where the clothing is required by the taxpayer’s income-producing activities.
Case study 12.37: Expenses on conventional clothing not deductible
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In Case U80 (1987) 87 ATC 470, the taxpayer was a shop assistant at the retailer David Jones. She was required to wear “all black” clothing when performing her employment duties. The clothing was not distinctive or unusual and could be worn outside the taxpayer’s employment. The taxpayer tried to argue that the clothing was not suitable for private use as the colour did not suit her and she would not ordinarily wear black clothing. The AAT found that, as the garments were conventional attire, the clothing expenses were a private or domestic expense. As such, the expenses were not deductible due to the second negative limb of the predecessor to s 8- 1. A similar outcome was reached by the AAT in Westcott v FCT (1997) 37 ATR 1017, which denied the taxpayer, a manager and head waiter at a restaurant, a deduction for the cost of black trousers purchased in order to perform his employment duties. The taxpayer was required by his employer to wear black trousers and did not wear the black trousers on any other occasions apart from work. Nonetheless, the fact that the taxpayer could wear the black trousers outside of work meant that they were a private or domestic expense and not deductible due to the second negative limb of the predecessor to s 8-1. However, two main exceptions to the general rule regarding the non- deductibility of expenses on conventional clothing have developed from case law.
Abnormal expenditure on conventional clothing [12.760] In FCT v Edwards (1994) 28 ATR 87, the Full Federal Court permitted the taxpayer a deduction for expenses incurred on conventional clothing as the expenses incurred were clearly an abnormal cost unique to the taxpayer’s employment and the expenses were therefore incurred in gaining or producing assessable income, rather than being a private expense.
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Case study 12.38: Expenses on conventional clothing an abnormal cost In FCT v Edwards (1994) 28 ATR 87, the taxpayer was the personal secretary to the wife of the Governor of Queensland. As part of her job, the taxpayer incurred expenditure on formal daytime clothing and evening wear. The amount of the expenditure was fairly significant as the taxpayer was required to change outfits many times during the day for her job. She was also required to travel interstate where laundry facilities were not readily available, and the taxpayer was required to have a number of outfits so that she had immediately wearable fresh clothing. The taxpayer had previously been an executive secretary for a large international hotel chain where she was required to wear high-quality clothing but her wardrobe was not as extensive (and not required to be). The taxpayer sought a deduction for a portion of her clothing expenditure on the basis that the additional expenditure was clearly incurred in gaining or producing her assessable income. The additional expenditure was incurred in purchasing the additional outfits that the taxpayer required to fulfil her duties in her new role. During the period August to November 1990, the taxpayer purchased 51 new items of clothing. The taxpayer also argued that, as she was required to live in Government House and her employment was seven days a week, she had very little personal time and very seldom had the opportunity to wear her official wardrobe in her private time. The Commissioner denied the deductions on the basis that the expenditure related to conventional clothing and was therefore a private or domestic outgoing. The Full Federal Court permitted the taxpayer a deduction for the additional clothing expenses as it was clear that the taxpayer incurred an abnormal cost in relation to her clothing due to her job and that she would not otherwise wear such clothes, especially the formal evening wear. The Court referred to the AAT’s factual findings that while one set of clothes for the day may be attributable to her private purposes, the only explanation for the additional clothing was to satisfy her employment duties. Therefore, the expenses were incurred in the course of gaining or producing the taxpayer’s assessable income (satisfying the positive limbs of the predecessor to s 8-1) and were not a private or domestic expense (thereby not attracting the second negative limb of the predecessor to s 8-1). [12.770] Although expenses on conventional clothing may therefore be deductible under s 8-1 of ITAA 1997, it should be noted that FCT v Edwards (1994) 28 ATR 87 involved unique circumstances and taxpayers will need to be able to similarly demonstrate that their expenditure on conventional clothing is an abnormal cost that is related to their income-producing activities. The
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460 [12.780] PRINCIPLES OF TAXATION LAW 2020 Commissioner’s guidance as to when a taxpayer may be able to deduct abnormal expenditure incurred on conventional clothing is contained in Ruling TR 94/22. In that Ruling, the Commissioner suggests that a sufficient connection will not be established in most cases. For example, in Case M28 (1980) 80 ATC 187, the Board of Review did not permit the taxpayer a deduction for the dry-cleaning costs of suits. The taxpayer was a lecturer who argued that the dry-cleaning costs were an abnormal expense due to the taxpayer’s work environment of chalk dust. The Board of Review found that the expenses, while coming close to deductibility, were not sufficiently abnormal as chalk dust is readily brushed out of suits and would not require the suits to be dry-cleaned any more often than they would otherwise need.
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On the other hand, in Westcott v FCT (1997) 37 ATR 1017, where the taxpayer was a manager and head waiter at a restaurant and was denied a deduction for the cost of black trousers purchased in order to perform his employment duties, the taxpayer was permitted a deduction for his dry-cleaning costs as this was an “abnormal cost” related to his income-producing activities. As a result of his employment as a manager and head waiter of a restaurant, the taxpayer was required to handle food and wine, which frequently spilled on his clothing. The spills had to be removed by dry-cleaning and the clothes sometimes needed to be dry-cleaned as often as every second day. The AAT accepted that this was an abnormal cost which was caused by the taxpayer’s income-producing activities and therefore the dry-cleaning expenses were sufficiently connected to the production of the taxpayer’s assessable income (satisfying the positive limbs of the predecessor to s 8-1) and were not a private or domestic expense (thereby not attracting the second negative limb of the predecessor to s 8-1). In FCT v Edwards (1994) 28 ATR 87, it was accepted by the Commissioner and the taxpayer that, if the expenses were found to be deductible, only a portion of those expenses would be deductible. In other words, some portion of the taxpayer’s clothing expenditure would be attributable to private purposes, and therefore not deductible, while the portion that constituted the “additional expenditure” would be for income-producing purposes, and therefore deductible. As discussed at [12.270], there is no precise formula for apportionment which should be done on a case-by-case basis depending on the taxpayer’s particular circumstances. In FCT v Edwards, it was accepted that a comparison between the taxpayer’s current year expenditure and her average expenditure in the previous two years was an accurate basis for determining the proportion of the taxpayer’s expenditure that constituted “additional expenditure”.
Expenditure caused by taxpayer’s work conditions [12.780] Expenses incurred by a taxpayer on conventional clothing or related items may also be deductible where the need for the items is created by the
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taxpayer’s working conditions or environment: Mansfield v FCT (1995) 31 ATR 367; Morris v FCT (2002) 50 ATR 104; Ruling TR 2003/16. Case study 12.39: Expenses on conventional clothing deductible In Mansfield v FCT (1995) 31 ATR 367, the taxpayer was a flight attendant who incurred expenditure on stockings, shoes, moisturiser, cosmetics and hairdressing. The taxpayer argued that the expenses were incurred in gaining or producing assessable income since she was required to be well groomed as part of her job. Further, the taxpayer showed that her shoes were a half-size bigger than her ordinary shoes due to the swelling caused by cabin pressure and the moisturiser was required due to the dry cabin air. The Commissioner denied the taxpayer’s deductions on the basis that the expenses related to conventional clothing items, which could be used outside of work. The Federal Court permitted the taxpayer a deduction for the expenses relating to the shoes and moisturiser as the need for them was created by the taxpayer’s working conditions, that is, the cabin pressure and dry air of an aeroplane. The Court also permitted the taxpayer a deduction for the stockings on the basis that this was part of the taxpayer’s uniform. However, the Court did not permit the taxpayer a deduction for the cosmetics and hairdressing costs as this was considered to be a private expense as a result of the taxpayer’s personal choice and not due to the taxpayer’s working environment.
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Case study 12.40: Expenses on conventional clothing deductible Morris v FCT (2002) 50 ATR 104 involved 10 different taxpayers, all of whom worked in occupations which required them to work outdoors in the sun. The taxpayers incurred expenditure on sun protection items, such as sunscreen, hats and sunglasses. The taxpayers claimed a deduction for expenses relating to the sun- protection items on the basis that the expenses were incurred in gaining or producing assessable income. The Commissioner denied the deductions on the basis that the items were conventional and could be used outside work and that the costs of obtaining them were therefore private or domestic outgoings. The Federal Court allowed all of the taxpayers a deduction for the sun- protection items as the expenses clearly arose out of their working conditions (in the sun) and were therefore incurred in the course of gaining or producing the taxpayers’ assessable income. The Court rejected the Commissioner’s argument that, to be deductible, the expenses must
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relate to artificial work conditions. The expenses satisfied the first positive limb of s 8-1 and did not fall within the second negative limb of s 8-1 as they were not private or domestic expenses. In these situations, the expenses arise due to the taxpayer’s work conditions and are incurred in the course of gaining or producing the taxpayer’s assessable income. As such, the expenses are sufficiently connected to the taxpayer’s production of assessable income and satisfy the positive limbs of s 8-1. The expenses are not considered private or domestic in nature and the negative limbs of s 8-1 do not apply to deny a deduction.
Occupation-specific clothing, protective clothing and uniforms [12.790] Occupation-specific clothing and protective clothing are generally deductible under s 8-1 of ITAA 1997 as they are incurred in the course of gaining or producing assessable income and are not a private or domestic outgoing: Morris v FCT (2002) 50 ATR 104; Rulings TR 2003/16 and TR 97/12. There is sufficient connection to the taxpayer’s income-producing activities and the positive limbs of s 8-1 are satisfied. The expenses are not private or domestic and none of the negative limbs of s 8-1 apply to deny a deduction.
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Occupation- specific clothing identifies the wearer as a person associated with a particular profession, trade, vocation, occupation or calling: s 34-20(1). Examples of occupation-specific clothing include barrister’s robes, a white dress worn by nurses and black-and-white chequered trousers worn by chefs. Protective clothing will be sufficiently connected to the taxpayer’s production of assessable income where, for instance, there is a real risk of their being exposed to illness or injury in the course of carrying out their income-producing activities: s 34-20(2). Examples of protective clothing items include sun-and rain-protection items for taxpayers required to work outdoors (eg, sunglasses, hat, raincoat, umbrella), white coat and goggles for laboratory technicians or assistants, hard hat for construction workers, and gloves for mechanics or gardeners. Ruling TR 2003/16 contains further guidance as to when a deduction will be allowed for protective clothing. The deductibility of uniforms will depend on the taxpayer’s specific circumstances. As we have seen at [12.750], expenses on conventional clothing are generally not deductible even though the taxpayer may be required to wear specific items of clothing for work purposes. As stated by Hill J in Mansfield v FCT (1995) 31 ATR 367 at 375, “a uniform is not merely a set of clothes reserved for the occasion of work”. A uniform is usually sufficiently distinctive
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so that the casual observer can clearly identify the employee as working for the particular employer: s 34-15. Where the taxpayer is required to wear a uniform to perform their duties, the uniform will be deductible under s 8-1 as the expense is incurred in the course of gaining or producing the taxpayer’s assessable income and the positive limbs of s 8-1 are satisfied. The expenses are not considered a private or domestic outgoing and, as such, the negative limbs of s 8-1 do not operate to deny deductibility. Note that for the expenses to be deductible, the whole uniform must be worn: Ruling TR 97/12. Expenditure on non-compulsory uniforms is not deductible under s 8-1 unless the employer has registered the design of the uniform in accordance with the provisions of Div 34: s 34-10. However, this limitation does not apply to occupation-specific or protective clothing: s 34-10(3).
Capital expenses [12.800] Although certain clothing expenses may not be treated as a private or domestic outgoing, the expenses may still not be deductible under s 8-1 of ITAA 1997 if they are capital in nature: see [12.170]–[12.210]. For example, this would be the case where the clothing items are expected to last the taxpayer for a number of years. However, the taxpayer may be entitled to deduct the expense over a number of years under Div 40: see Chapter 14.
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Example 12.27: Clothing expenses that are capital in nature Chris is a barrister. He had to purchase a wig to wear when he appears in court. Chris does not go to court very often and looks after his wig very well. He expects that the wig will last him for at least five years. The wig is occupation-specific clothing and is therefore not a private or domestic expense. However, it is not deductible under s 8-1 of ITAA 1997 as Chris expects it to last for at least five years and therefore it is capital in nature. The cost of the wig may be deductible over a number of years, as discussed in Chapter 14.
Interest expenses [12.810] Interest expenses are one of the most common types of expenses incurred by taxpayers. Interest expenditure may be deductible under s 8-1 of ITAA 1997 where there is sufficient connection to the production of assessable
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464 [12.820] PRINCIPLES OF TAXATION LAW 2020 income and none of the negative limbs of s 8-1 are satisfied. “Interest” has been defined as “compensation paid by the borrower to the lender for deprivation of use of his money”: Riches v Westminster Bank Ltd [1947] 1 All ER 469 at 472. In essence, “interest” is the cost of borrowing money and can include interest on interest (ie, compound interest). As a general rule, the deductibility of interest expenses will depend on the taxpayer’s use of the borrowed funds: FCT v Munro (1926) 38 CLR 153. Where the taxpayer uses the borrowed funds to gain or produce assessable income (eg, by purchasing an income-producing asset or in a business), any interest arising in relation to the borrowing may be deductible under s 8-1. For example, interest incurred on a home loan may be deductible where the loan is used to purchase an investment property that produces rental income. On the other hand, the interest would not be deductible where the loan is used to purchase a property that is the taxpayer’s residence and is not used to produce any assessable income. As we have seen in Steele v DCT (1999) 41 ATR 139 (see Case Study [12.8]), interest expenses can be sufficiently connected to the production of assessable income even where the income is only gained or produced in a future income year. The Commissioner’s guidance on the deductibility of interest incurred prior to or after the production of assessable income is contained in Ruling TR 2004/4.
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The deductibility of “penalty interest payments” (ie, an amount payable by a borrower in consideration for the lender agreeing to an early repayment of a loan) will also depend on the taxpayer’s use of the borrowed funds (for gaining or producing assessable income or in a business carried on for that purpose) and whether the recurring interest liability on the terminated loan would have been deductible if incurred: see Taxation Ruling TR 2019/2.
Gearing [12.820] Gearing refers to the borrowing of money in order to invest, commonly in the property or share markets. Positive gearing refers to the situation where the income from the investment exceeds the costs, both interest and other deductions, of the investment. Negative gearing refers to the borrowing of money to make an investment where the interest on those borrowings, along with other deductions, exceeds the income from the investment. Provided the investments are genuine, the excess can then be claimed as a deduction against a taxpayer’s other income. Negative gearing is a strategy often used by high-income taxpayers to reduce their annual income tax payable –they hope that obtaining long-term capital gains will at least compensate for the annual loss from negative gearing.
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In relation to the general deductibility of interest under s 8-1 of ITAA 1997, the courts will consider whether an expense is appropriate and adapted towards the production of assessable income, rather than whether the expense is warranted from a commercial perspective. In other words, interest will be deductible if it satisfies one of the two positive limbs of s 8-1 regardless of whether the total deductible costs (including interest) exceed the assessable income from the investment. Example 12.28: Negative gearing and tax Natasha has been closely watching the property market over the last few months and she is of the view that it is likely to rise significantly over the next three years. Even though Natasha has a very secure and highly paid job, she does not have any spare cash, so she decides to borrow $200,000 to invest in a rental property. Natasha is able to borrow the money at a rate of 10% pa on an interest-only basis and purchases a suitable property. During the current tax period, Natasha incurred interest and other running costs of $25,000 but only received assessable income in the form of rent of $15,000.
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The interest and other running costs are incidental and relevant to the production of assessable income (rent) and therefore will be fully deductible under s 8-1 of ITAA 1997. The rental income of $15,000 is assessable under s 6-5, which results in a net tax loss of $10,000 from the investment. If Natasha is on the top marginal tax rate of 47% (including the Medicare levy of 2%), the $10,000 tax loss will reduce her total taxable income from her salary and save her $4,700 ($10,000 × 47%) in tax. However, the tax saving has not made this investment profitable; it has only reduced the loss from $10,000 to $5,300 ($10,000 –$4,700). To justify this investment, there would still need to be an expectation that either rents will rise and the investment will become positively geared or the after-tax capital gain on disposal of the property would be sufficient to cover the annual loss and warrant the risk associated with the investment.
Capital expenses [12.830] Although interest expenses are generally treated as revenue expenses, they may be considered a capital expense in certain circumstances. In St George Bank Ltd v FCT (2009) 73 ATR 148, the Full Federal Court held that interest expenses incurred by the taxpayer were capital in nature. The
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466 [12.840] PRINCIPLES OF TAXATION LAW 2020 case involved a complex financing arrangement which came about because the taxpayer was required by the Reserve Bank of Australia to increase its capital. The Court found that the arrangement related to the acquisition of permanent capital for the business and thus the interest expenses were for a structural advantage of a lasting character, which is a capital expense according to Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (see Case Study [12.10]). The taxpayer tried to argue that the interest expenses were a revenue expense because they were recurrent, but this argument was specifically rejected by the Court. The Court stated that the recurrence of a payment may be a relevant factor but is certainly not decisive. The High Court refused the taxpayer special leave to appeal from the decision of the Full Federal Court. Whether or not interest expenses are capital in nature will depend on whether the expenses relate to the taxpayer’s income- producing structure (capital) or their income- producing process (revenue): see [12.170]–[12.210].
Legal expenses [12.840] As discussed at [12.170]–[12.210], distinguishing between capital and revenue expenses is often a difficult issue in practice. Legal expenses are a prime example of the difficulty in characterising an expense as either capital or revenue.
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Case study 12.41: Legal expenses not capital in nature In Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, the taxpayer was a manufacturer of fridges which incurred legal expenses in successfully blocking a competitor’s application to extend a patent. Utilising the “enduring benefit” test discussed at [12.180], a majority of the High Court found that the expenses were deductible under the predecessor to s 8-1 of ITAA 1997 as they were not capital in nature. In reaching this conclusion, the majority found that the expenses were incidental to the taxpayer’s production of assessable income. This was because the legal expenses were incurred to protect the taxpayer’s existing rights (to manufacture its refrigerators in the way it wished) and did not result in the acquisition of any new rights or benefits. Dixon J (dissenting), who set out the test and factors in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337 (see Case Study [12.10]), concluded that the legal expenses were capital in nature as they related to the taxpayer’s income-producing structure and not to its income-producing processes. This opinion was referred to by the Court in Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 (see Case Study
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producing structure [12.42]). Following the importance of the income- versus the income-producing process distinction adopted in Broken Hill Theatres and subsequent cases, Hallstroms is now mainly relevant for Dixon J’s dissenting opinion.
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Case study 12.42: Legal expenses of a capital nature In Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, the taxpayer was the sole cinema operator in Broken Hill. The taxpayer incurred legal expenses in successfully blocking a competitor’s application to operate a cinema. Such applications were conducted annually and therefore the taxpayer argued that the expenses were not capital in nature as they did not provide the taxpayer with a lasting benefit. The taxpayer also argued that as it had already successfully blocked five such applications, the expenses were recurrent. The Full High Court (now under the leadership of Dixon CJ) found that the expenses were not deductible under the predecessor to s 8-1 of ITAA 1997 because the advantage of being free from competition, even if only for 12 months, was regarded as “just the very kind of thing which has been held in many cases to give to moneys expended in obtaining it the character of capital outlay” (at 434). The Court did not accept the argument that, where no new right or tangible asset was acquired by the expenditure, it must be on revenue account. In relation to the argument that the expenditure was recurrent, the Court stated that it was not recurrent in the relevant sense because it was made on a particular and isolated occasion and it could not be known for certain whether another application would be made by a competitor in future. The Court focused on the distinction between expenses related to the taxpayer’s income- producing structure (ie, the preservation and protection of that structure), as opposed to its income-producing activities or processes.
Case study 12.43: Legal expenses of a capital nature In John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30, the taxpayer, a newspaper publisher, acquired control of another newspaper company, Associated, through a share allotment. An existing shareholder of Associated brought an action in the Supreme Court of NSW arguing that the share allotment was improper and seeking a declaration that the issuance was void and the taxpayer should be removed from Associate’s share register. The taxpayer incurred legal expenses in relation to the court action (which was dismissed after several court hearings).
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The Full High Court rejected the taxpayer’s argument that the expenses were revenue in nature as they were incurred in protecting its existing rights and that no new rights or benefits were acquired. However, their Honours adopted different reasons in reaching their conclusion that the expenses were capital in nature. Dixon CJ, continuing his approach established in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337, found that the expenses related to the taxpayer’s income-producing structure and were thus capital expenses. Menzies J similarly held that the expenses “were affairs of capital, relating as they did to the profit making subject rather than its operation”. Fullager J, on the other hand, found that the expenses were capital in nature because they were part of the acquisition cost. Kitto J agreed with all three, while Taylor J concurred with Fullager and Menzies JJ.
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Case study 12.44: Legal expenses held to be revenue in nature In FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281, the taxpayer was a manufacturer of pesticides and fertilisers. The taxpayer had obtained a licence from a US company to sell particular products, incorporating specific technology, in Australia. The developer of the technology commenced an action against the US company which could potentially affect the taxpayer’s rights under the licensing agreement. The taxpayer incurred legal expenses in joining the defence of the US company. The Full Federal Court held that the legal expenses were not capital in nature. The taxpayer was already the possessor of a “profit- yielding subject” and the legal expenses were incurred to protect that source of income. The Court drew a distinction between this case and Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 (see Case Study [12.42]) and John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 (see Case Study [12.43]). The Court suggested that expenses to protect a business will be capital in nature where they are incurred on an isolated occasion for that purpose, while such expenditure incurred in the course of the prudent management of the business would be a revenue expense. Here, the taxpayer’s licensed technology could be threatened by a number of parties and the protection of the technology was a regular incident of the taxpayer’s business. Thus, the legal expenses were a revenue expense. [12.850] Following Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 (see Case Study [12.42]) and John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 (see Case Study [12.43]) and similar cases, it is generally accepted that legal expenses incurred to protect the taxpayer’s title in an asset or to protect its existing business structure will be classified as a capital expense.
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This will be the case even where the taxpayer has not acquired any new rights or benefits and is merely protecting its existing position. The key distinction is that expenses incurred to protect the taxpayer’s business structure will be capital, while expenses incurred to protect the taxpayer’s business processes will be revenue. FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281 (see Case Study [12.44]) suggests that legal expenses to protect the taxpayer’s business will be for the protection of the taxpayer’s income-producing processes (and therefore a revenue expense) where it is a regular incident of the taxpayer’s business. Where the legal expenses relate to defending charges and allegations made against a business taxpayer, Dixon CJ in FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431 (see Case Study [12.4]) suggested that the expenses would not be of a capital nature if the taxpayer’s business structure or capital assets were not imperilled or the investigating authority did not have the authority to put the taxpayer out of business. Where the investigations are conducted by an authority with the power to put the taxpayer out of business (eg, deregister a company), expenses incurred in defending the investigations may be capital in nature.
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Note that the success or failure of the legal proceedings has no impact on the deductibility of legal expenses related to those proceedings. Where the expenses are capital in nature, the taxpayer may be entitled to take the expense into account for tax purposes through the capital allowances provisions (see Chapter 14), the capital gains provisions (see Chapter 11) or the “black hole expenditure” provisions: see Chapter 14. Note that some legal expenses, such as costs related to obtaining tax advice, preparing leases and discharging mortgages, may be deductible under a specific deduction provision: see Chapter 13.
Questions [12.860] 12.1 Melissa is a mechanic. She runs her own business specialising in repairing electric cars. During the year, Melissa incurred the following expenses: a) salary costs to her two regular employees of $100,00 (paid electronically through the business’s payroll system which automatically applies the relevant tax withholding and pays the amount to the ATO); b) salary costs to casual employees of $10,000 (these employees are only required during busy periods and are paid in cash “of the books”);
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470 [12.860] PRINCIPLES OF TAXATION LAW 2020 c) salary costs of $2,000 to her brother who is a university student (paid electronically through the business’s payroll system; Melissa knows the amount is excessive, but she wants to support him in his studies); d) travel costs of $3,000 for travel from her home to her repair shop; e) $5,000 on special overalls and eye goggles for Melissa and her employees to use when they are repairing cars; f) childcare costs of $22,000 so that Melissa is able to go to work every day; g) $1,000 on a one-day course on a new accounting software program that Melissa wants to use in the business to better comply with new tax reporting requirements. Advise Melissa as to whether the above expenses would be deductible for income tax purposes. 12.2 Jurgen is a teacher at a German-language school in Australia. As part of a competitive process, he was selected to participate in a prestigious two-week education conference in Germany. His employer supported Jurgen’s participation by allowing him to travel to the conference without leave but did not pay for the travel expenses. Jurgen incurred expenses of $2,000 on a return plane ticket between Germany and Australia and $300 on travel insurance. His hotel costs during the conference were covered by the conference organiser, but Jurgen stayed an additional five days at the hotel so that he could do some sightseeing. The extra nights at the hotel cost him $1,000.
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Advise Jurgen as to whether the above expenses would be deductible for income tax purposes. 12.3 QI Pty Ltd is a job recruitment agency located in the Melbourne CBD. The company uses new technology invented by its parent company in the UK. QI recently incurred $200,000 of legal expenses in successfully preventing a rival UK company from using the same technology in Melbourne. The court order prevents the rival UK company from using the same technology in Melbourne for a period of five years. Advise QI as to the deductibility of the legal expenses. 12.4 Rumpole is a scientist. He uses his own car to travel to various locations to conduct experiments. He acquired the car on 1 October 2019 for $60,000. The acquisition cost was funded entirely by a loan at an interest rate of 15%. He has determined that the depreciation deduction on the car would be $2,300 for the year. In addition, Rumpole incurred the following expenses during the year: • Registration and insurance = $2,000; • Repairs and maintenance = $1,000; and • Oil and fuel costs = $1,500.
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For the period 1 October 2019 to 30 June 2020, Rumpole estimates that the car travelled a total of 15,000 kilometres, 12,000 of which were for business purposes. You may assume that Rumpole has maintained all necessary records and a logbook. Calculate Rumpole’s deduction for car expenses under the two methods in Div 28 of ITAA 1997. Assume that depreciation has been adjusted for part year use and the impact of the car limit. 12.5 Sarah is employed as a personal assistant to Martha Tallis, a successful freelance lifestyle consultant and motivational speaker. One day, Martha told Sarah to go to the library and borrow a book which Martha needed to prepare for a speech. Sarah borrowed the book and gave it to Martha. Four weeks later, Sarah received an email from the library advising her that the book was overdue. Sarah asked Martha for the book so that she could return it. Martha could not find the book. When Sarah told the library that the book was lost, the library demanded that she pay a $110 fine for the loss of the book. Advise Sarah as to the deductibility of the $110 fine payment. 12.6 Following on from 12.5, Sarah did not have $110 in cash in order to pay the library fine, so she charged the fine payment to her credit card, which incurred interest at a rate of 20% per annum. On that same day, Sarah also paid a $190 speeding fine with her credit card, which was the result of her speeding to get to work on time. Twelve months later, Sarah was able to pay off the total amount of $300 which she had charged to her credit card. By that time, she had paid an amount of $60 in interest.
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Advise Sarah as to the deductibility of the interest. 12.7 Following on from 12.5 and 12.6, Sarah felt extremely annoyed about the library fine and decided to talk to Martha about it. She told Martha that she thought that Martha should reimburse her for the cost of the library fine, since it was Martha who had lost the book. Martha replied that it was Sarah’s job as her personal assistant to make sure Martha didn’t lose any books, and so it was only right that Sarah should bear the cost. They argued for a long time. After the argument, Martha rang her lawyer and the lawyer advised her that she should reimburse Sarah for the library fine. The next day, Martha reimbursed Sarah $110. How does the reimbursement impact upon Sarah’s ability to claim a deduction for the fine payment? 12.8 Following on from 12.5 to 12.7, after Martha reimbursed Sarah the $110, she discovered that Sarah had sent out to all of Martha’s clients an email describing Martha as “a fraud and a bully”. Unfortunately, the email had been passed on to a popular gossip website and it was running as its lead story “Martha Tallis bullies PA”. Martha realised immediately that this could seriously impact upon her business. She
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472 [12.860] PRINCIPLES OF TAXATION LAW 2020 fired Sarah and called her lawyer again. Her lawyer agreed to begin preparing a defamation suit against Sarah and the gossip website. Three weeks later, Martha’s lawyer sent her a bill, which included: (a) a charge of $250 for the oral advice given over the phone in relation to whether Martha should reimburse Sarah for the library fine (described in Question 12.7); and (b) a charge of $10,000 for the lawyer’s work in preparing the defamation suit. Advise Martha as to the deductibility of the legal fees.
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12.9
Following on from 12.5 to 12.8, within six months, it was clear to Martha that her business had suffered greatly and her revenue had dropped by 50%. She was forced to give up her lease on an office in the city and work from home in her lounge room. She put her desk in one corner of the lounge room and worked there on her laptop, which she leased from Executive Rentals. Advise Martha as to the deductibility of the mortgage payments for her home, electricity costs for lighting and heating, and lease payments for the laptop. 12.10 Following on from 12.5 to 12.9, in order to rebuild her business, Martha decided to put together a DVD, which included the best parts of all her motivational speeches and a summary of her key philosophies as a lifestyle consultant. She sent the DVD to all her former clients, her few remaining current clients and to potential new clients. Martha spent $20,000 to make the DVD. Although it is a lot of money, she believes that it will be worth it in the long run. Advise Martha as to the deductibility of the DVD production costs. 12.11 Jake is an accountant who migrated to Australia three years ago. As part of establishing himself in Australia, he intends to invest in the property market. As Jake is not familiar with the Australian property market, he engaged the assistance of a property broker to assist with finding a suitable investment property. The broker charged an upfront fee of $5,000. Six months later, the broker located a vacant block of land and suggested that Jake develop three townhouses on it. The cost of the land ($1 million) and estimated development costs ($900,000) exceeded Jake’s budget, and he decided to undertake the venture with a business partner. The agreement with the business partner was that Jake would purchase the land and the partner would incur all development costs. The profits from the eventual sale of the townhouses, expected to be in 18 months, would be split equally between Jake and the partner. Jake established a $1 million line of credit facility with his bank which would enable him to access the required funds as necessary. The interest rate on the facility was 8.5% pa, and Jake provided the title to the land as security for the funds.
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Advise Jake as to the deductibility of the property broker’s fee and bank interest charges under s 8-1. 12.12 Following on from 12.11, shortly after the land was purchased, Jake’s business partner declared bankruptcy. Jake was unable to find another suitable business partner and subsequently sold the land at auction at a loss for $900,000. With sale proceeds being insufficient to discharge his borrowings, Jake continues to pay interest charges on the remaining $100,000 owed to the bank. Advise Jake as to the deductibility of the interest charges incurred after the land was sold. 12.13 Consider the facts from 12.11. Would your response to the deductibility of the bank interest charges change if Jake borrowed the money from the bank and provided the title to his residential home as security for the line of credit facility? Assume that the value of Jake’s residential home exceeds $1 million. 12.14 Following on from 12.11, would your response to the deductibility of the bank interest charges change if, instead of buying the block of land himself, Jake on-lent the funds to his sister at an interest rate of 3% and Jake’s sister purchased the block of land in her name?
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13 Specific deductions
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Key points.................................................................................................... [13.00] Introduction................................................................................................ [13.10] Tax-related expenses................................................................................. [13.20] Repairs ........................................................................................................ [13.30] Meaning of repair................................................................................. [13.33] Income-producing purpose................................................................. [13.35] Capital expenses.................................................................................. [13.37]
Initial repairs............................................................................................. [13.40] Improvements.......................................................................................... [13.50] Replacements........................................................................................... [13.60] Notional repairs not deductible............................................................... [13.70] Bad debts.................................................................................................... [13.80] Determining that a debt is “bad”......................................................... [13.83] Money-lending business...................................................................... [13.85] Corporate taxpayers............................................................................ [13.90] Payments to associations........................................................................ [13.100] Travel between workplaces..................................................................... [13.110] Gifts ���������������������������������������������������������������������������������������������������������� [13.130] Limitations on deductions for gifts or donations.............................. [13.140] Political contributions and gifts............................................................. [13.150] Deductibility of gifts or donations under s 8-1................................. [13.160] Prior year losses........................................................................................ [13.180] Corporate taxpayers.......................................................................... [13.190] Limitations on losses......................................................................... [13.200] Other specific deduction provisions....................................................... [13.210] Questions................................................................................................... [13.220]
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Key points
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[13.00] • In addition to the general deduction rule, discussed in Chapter 12, taxpayers may claim a deduction for various expenses under a specific deduction provision. • A specific deduction provision provides taxpayers with a deduction for a specific type of expense. • Where a taxpayer is entitled to deduct an expense under both the general deduction provision (s 8-1 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997)) and a specific deduction provision, the taxpayer should deduct the expense under the specific deduction provision as it is the most appropriate provision. • Most specific deduction provisions are contained in Div 25 of ITAA 1997, but a number of specific deduction provisions are contained in other Divisions of the legislation, such as Div 30 and Div 36. • Examples of expenses which may be deducted under a specific deduction provision include: – the cost of managing one’s tax affairs; – non- capital expenses incurred in repairing property used for income-producing purposes; – bad debt write-offs where certain conditions are satisfied; – payments for membership of a trade, business or professional association; – expenditure incurred by a taxpayer in travelling directly between two workplaces; – gifts or donations to qualifying recipients; and – tax losses incurred in prior income years.
Introduction [13.10] As discussed in Chapter 12, there are two categories of deductions: general deductions and specific deductions. The general deduction rule is in s 8-1 of ITAA 1997. Specific deductions arise where a specific provision in the legislation, outside Div 8, provides the taxpayer with a deduction for an expense: s 8-5. A specific deduction provision may relate to an expense that is otherwise deductible under s 8-1 or it may apply to an expense that is not deductible under s 8-1 either because it does not satisfy the positive limbs of s 8-1 or because it is denied by one of the negative limbs of s 8-1. An expense that is deductible under both a specific deduction provision and the general deduction provision should be deducted under the “most appropriate” provision: s 8-10.
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As a general rule of statutory construction, the specific deduction provision would usually be the most appropriate provision. Where an expense is not deductible under a specific deduction provision, because either the expense does not satisfy the requirements of the specific deduction provision or there is no applicable specific deduction provision, the taxpayer should consider the deductibility of the expense under the general deduction rule in s 8-1. Section 12-5 lists the specific deduction provisions in the income tax legislation. Most specific deduction provisions are contained in Div 25, but a number of specific deduction provisions are contained in other Divisions of the legislation. Only some of the more common specific deduction provisions are discussed in this chapter. Figure 13.1: Overall guide
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Tax-related expenses [13.20] Section 25-5 of ITAA 1997 provides taxpayers with a deduction for any expenditure incurred in managing their “tax affairs”. The definitions of “tax affairs” and “tax” in s 995-1 limit the deduction to expenses incurred in relation to the taxpayer’s income tax obligations. While business taxpayers may be able to deduct such expenses under s 8-1, non-business taxpayers are unlikely to be able to deduct the expenses under s 8-1 as they would be classified as private or domestic expenses. Expenses relating to compliance with other taxes, such as fringe benefits tax (FBT) and goods and services tax (GST), are not deductible under s 25-5 but are likely to be deductible under s 8-1 as the expenses incurred in fulfilling the taxpayer’s obligations in relation to those taxes would generally be incurred in the carrying on of a business. The section also provides taxpayers with a deduction for any expenses incurred in complying with an obligation imposed on the taxpayer by a Commonwealth law, where the obligation relates to the taxpayer’s tax affairs, the general interest charge (eg, on underpayment or late payment of tax), a penalty payable because the taxpayer’s varied GST instalments are too low and certain valuation expenses (eg, in relation to a gift of property).
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478 [13.30] PRINCIPLES OF TAXATION LAW 2020 The payment of income tax, amounts withheld or payable under the Pay As You Go (PAYG) system, interest incurred in borrowing money to pay income tax or PAYG amounts and expenditure related to the commission or possible commission of an offence under Australian or foreign law are not deductible under s 25-5: s 25-5(2). Note that fees or commissions paid in obtaining advice in relation to the operation of a Commonwealth law relating to taxation are only deductible when the advice is provided by a “recognised tax adviser”: s 25-5(2) (e). “Recognised tax adviser” is defined in s 995-1 as a registered tax or GST agent or a legal practitioner. Any expenses that are not deductible under s 8-1 due to the operation of a specific provision that denies the deduction are also not deductible under s 25-5: s 25-5(3). Tax- related expenses are also not deductible if the expenses are capital expenditure: s 25-5(4). For example, the cost of acquiring a computer used solely in completing tax returns is not deductible under s 25-5 as it is capital expenditure. However, the cost of the computer may be deducted over a number of years in accordance with the capital allowances provisions discussed in Chapter 14. As we will see, the capital allowances provisions only provide a deduction for property used for an income-producing purpose. The use of property in complying with tax affairs is taken to be for income-producing purposes under s 25-5(5). Note that the subsection specifies that an expense will not be a capital expense simply because the tax affairs concerned relate to matters of a capital nature.
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Example 13.1: Cost of managing tax affairs Robin uses a tax agent to complete his income tax return every year. This year, Robin paid his tax agent $110 to complete his tax return. He also paid his tax agent $300 for advice in relation to the disposal of property which was subject to the capital gains provisions. Robin is entitled to a deduction of $410 under s 25-5 as the fees are a cost of managing his tax affairs. The $300 is deductible even though the advice relates to a capital transaction. In Determination TD 2017/ 8, the Commissioner confirms that the cost of travelling to have a tax return prepared by a “recognised tax adviser” is deductible under s 25-5.
Repairs [13.30] Under s 25-10 of ITAA 1997, taxpayers are permitted a deduction for expenditure incurred on repairs to premises or depreciating assets used for
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income-producing purposes. The term “property” is used in this chapter to refer to both premises and depreciating assets. There is some question as to the necessity for s 25-10 as a specific deduction provision as any expenses that are deductible under this section are likely to be deductible under s 8-1. Regardless, if applicable, repairs should be deducted under s 25-10, rather than s 8-1, as it is the most appropriate provision: s 8-10. To claim a deduction for repairs under s 25-10(1), it is necessary to show that: • the expenditure relates to a repair; • the property is used for income-producing purposes; and • the expense is not a capital expense.
Meaning of repair [13.33] The word “repair” is not defined in the income tax legislation and takes on its ordinary meaning. “Repair” generally refers to the remedying of a defect in a property. In Lurcott v Wakely and Wheeler [1911] 1 KB 905, Buckley LJ provided the following examples of “repair”:
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A skylight leaks; repair is effected by hacking out the putties, putting in new ones, and renewing the paint. A roof falls out of repair; the necessary work is to replace the decayed timbers by sound wood; to substitute sound tiles or slates for those which are cracked, broken, or missing; to make good the flashings, and the like. Part of a garden wall tumbles down; repair is effected by building it up again with new mortar, and, so far as necessary, new bricks or stone.
The property must be in need of restoration for the work to constitute a “repair” (Case J47 (1958) 9 TBRD 244) and pure maintenance work will generally not be considered a repair. For example, painting a wall which has deteriorated would be considered a repair, whereas oiling a part which is in perfect working condition would constitute maintenance, and not a repair. Expenses for maintenance work which are not deductible under s 25-10 of ITAA 1997 may be deductible under the general deduction provision, s 8-1. Example 13.2: Expenses not for repairs A shopkeeper, Sam, decides to replace his shop’s awning with a more modern and aesthetically pleasing equivalent. The old awning is in good condition before the work is done –there is nothing to be restored, there are no decayed or worn-out parts to be replaced and nothing loose or detached that needs to be fixed.
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The expenditure involved is not for repairs because the awning was in good repair before the work was done, so the expenses are not deductible under s 25-10. Source: Adapted from Example 1, Ruling TR 97/23. In Ruling TR 97/23, the Commissioner suggests that work done solely to meet the requirements of regulatory bodies will not be a repair unless the work remedies defects in the property. For example, the cost of removing asbestos insulation from factory walls and replacing it with modern insulation material would not be considered a repair if the insulation is not in need of repair.
Income-producing purpose [13.35] The property must be used for an income-producing purpose for repairs to be deductible under s 25-10 of ITAA 1997. Examples of the use of property for income-producing purposes include property used to earn rental income or to carry on a business.
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Section 25-10(2) ensures that a partial deduction is available, where the taxpayer only partly held or used the property for income- producing purposes during the income year. In this case, the taxpayer is entitled to a deduction for the amount of the expense that is considered “reasonable”. In Ruling TR 97/23, the Commissioner suggests that “reasonable” would be in proportion to the part of the property or period used for income-producing purposes.
Example 13.3: Repairs on premises partly used for income-producing purposes Emma owns a two-bedroom house. She lives in one bedroom and she rents out the other bedroom. Emma incurred $100 of expenses on repairs to the house. Emma is entitled to a deduction of $50 under s 25-10(2) as 50% of the house is used for income-producing purposes. Where the repairs are undertaken after the property ceases to be held, occupied or used for income- producing purposes, the cost of the repairs will be deductible if the necessity for the repairs can be related to the use of the property for income-producing purposes and the property did produce assessable income during the year when the expenses were incurred: Ruling IT 180.
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Capital expenses [13.37] Once it is determined that the property is used for income-producing purposes, the main issue in claiming a deduction for repairs is to determine whether the expenditure constitutes a capital expense. As with s 8-1 of ITAA 1997, s 25-10(3) denies taxpayers a deduction for repairs that constitute capital expenditure. Whether or not a repair constitutes a capital expense is determined in accordance with the test and factors outlined in Sun Newspapers Ltd and Associated Newspapers Ltd v FCT (1938) 61 CLR 337: see [12.180]. A repair that relates to the business structure is likely to constitute a capital expense, whereas a repair that is a working or operating expense will be deductible under s 25-10. Broadly, case law has developed three categories of expenditure on repairs which may be classified as capital expenditure: • initial repairs: see [13.40]; • improvements: see [13.50]; and • replacements: see [13.60].
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Initial repairs [13.40] Initial repairs are repairs undertaken to remedy defects which exist at the time the property is acquired. The courts have held that such repairs are not deductible as they are capital expenses: Law Shipping Co Ltd v Inland Revenue Commissioners (1923) 12 TC 621; W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. It is considered likely that the taxpayer would have received a reduction in the purchase price of the property to take into account the cost of the repairs and it is therefore appropriate to treat the expenditure as a part of the cost of acquisition. However, even where the taxpayer may not have been aware of the defects at the time of acquisition, initial repairs are still not deductible: W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. Note that the test is that the defects must have existed at acquisition time and not that the repairs have to be undertaken at that time. Repairs undertaken at a later point in time may still be treated as initial repairs if the defects existed at the time of acquisition. Similarly, repairs made soon after the property is acquired may not necessarily be initial repairs and it would depend on whether the defects existed at the time of the acquisition. Example 13.4: Initial repairs –possible partial deduction Micah purchased a house close to the local university with the intention of renting the house out to students. At the time of the acquisition, the
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house desperately required repainting but Micah did not have sufficient money to do so. He managed to rent it out to some students for a year at lower rent and then repainted the house once they left, 12 months later. The repainting cost Micah $2,000. The $2,000 would generally be deductible under s 25-10 as it relates to the repair of premises used for an income-producing purpose (to gain or produce rental income). However, in this case, the $2,000 may not be fully deductible under s 25-10 as the repainting is to remedy a defect which existed at the time of acquisition and is therefore an “initial repair” which constitutes a capital expense. Micah may be able to claim a deduction for some portion of the $2,000 if it could be argued that the expense is attributable to the one year when the house was rented out to the students.
Example 13.5: Initial repairs capital in nature and not deductible
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William purchased a house that was in good repair, but to make it more attractive to prospective tenants he undertook minor repairs and renovations. The minor repairs and renovations were initial repairs and their cost is of a capital nature and is not deductible under s 25-10. During the course of the repairs and renovations, William discovered that the woodwork was seriously affected by white ants. He incurred substantial expenditure to remedy the white-ant-related problems in order to restore the house to a state suitable for occupation by tenants. The white-ant-related problems existed at the date of purchase and the expenditure incurred to fix those problems constitutes initial repairs which are capital in nature and not deductible under s 25-10. The facts that William was unaware of the problem when he purchased the house and would have paid a lower purchase price if he had known of the need for repairs do not alter the capital nature of the expense: Case 64 (1944) 11 TBRD (OS) 202; W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. Source: Adapted from Example 13, Ruling TR 97/23.
Improvements [13.50] As stated by Windeyer J in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58 at 72, “repair involves restoration of a thing to a condition it formerly had without changing its character”. In some cases, the work done to property may surpass being a repair and constitute an improvement, in which case the expenditure will be capital in nature. Generally, repairs remedy a defect due to
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wear and tear, whereas an improvement enhances the efficiency or character of the property. Distinguishing between a repair and an improvement is a question of fact and will depend on the exact work done. A repair may constitute an improvement if the materials used to repair the property are different to the original materials or where the work done to the property involves technological advancements. Generally, a repair should only restore the property to its previous condition (ie, before wear and tear due to the taxpayer’s income-producing activities, which will generally be its condition when acquired by the taxpayer) and not change the character or efficiency of the property. Case study 13.1: Improvements not deductible due to change of character of property
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In FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102, the taxpayer wanted to repair a damaged ceiling at its cinema but the existing materials were no longer available and therefore the taxpayer “repaired” the ceiling with newer, better material. The new material, fibrous plaster, had a much longer life than the old material, was harder and was also better decorative material as it could be moulded. The High Court denied the taxpayer a deduction for the cost of repairing the ceiling with the new material on the basis that the use of the new material was an improvement and the purported repair changed the character of the property and did not merely restore it to its previous condition. This is despite the fact that the existing material was no longer available and the taxpayer did not have a choice in using the new material. The Court stated that the test was whether the actual expenditure incurred by the taxpayer constituted a repair.
Example 13.6: Repair constitutes improvement –not deductible Elle uses her truck for income-producing purposes. She replaces the truck’s worn- out petrol engine with a diesel engine, which improves the economy of operation of the truck. Due to the significantly greater efficiency in the truck’s function, the costs relate to improvement of the truck and not just a repair. The engine, being a major and important part of the truck, is a new and better engine with considerable advantages over the old one, including reducing the likelihood of future repair bills. The costs are capital in nature and are not deductible under s 25-10. Source: Adapted from Example 3, Ruling TR 97/23. See also Case 82 (1953) 3 CTBR (NS).
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Example 13.7: Repair not an improvement –deductible Mary owns a factory and she needs to repair its floor, which is made of bitumen laid on a gravel base. She replaces it with a new floor consisting of an underlay of concrete topped with a paving stone made of crushed granite and cement. The new floor, from a functional efficiency (rather than aesthetic) point of view, is not superior in quality to the old floor and it performs exactly the same function as the old floor. In fact, the new floor will be more expensive to repair than the old floor. Because the new floor is not a substantial improvement, it is a repair and its cost is deductible under s 25-10. Source: Adapted from Example 8, Ruling TR 97/23. See also Case T75 (1968) 18 TBRD 377; Case 40 (1968) 14 CTBR (NS). Where repairs and improvements are done concurrently, the taxpayer may be entitled to a deduction for the expenses which constitute a repair if the expenses can be separately identified and quantified. Example 13.8: Repairs and improvements done concurrently –partial deduction
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Tracy owns a factory, for which the council has advised her to repair faulty wiring, reposition existing electrical outlets and install new power points, mains and switchboards. The cost of the work relating to repairing the faulty wiring only is deductible under s 25-10 provided Tracy can separate the costs of repairing the wiring from the (capital) costs of the electrical improvements. Tracy should seek separate quotes and maintain separate accounts in relation to the costs of repairing the wiring and the cost of the electrical improvements. Source: Adapted from Example 12, Ruling TR 97/23.
Replacements [13.60] Finally, where the repair to property involves a replacement, it is necessary to ascertain whether the replacement is of part of an asset (which is a repair and therefore deductible) or the whole of an asset (which is a replacement and therefore capital): Lindsay v FCT (1960) 106 CLR 377. Distinguishing between replacements of a part of an asset, as opposed to the whole of an asset, can be a difficult issue and depends on the individual facts of a case. Essentially, an asset will be an asset in itself, where it is separately identifiable from the entire asset and is capable of independent use.
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For example, in Samuel Jones & Co (Devondale) Ltd v IRC (1951) 32 TC 513, the Court accepted that the replacement of a chimney in need of repair with a new chimney of similar dimensions and quality was a repair and not a replacement as the chimney was an inseparable part of the entire asset, being the factory. In FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102, although the taxpayer changed the entire roof of the cinema, the replacement of the roof was the replacement of part of an asset only and not the whole of the asset, being the cinema. The roof was not a separately identifiable asset in itself and had no independent use. Similarly, in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58, a building was held to be the entire asset with the floor and walls being parts of the asset. Example 13.9: Replacement of part of asset –deductible Micah owns an investment property which is rented out to students. He recently had an electrician attend the premises to fix the air conditioner in the property as the tenants complained that it was leaking. The electrician changed the compressor in the air conditioning unit, which solved the problem. The changing of the compressor is a repair as the compressor is part of the asset (the air conditioner) and does not have any independent use. As such, the costs incurred in changing the compressor are deductible under s 25-10 of ITAA 1997 as a repair.
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On the other hand, if the electrician had changed the air conditioning unit, installing a new, identical unit, that would have been the replacement of an entire asset and the costs incurred would not be deductible under s 25-10, as they would be a capital expense.
Example 13.10: Replacement of part of an asset and whole asset – partial deduction Stuart and Jeff are neighbouring farmers affected by a severe bushfire. Stuart restores his existing fencing to good condition by mending it and replacing damaged sections, for example, the fence on the northern boundary. Jeff replaces the entire fence surrounding his property. Stuart is entitled to claim a deduction for the cost of repairing his fence under s 25-10. The entirety is the total fencing, so replacing the fences on the northern boundary is a replacement of a subsidiary part of the whole fencing. However, Jeff’s expenditure is not deductible under s 25-10 because the whole fence was replaced, making it a reconstruction of the entirety. The total fence is not a subsidiary part of the rural property or of anything else.
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To replace entire fencing with new fencing is to replace one capital asset with another capital asset. The cost is therefore of a capital nature. Source: Adapted from Example 4, Ruling TR 97/23. See also Case 58 (1962) 10 CTBR (NS); Case 44 (1963) 11 CTBR (NS).
Example 13.11: Replacement of separately identifiable asset not deductible Mr Bowser owns a service station that is not connected to the mains power supply. He has meters and a pumping plant to supply power to the service station, both of which he needs to replace due to old age. The meters and the pumping plant are entireties in their own right, separate and distinct from the service station. Their replacement is not a repair and the cost is not deductible under s 25-10. Source: Adapted from Example 6, Ruling TR 97/23. See also Case 36 (1949) 15 TBRD (OS) 287. Expenditure incurred in repairing an asset which is not deductible because it constitutes the replacement of the entire asset may be deductible under the capital allowances provisions if the asset is a depreciating asset (see Chapter 14) or it may be added to cost base if the asset is a CGT asset (see Chapter 11).
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Notional repairs not deductible [13.70] Consistent with the provisions of the tax legislation generally, taxpayers are only entitled to a deduction under s 25- 10 for the actual expenditure incurred by the taxpayer on repairs and not some notional (ie, theoretical or estimated) amount. For example, where the taxpayer’s expenditure on repairs is not deductible because the expenditure is capital in nature, the taxpayer is not entitled to claim a deduction for “notional repairs”: FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102. “Notional repairs” refers to the cost that would have been incurred by a taxpayer had he or she merely repaired the property, rather than improved it or replaced the entirety. The taxpayer also cannot argue that expenses should be deductible as the improvement or replacement would save on future expenditure for repairs which would be deductible. Case study 13.2: Notional repairs not deductible As discussed in Case Study [13.1], the High Court in FCT v Western Suburbs denied the taxpayer a deduction for expenditure on repairs to a ceiling on the basis that the repairs undertaken constituted an improvement due to
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the use of new material. In the alternative, the taxpayer sought to claim a deduction for £603, being the architect’s estimate of the cost that would have been incurred by the taxpayer had the ceiling been repaired using the old material instead of the new material. The Court denied the taxpayer a deduction for the £603 as well on the basis that the deduction was for “notional repairs” and there was no basis in law for a deduction for repairs that could have been undertaken by the taxpayer. Again, the test of deductibility depends on the actual cost incurred by the taxpayer.
Example 13.12: Notional repairs not deductible Ken runs a factory in a building, where the wooden floor needs repairing. He has two options. He can either repair the old floor or replace it with an entirely new one made of steel and concrete. Ken chooses the second option because it will save on future expenditure on repairs and because it has distinct advantages over the old wooden floor. Ken cannot claim a deduction for the costs incurred in replacing the floor or the costs he would have incurred if he had simply repaired the wooden floor. The replacement of the floor with the new material constitutes an improvement and his actual expenditure is capital, so none of it is deductible as a repair under s 25-10.
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Source: Adapted from Example 7, Ruling TR 97/23.
Bad debts [13.80] Taxpayers who account for their income on an accruals basis rather than on a cash basis (see Chapter 16) include their business income in their assessable income at the time it is derived, rather than when it is received. However, in some cases, the taxpayer may find that it is unable to recover moneys owed and has a bad debt. In this situation, s 25-35(1)(a) of ITAA 1997 provides taxpayers with a deduction for the write-off of a bad debt, where the debt was previously included in the taxpayer’s assessable income. Where the taxpayer is carrying on a money-lending business, s 25-35(1)(b) provides the taxpayer with a deduction for the write-off of a bad debt. In order for a taxpayer to claim a deduction under s 25-35, it is important that in the income year when the taxpayer claims the deduction: • there is an existing debt (ie, the taxpayer is legally or equitably entitled to receive an amount from another entity);
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488 [13.83] PRINCIPLES OF TAXATION LAW 2020 • the debt is bad; and • the debt was actually written off –merely creating a provision for bad debts will not constitute a write-off; there must be some written record, for example, board minutes, memo from financial controller or accounting entries, to evidence the taxpayer’s decision to write off the debt. The taxpayer will not be entitled to a deduction for a bad debt under s 25-35, where all of these elements are not satisfied: Point v FCT (1970) 119 CLR 453. Case study 13.3: Bad debt deductions denied –write-off in wrong year In Point v FCT (1970) 119 CLR 453, the taxpayer entered into an agreement to release a debtor from its obligations to the taxpayer in one income year and the debt was written-off in the taxpayer’s accounts in the following income year. The High Court found that the taxpayer was not entitled to a bad debt deduction under the former equivalent provision of s 25- 35 in either income year. In the first year, the taxpayer was not entitled to a deduction as the debt had not actually been written-off, while a deduction was not available in the following year, as there was no debt in existence at that time. This was because the debtor had been released from its obligations in the previous income year.
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Example 13.13: Bad debt deductions Company R sells goods on credit. It includes the amount of a sale in its assessable income at the time of sale. As of 30 June, Company R had $10,000 in debts relating to past sales. The company created a provision for bad debts of $2,000 for debts that remained unpaid after three months and also wrote off debts of $1,000, which were still unpaid after six months. Company R is entitled to a deduction of $1,000 under s 25-35 of ITAA 1997 in respect of the write-off as the $1,000 had previously been included in Company R’s assessable income at the time of sale, and all of the other conditions in s 25-35 are satisfied. The provision for bad debts of $2,000 is not deductible as it does not constitute a “write-off”.
Determining that a debt is “bad” [13.83] Taxpayers are only entitled to a deduction for a debt that is “bad” under s 25-35 of ITAA 1997. In Ruling TR 92/18, the Commissioner suggests
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that it is not necessary that the taxpayer take all available legal steps to recover a debt before it can be classified as “bad”. It is sufficient that the taxpayer make a bona fide assessment based on sound commercial considerations that the debt is bad. In Ruling TR 92/18, the Commissioner states: 31. A debt may be considered to have become bad in any of the following circumstances: (a) the debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied; (b) the debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which action could be taken; (c) where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for non-payment; (d) if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt; (e) where, on an objective view of all the facts or on the probabilities existing at the time the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or the part of the debt, being recovered.
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32. While individual cases may vary, as a practical guide a debt will be accepted as bad under category (e) above where, depending on the particular facts of the case, a taxpayer has taken the appropriate steps in an attempt to recover the debt and not simply written it off as bad. Generally speaking such steps would include some or all of the following, although the steps undertaken will vary depending upon the size of the debt and the resources available to the creditor to pursue the debt: (i) reminder notices issued and telephone/mail contact is attempted; (ii) a reasonable period of time has elapsed since the original due date for payment of the debt. This will of necessity vary depending upon the amount of the debt outstanding and the taxpayers’ credit arrangements (eg 90, 120 or 150 days overdue); (iii) formal demand notice is served; (iv) issue of, and service of, a summons; (v) judgment entered against the delinquent debtor; (vi) execution proceedings to enforce judgment; (vii) the calculation and charging of interest is ceased and the account is closed (a tracing file may be kept open; also, in the case of a partial debt write-off, the account may remain open); (viii) valuation of any security held against the debt; (ix) sale of any seized or repossessed assets.
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490 [13.85] PRINCIPLES OF TAXATION LAW 2020 While the above factors are indicative of the circumstances in which a debt may be considered bad, ultimately the question is one of fact and will depend on all the facts and circumstances surrounding the transactions. All pertinent evidence including the value of collateral securing the debt and the financial condition of the debtor should be considered. Ultimately, the taxpayer is responsible for establishing that a debt is bad and bears the onus of proof in this regard.
Money-lending business
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[13.85] The determination as to whether a taxpayer is carrying on a business of money-lending is a factual one to be made on a case-by-case basis in accordance with the principles discussed in Chapter 8. In the case of banks and finance companies, it will generally be clear that they are carrying on a business of money-lending. One issue that sometimes arises in practice is whether an in-house finance company is in the business of money lending: see, for example, FCT v BHP Billiton Finance Ltd [2010] FCAFC 25 (note that the case was appealed to the High Court but on a different issue: FCT v BHP Billiton Ltd [2011] HCA 17). This is a factual question to be determined based on the taxpayer’s circumstances and it has been accepted that a taxpayer can be in the business of money-lending, even if it only lends to a particular class of borrowers, as long as it does so in a business-like manner with a view to making a profit: Fairway Estates Pty Ltd v FCT (1970) 1 ATR 726. In FCT v National Commercial Banking Corp of Australia Ltd (1983) 15 ATR 21, the Full Federal Court confirmed that a taxpayer that is in the business of money-lending is entitled to a bad debt deduction even where an amount has not been previously included in the taxpayer’s assessable income in relation to the debt. The deduction is not only limited to the unpaid loan principal but also includes any capitalised interest and associated costs, such as fees and charges.
Corporate taxpayers [13.90] Companies are only entitled to a deduction for bad debts, where the company satisfies the loss recoupment tests discussed in Chapter 21. Essentially, a company must have the same owners or the same or similar business from the time the debt was incurred to the time when a bad debt deduction is claimed for the debt.
Payments to associations [13.100] Section 25-55 of ITAA 1997 provides taxpayers with a deduction for payments for membership of a trade, business or professional association.
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However, the maximum amount deductible under this section is $42. Therefore, as the note to s 25-55 points out, a taxpayer would be better advised to claim a deduction for payments to associations under s 8-1 if the taxpayer satisfies the requirements of that section. The difference between the two sections is that s 8-1 requires a connection between the expense and the production of income, whereas there is no such nexus requirement in s 25-55. Example 13.14: Payments to associations deductible under ss 8-1 and 25-55 Talil is an accountant and is a member of the Accounting Institute of Australia. His membership fees for the year were $700. Talil would claim a deduction of $42 under s 25-55 of ITAA 1997 and a deduction of $658 under s 8-1 as the expense was incurred in gaining or producing his assessable income.
Example 13.15: Payments to associations deductible under s 25-55 only Following on from Example 13.14, assume that Talil has decided to pursue his true passion for cooking and works as a chef instead of as an accountant.
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Talil would claim a deduction for $42 under s 25-55 for his accounting membership fees but would not be entitled to a deduction under s 8-1 for the remaining $658 as the membership fees are not incurred in gaining or producing his assessable income.
Travel between workplaces [13.110] As discussed in Chapter 12, in FCT v Payne (2001) 202 CLR 93, the Full High Court found that expenses incurred by a taxpayer in travelling between two unrelated places of work are not deductible under s 8-1 of ITAA 1997 as the expenses are not incurred in the course of gaining or producing assessable income but rather in putting the taxpayer in a position to gain or produce assessable income. As such, the expenses do not satisfy the positive limbs of s 8-1. A workplace is a place where the taxpayer is engaged in activities which gain or produce assessable income (eg, place of employment or place of business). The Government subsequently introduced s 25-100, which provides taxpayers with a deduction for travel directly between two workplaces, where the taxpayer
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492 [13.130] PRINCIPLES OF TAXATION LAW 2020 is engaged in income-producing activities at each workplace (eg, employment or business). However, the expenses are not deductible under s 25-100, where one of the workplaces is also the taxpayer’s residence. The taxpayer in FCT v Payne, for example, would not be assisted by s 25-100 as the location of his deer-farming business activity was also his residence. Example 13.16: Travel between workplaces Nash works as an accountant at a large accounting firm. He also works in his family business. Under an arrangement with the accounting firm, he leaves the accounting firm at 3 pm each day to go and work in the family business (where he receives salary income). Nash takes a train from the accounting firm to the family business. Nash would be entitled to a deduction for the cost of his train ticket for the travel between the accounting firm and his family business under s 25-100 of ITAA 1997. The travel is directly between two workplaces, where he gains or produces assessable income and neither is his residence.
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Gifts [13.130] Division 30 of ITAA 1997 provides taxpayers with a deduction for gifts or contributions made to particular recipients. The gift or contribution can be of money or property. Note that the amount of the deduction is generally limited to the amount “paid” or “contributed” and does not include the incurring of a liability: s 30-15; Arnold v FCT [2017] AATA 1318. Broadly, a gift or contribution must be made to a “deductible gift recipient” (DGR) to qualify for a deduction under Div 30. A “deductible gift recipient” is an entity which meets the requirements to be registered as such by the relevant body, for example, public universities, public hospitals, charities (such as World Vision) or research organisations (such as Cancer Council Australia). Most organisations would generally publicise the fact that they are a registered DGR so that potential donors are aware that any gifts or contributions to the organisation would be deductible for tax purposes. The issue in relation to the deductibility of gifts or contributions is that the payment must be a “true” gift and made with no expectation of material advantage in return: FCT v McPhail (1968) 117 CLR 111. In Ruling TR 2005/13, the Commissioner suggests that a deductible gift must be one that is voluntary, transfers the taxpayer’s beneficial interests in the property to the recipient and is made without the expectation of a material advantage in return.
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Case study 13.4: Gift not deductible due to receipt of material advantage in return In FCT v McPhail (1968) 117 CLR 111, the taxpayer made a contribution to a building fund for the school attended by his son. The school charged different fees depending on whether a contribution was made to the building fund. As such, the taxpayer was charged lower school fees for his son than he would have otherwise paid. The High Court denied the taxpayer a deduction for the contribution to the building fund on the basis that it was not a true gift as the taxpayer received a material advantage in return, being the lower school fees for his son’s education. Example 13.17: Deductibility of charitable donations
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Sam is a strong supporter of Cancer Council Australia. He makes a monthly donation of $10 to the organisation. In addition, he purchased 20 raffle tickets which cost him $2 each. The raffle prize was the latest model BMW car which was Sam’s dream to own. Cancer Council Australia is a registered DGR. Sam would be entitled to a deduction for the $10 monthly donation to Cancer Council Australia under Div 30 of ITAA 1997 as it is a donation to a DGR. However, Sam would not be entitled to a deduction for the purchase of the raffle tickets ($40) as it is not a “true” gift. Sam has received a material advantage in return for the $40, being his entry into the raffle competition and the opportunity to win the BMW car. Further, the payment is not “voluntary” as it is in effect a payment for the right to enter a competition. Whether or not the taxpayer has received a material advantage from the gift or donation is a question of fact, and the Commissioner provides a number of examples in Ruling TR 2005/13 on this issue. For example, where the taxpayer receives items such as chocolates, calendars, pens or mugs in return for a gift or donation, the Commissioner considers it likely that the taxpayer has received a material advantage in return for the gift or donation as these are utility items which benefit the taxpayer. On the other hand, where the taxpayer receives token items, such as a lapel badge, bumper sticker, red nose or daffodils, the items are not considered to provide the taxpayer with a material advantage as they are not utility items and primarily serve as promotional or advertising material for the recipient. Public recognition of a gift or donation (eg, on a telethon or in a publication) generally does not constitute a material advantage. However, public recognition that is used in the donor’s advertising or marketing may constitute a material advantage.
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Limitations on deductions for gifts or donations [13.140] A taxpayer’s deduction for a gift or donation may be limited or disallowed in certain circumstances. Under s 26-55(1) of ITAA 1997, a taxpayer is not entitled to a deduction for a gift or contribution under Div 30 if the deduction would result in the taxpayer incurring or increasing a tax loss for the year. Example 13.18: Charitable donations and losses Jasper has assessable income of $100,000 and deductions of $120,000. His deductions of $120,000 include donations of $30,000, which satisfy the requirements in Div 30 of ITAA 1997. Jasper is only entitled to a deduction of $10,000 in respect of his donations, which would result in his taxable income for the year being nil.
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Jasper is not entitled to a deduction for the remaining $20,000 of donations under Div 30 as that would result in him incurring a loss in the current year: s 26-55(1). However, s 26-55 does not limit deductions for gifts or donations that satisfy the general deduction rule in s 8-1 and Jasper may be able to deduct the remaining $20,000 of donations under s 8-1 if the requirements of that provision are satisfied (see [13.160]). In addition, an anti-avoidance rule in s 78A of ITAA 1936 does not permit a deduction for gifts or donations under Div 30 in certain circumstances. A gift or deduction may not be deductible, where: • the amount or value of the benefit derived by the DGR as a consequence of the gift is, or will be, or may reasonably be expected to be, diminished subsequent to the receipt of the gift: s 78A(2)(a); • another fund, authority or institution, other than the recipient DGR makes, or becomes liable to make, or may reasonably be expected to make a payment, or transfer property to any person or incur any other detriment, disadvantage, liability or obligation: s 78A(2)(b); • the giver or the giver’s associate obtains, or will obtain, or may reasonably be expected to obtain any benefit, advantage, right or privilege apart from the benefit of a tax saving associated with the gift deduction: s 78A(2)(c); or • the recipient DGR or another fund, authority or institution acquires property, directly or indirectly, from the giver or the giver’s associate: s 78A(2)(d). Under s 78A(3), a donation of property may not be deductible, where the donor retains the right to use the donated property. In essence, s 78A
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addresses situations, where the gift or donation is not in fact a “true” gift or donation.
Political contributions and gifts [13.150] Section 26-22 denies business taxpayers a deduction for political gifts or donations. A political gift or donation can be a contribution to a registered political party or an individual who is a candidate in a government election (federal, state or local) or a current member of government. Individuals can claim a maximum deduction of $1,500 for political gifts or donations but not if the gift or donation is made in the course of carrying on a business: ss 30-242 and 30-243. Where an individual makes a political gift or contribution in the course of carrying on a business, the amount is not deductible under s 26-22.
Deductibility of gifts or donations under s 8-1 [13.160] Where a gift or donation, other than a political gift or donation, is not deductible under Div 30 of ITAA 1997, the gift or donation may nonetheless be deductible under the general deduction provision, s 8-1: see Chapter 12. The key issue is that the gift or donation must be sufficiently connected to the production of the taxpayer’s assessable income. The limitation on the deductibility of political gifts and donations in s 26-22 also applies to deductions under s 8-1. However, the limitations in s 26-55 and s 78A apply to deductions for gifts or donations under Div 30 only.
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The following examples illustrate when gifts or donations that are not deductible under Div 30 may be deductible under s 8-1. Example 13.19: Gift or donation incurred in gaining or producing assessable income Lucas runs his own advertising agency. During the month of July, he agrees to donate a percentage of his fees from any new clients to a DGR nominated by the client. The donation to the DGR by Lucas is unlikely to be deductible under Div 30 as Lucas has received a material advantage in return –that is, the custom of the new client. However, Lucas is likely to be able to claim a deduction for the donation under s 8-1 as the donation is incurred in the course of gaining or producing Lucas’ assessable income, thereby satisfying the positive limbs of s 8-1. None of the negative limbs of s 8-1 apply to deny a deduction.
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Example 13.20: Gift or donation incurred in gaining or producing assessable income Robert owns a costume shop. He makes a payment of $20,000 to a cultural DGR on the basis that it will place a prominent sign at the entrance to its complex thanking Robert’s Costume Shop for its generous support. The $20,000 payment is not a gift, as Robert receives a material benefit, namely advertising for his shop, in return for it. In addition, the payment would not be deductible because of s 78A(2)(c). However, Robert may be entitled to a deduction under s 8-1 for the contribution as a business expense. Source: Adapted from Example 66 in Ruling TR 2005/13.
Example 13.21: Gift or donation incurred in gaining or producing assessable income As part of its “corporate philanthropy” program, a large retailer sponsors a local symphony orchestra (a DGR). The retailer’s business name is to be included in the name of all concerts, all advertising and displays at concerts are to feature the retailer’s logo and name in the dimensions it specifies, and such advertising and displays are to emphasise the retailer’s support and commitment to the symphony orchestra. The retailer will give the orchestra $400,000 for the year. The payment will not be a gift. The retailer receives material benefits from the advertising. However, the retailer may be entitled to a deduction under s 8-1 for the payment as a business expense. Copyright © 2019. Thomson Reuters. All rights reserved.
Source: Adapted from Example 68 in Ruling TR 2005/13. In Ruling TR 1999/10, the Commissioner suggests that donations of trophies, books and sporting equipment or gifts such as flowers and cards for birthdays and other occasions by a parliamentarian to their constituents may be deductible under s 8-1, even though the recipients are not DGRs. In Determination TD 2016/14, the Commissioner suggests that gifts to former or current clients may be deductible under s 8-1 if the gift is made for the purpose of producing future assessable income.
Prior year losses [13.180] A taxpayer incurs a tax loss in an income year, where the taxpayer’s deductions exceed his or her assessable income. As a result,
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the taxpayer does not pay any income tax in that income year. In addition, the taxpayer is entitled to carry forward the loss and utilise it as a deduction against assessable income in subsequent income years under Div 36 of ITAA 1997. Unutilised losses can be carried forward indefinitely until death in the case of an individual taxpayer or for as long as the loss recoupment tests (see [13.190]) are satisfied in the case of a corporate taxpayer. Note that these rules are in relation to a taxpayer’s non-capital losses, whereas the application of prior year capital losses is governed by the capital gains provisions discussed in Chapter 11. The amount of a taxpayer’s tax loss in a particular income tax year is calculated by reference to s 36-10 as follows: Deductions (excluding prior year tax losses ) – Assessable income – Net exempt income
where Net exempt income = Exempt income − Losses or outgoings incurred in producing exempt income − Any foreign tax paid
Example 13.22: Current year loss amount
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Ambrose determined that his assessable income for Year 1 was $100,000, while his total deductions for the year were $150,000. Ambrose also had $20,000 of exempt income in that year. Ambrose has incurred a tax loss of $30,000 for the income year ($150,000 − $100,000 − $20,000). He is entitled to carry forward the tax loss of $30,000 and utilise it as a deduction against future assessable income. The relevant provisions regarding the deductibility of prior year losses are ss 36-15 (for entities other than corporate entities, ie, individuals, partnerships and trusts) and 36-17 (for companies). The sections provide that the taxpayer is entitled to a deduction against assessable income for prior year losses. However, where the taxpayer has any exempt income, any prior year losses must be applied against the taxpayer’s exempt income first and any remaining amount then applied to the taxpayer’s assessable income. Where the taxpayer has losses from more than one year, the losses are deducted in the order in which the taxpayer incurred them, that is, on a first-in-first-out basis: ss 36- 15(5) and 36-17(7).
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Example 13.23: Losses in consecutive years Following on from Example 13.22, Ambrose has carried-forward losses of $30,000 from Year 1. In Year 2, Ambrose again makes a tax loss of $30,000. Ambrose does not have any excess assessable income in Year 2 and therefore he cannot claim a deduction for the prior year loss. His Year 2 loss is added to the Year 1 loss and carried forward for deduction against future assessable income.
Example 13.24: Utilisation of prior year losses Following on from Examples 13.22 and 13.23, Ambrose has carried- forward losses of $30,000 from Year 1 and $30,000 from Year 2. In Year 3, Ambrose has assessable income of $200,000, exempt income of $10,000 and deductions of $160,000. In working out his tax liability for Year 3, Ambrose must first deduct his carried-forward losses of $60,000 against his exempt income (if any). In this case, Ambrose has exempt income of $10,000, which leaves him with carried-forward losses of $50,000.
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The $50,000 of carried-forward losses is then deducted against the excess of Ambrose’s assessable income over his deductions, which in this case is $40,000, and leaves Ambrose with carried-forward losses of $10,000, which can be applied against his future assessable income. Note that the losses are assumed to be utilised on a first-in-first-out basis and therefore the remaining $10,000 carried-forward loss is assumed to have been incurred in Year 2.
Corporate taxpayers [13.190] The key difference between s 36-15 of ITAA 1997 for non-corporate entities and s 36-17 for companies is that companies can choose how much of their carried-forward losses they want to apply against their current year assessable income after applying the losses against any exempt income. Individuals, on the other hand, are not entitled to choose the amount of a prior year loss that they wish to deduct and instead must apply as much of the loss as is available to reduce their taxable income. Companies can choose how much of their carried-forward losses to deduct in the current year due to the operation of the imputation system, which is discussed in Chapter 21. In some cases, a company may want to pay tax in
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order to receive a credit to its franking account so that it can distribute franking credits to shareholders upon payment of a dividend. Example 13.25: Prior year losses –company Assume that in Examples 13.22, 13.23 and 13.24 the taxpayer was not Ambrose but Company R. In working out its tax liability for Year 3, Company R must still deduct its carried-forward losses of $60,000 against its exempt income first. In this case, Company R has exempt income of $10,000, which leaves it with carried-forward losses of $50,000. Instead of deducting $40,000 of carried-forward losses against its excess of assessable income over deductions of $40,000 in the current year, Company R can choose to deduct any amount (or none) of its carried- forward losses in the current year. For example, if Company R chose to deduct $10,000 of prior year losses, it would have taxable income of $30,000 in Year 3 on which it must pay tax and $40,000 of losses to be carried forward and utilised in future income years.
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Limitations on losses [13.200] All taxpayers are entitled to carry forward prior year losses indefinitely for use against future assessable income. However, a taxpayer’s entitlement to utilise prior year losses in future years may be restricted by the following rules in relation to: • companies: the continuity of ownership and same or similar business loss recoupment tests (discussed in Chapter 21); and • individuals: the non-commercial losses rules in Div 35 of ITAA 1997 (discussed in Chapter 23).
Other specific deduction provisions [13.210] There are many specific deduction provisions in Div 25 of ITAA 1997 and it is beyond the scope of this book to discuss all of them here. As a specific deduction provision takes precedence over the general deduction provision (s 8-10), it is necessary to first check whether there is an applicable specific deduction provision before considering the deductibility of an expense under s 8-1. The following specific deduction provisions are worth noting but are not discussed in detail:
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500 [13.220] PRINCIPLES OF TAXATION LAW 2020 • Expenditure incurred in preparing, registering or stamping a lease of property or an assignment or surrender of a lease of property, where the property is used for an income-producing purpose: s 25-20. • Any expenses incurred by a taxpayer in borrowing money are deductible, where the loan amount is used for an income-producing purpose: s 25-25. This provision captures borrowing costs such as loan establishment fees, valuation fees or loan guarantee insurance which would not be deductible under s 8-1 as they constitute capital expenses. The expenses are generally deductible over the term of the loan or five years. Interest expenses, which are deductible under s 8-1, are not considered borrowing expenses. • A loss from a profit-making undertaking or plan is deductible under s 25-40 if any profit from that plan would have been assessable under s 15-15. However, this provision does not apply to property acquired on or after 20 September 1985. • A deduction is available for a loss of money caused by theft, stealing, embezzlement, larceny, defalcation or misappropriation by the taxpayer’s employee or agent (but not an individual employed solely for private purposes) where the money was included in the taxpayer’s assessable income in the current year or an earlier income year: s 25- 45. The deduction is available in the year when the taxpayer discovers the loss. Any amount received by the taxpayer in relation to the loss may be included in the taxpayer’s assessable income under subdiv 20-A. A deduction is also available, where a balancing adjustment event (eg, a disposal) happens to a depreciating asset and the loss relates to an amount that was included in the termination value of the asset: s 25-47. • Payments of a pension, gratuity or retiring allowance to an employee, former employee or dependant of an employee or former employee are deductible under s 25-50, where the payments are made in good faith in relation to the past services provided by the employee or former employee in relation to the taxpayer’s business. However, the payments are only deductible under s 25-50 if they are not deductible under another provision (eg, s 8-1): s 25-50(3).
Questions [13.220] 13.1 Advise Cheryl of her tax consequences from the following transactions: (a) donation of $300 to the building fund of her local public primary school;
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(b) donation of $50 to her local public library (as a result she does not need to pay membership fees of $20 that year to borrow books from the library); and (c) payment of $700 membership fees to the real estate agents’ association. Cheryl is a professional real estate agent but she has not been working as one for the last two years following the birth of her child. However, she maintains her membership of the association as she intends to go back to work one day. 13.2 Digby owns a bookstore. He undertakes the following activities: (a) replastering and repainting a wall which had been damaged due to a leak; (b) recarpeting the whole shop as the old carpet had worn out due to normal wear and tear; (c) installing a new payment counter with new display signs; and (d) repainting the front of the store with a new type of glossy paint to make it more attractive to walk-in customers. Advise Digby of his tax consequences arising from the above information. 13.3 Alina recently inherited a large block of land from her uncle. She built a house on the land and subsequently sold the house and the land for $900,000. Alina received advice on the tax consequences of the sale from her accountant, who is a registered tax agent. The accountant’s fees for the year were $1,800. The fees related to the lodgement of Alina’s income tax return ($500) and the advice regarding the sale ($1,300). Advise Alina as to whether the $1,800 paid to her accountant is deductible for income tax purposes. 13.4 Chantal has provided you with the following information: Year 1: Assessable income = $100,000; Deductions = $500,000 Year 2: Assessable income = $500,000; Exempt income = $100,000; Deductions = $300,000 Year 3: Assessable income = $100,000; Exempt income = $200,000; Deductions = $100,000 Advise Chantal as to her taxable income /loss each year. Would your advice be any different if the taxpayer was Chantal Pty Ltd? 13.5 Big Shoes Pty Ltd sells shoes exclusively online. Customers are invoiced for the shoes when they are shipped and are only required to pay for
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502 [13.220] PRINCIPLES OF TAXATION LAW 2020
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the shoes once they have been received and deemed satisfactory. Big Shoes includes the invoice amount in its assessable income when the invoice is issued. As of 30 June, Big Shoes determined that it had $10,000 in unpaid invoices. Its records indicated that 70% of the invoices related to shoes sold within the last month, which was considered acceptable. However, of the remaining $3,000, $1,000 related to invoices which were more than three months overdue. In accordance with its customary practice, Big Shoes wrote off the $1,000 of outstanding invoices. Its standard practice is to issue payment reminders before writing off the debt and turning it over to a debt collector. Big Shoes also created a provision for bad debts of $2,000 at this time. Advise Big Shoes as to what amount (if any) it can deduct in relation to the unpaid invoices. 13.6 Jeremy is a personal trainer. He works at a local gym providing personal training services to members of the gym. Jeremy works at the gym until 3 pm each day. He then takes the train home. He has to be home by 4 pm as he trains clients at his home gym from 4 pm to 7 pm. Advise Jeremy as to the tax deductibility of his train fare. Would your answer be any different if Jeremy took the train to another gym, where he trained clients from 4 pm to 7 pm?
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14 Capital allowances Key points.................................................................................................... [14.00] Introduction................................................................................................ [14.10] Depreciation deductions............................................................................ [14.20] Depreciating asset................................................................................ [14.30]
Composite items...................................................................................... [14.35]
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Claiming a deduction........................................................................... [14.40]
Held .......................................................................................................... [14.50] Decline in value........................................................................................ [14.70] Taxable purpose..................................................................................... [14.100] Balancing adjustments....................................................................... [14.110] Depreciating asset used for non-taxable purpose........................................................................................... [14.115] Interaction with capital gains provisions.............................................. [14.118] Roll-over relief........................................................................................ [14.120] Cars..................................................................................................... [14.125] Pooling of assets................................................................................ [14.130] Low-value pool....................................................................................... [14.140] Software development pool.................................................................. [14.160] Small business entity concessions................................................... [14.165] Capital works deductions........................................................................ [14.170] Black hole expenses................................................................................. [14.180] Project pools...................................................................................... [14.190] Business-related costs....................................................................... [14.200] Start-up expenses.................................................................................. [14.215] Questions................................................................................................... [14.220]
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504 [14.00] PRINCIPLES OF TAXATION LAW 2020
Key points [14.00] • Expenses that are not immediately deductible under the general deduction provision or a specific deduction provision because they are capital or capital in nature may be deductible over a number of years under the capital allowances regime. • The cost of acquiring a depreciating asset used for income-producing purposes is one of the main categories of capital expenditure which is deductible under the capital allowances regime: Div 40 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997). • The holder of a depreciating asset used for income-producing purposes is entitled to a deduction in an income year for the decline in value of the depreciating asset for that year. • The decline in value of a depreciating asset is calculated in accordance with either the diminishing value method or the prime cost method. • The disposal of a depreciating asset may give rise to an assessable income or deduction amount. • Taxpayers may choose to calculate the depreciation deduction for certain depreciating assets on a pooled basis. • Capital expenses incurred in constructing a building used for income- producing purposes may be deductible under the capital works provisions in Div 43 of ITAA 1997. • Business taxpayers may be entitled to deduct certain capital expenses which are not otherwise taken into account under the income tax legislation over a period of five years under s 40-880 of ITAA 1997.
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• Small business taxpayers may be entitled to accelerated deductions in certain situations.
Introduction [14.10] As discussed in Chapters 12 and 13, most expenses are not immediately deductible under s 8- 1 of ITAA 1997 or a specific deduction provision, such as s 25-10 for repairs, where the expense is a capital expense. However, taxpayers may still be entitled to a deduction for capital expenses under the capital allowances regime. Essentially, the capital allowances regime provides taxpayers with a deduction for the expense over the period of time that the expense is expected to benefit the taxpayer. This approach aligns the timing of the deductions with the corresponding income expected to be generated by the expense. In this chapter, we consider the three categories of deductible capital expenditure set out in Figure 14.1.
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Figure 14.1: Overall guide
Depreciation deductions [14.20] One of the most common categories of capital expenditure that is effectively deductible for tax purposes is capital expenditure which relates to a depreciating asset used for income-producing purposes. Division 40 of ITAA 1997 provides taxpayers with a deduction over a period of years for capital expenses related to such depreciating assets (eg, acquisition cost). The deduction is only available for the time the taxpayer held the depreciating asset
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506 [14.20] PRINCIPLES OF TAXATION LAW 2020 and to the extent that the asset was used for the purpose of gaining or producing assessable income. The legislation does not use the term “depreciation” but that is essentially what Div 40 addresses by providing a deduction for the decline in value of the asset over its estimated useful life. The general depreciation rules do not apply in the following circumstances: • The asset is an eligible work-related item for the purposes of s 58X of Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA) and is provided as an expense payment fringe benefit or property fringe benefit: s 40-45(1). This measure was announced in the 2008 Federal Budget and applies to assets acquired after 7:30 pm (AEST) on 13 May 2008. The measure was introduced as it was considered inappropriate that employees could claim depreciation deductions for such assets, while employers could claim a deduction in respect of the provision of the fringe benefit and, under s 58X, avoid paying fringe benefits tax. Following the amendment, employees are not entitled to claim depreciation deductions in relation to such items as employees have effectively not borne the cost of the asset where it is provided as a fringe benefit. • Expenditure on capital works (ie, on buildings): s 40- 45(2). Capital works expenditure is deductible under Div 43: see [14.170].
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• Expenditure on assets related to investments in Australian films: s 40- 45(5). Such expenditure is generally dealt with under Divs 10BA and 10B of Pt III of Income Tax Assessment Act 1936 (Cth) (ITAA 1936). • Expenditure which is deductible under another subdivision, such as expenditure on primary production assets (subdiv 40-F); expenditure of primary producers or other landlords (subdiv 40-G); capital expenditure for the establishment of trees in carbon sink forests (subdiv 40- J) and expenditure allocated to a software development pool (subdiv 40-E): s 40-50. • Expenditure on a car where the deduction for car expenses has been calculated in accordance with the cents per kilometre method (see Chapter 12) in that year: s 40-55. • Second-hand depreciating assets used or installed in residential rental premises: s 40-27. Deduction is not available for the decline in value of such depreciating assets unless the asset is used in carrying on a business or, the taxpayer is a corporate tax entity, superannuation fund that is not a self-managed super fund, managed investment trust, public unit trust, or, a unit trust or partnership if each member of the trust or partnership is one of these entities. Note that “small business entities” can choose not to apply the general depreciation rules and use the simpler depreciation rules in subdiv 328-D (see [14.165]) instead.
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Depreciating asset [14.30] The first key issue is to determine whether the expense relates to a depreciating asset. “Depreciating asset” is defined in s 40-30(1) of ITAA 1997 as an asset which has a limited effective life (ie, limited usefulness) and can reasonably be expected to decline in value over the time that it is used. Common examples of depreciating assets include computers, furniture, cars, machinery, telephones, etc. Land is specifically excluded from the definition of “depreciating asset” as it is generally not expected to decline in value. Intangible assets are also excluded from being depreciating assets unless they are specifically listed in s 40-30(2). Examples of intangible assets that are treated as depreciating assets include mining, quarrying or prospecting rights or information, items of intellectual property (copyright, patents and registered designs) and in-house software. Buildings are effectively treated as not being depreciating assets as expenditure relating to buildings is considered capital works and is dealt with under Div 43: s 40-45(2). Note that: • the trading stock rules (discussed in Chapter 17) take precedence over the depreciating asset rules as items of trading stock are excluded from the definition of “depreciating asset”: s 40-30(1); and • the depreciating asset rules take precedence over the capital gains tax (CGT) rules (discussed in Chapter 11) as s 118-24 states that any capital gains or losses on depreciating assets are disregarded.
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Composite items [14.35] Where a depreciating asset is made up of a number of individual items, it may be necessary to determine whether each component is a separate depreciating asset or whether the item as a whole is the depreciating asset. This is a question of fact and degree which can only be determined in light of all of the circumstances of the particular case: s 40-30(4). In Draft Ruling TR 2017/D1, the Commissioner suggests, based on case law, that the following principles should be taken into account in determining whether a composite item is a single depreciating asset or more than one depreciating asset: • identifiable function –the depreciating asset will tend to be the item that performs a separate identifiable function, having regard to the purpose or function it serves in its business context; • use –a depreciating asset will tend to be an item that performs a discrete function. However, the item need not be self-contained or able to be used on a stand-alone basis;
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508 [14.35] PRINCIPLES OF TAXATION LAW 2020
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• degree of integration –the depreciating asset will tend to be the composite item where there is a high degree of physical integration of the components; • effect of attachment –the item, when attached to another asset having its own independent function, varies the performance of that asset; • system –a depreciating asset will tend to be the multiple components that are purchased as a system to function together as a whole and which are necessarily connected in their operation. For example, the motherboard in a laptop computer will not be a separate depreciating asset as it is not separately identifiable and has no independent use. The monitor or screen of a laptop is also not a separate depreciating asset. Although it can be separately identified, it has no independent use. A printer will be a separate depreciating asset as it is separately identifiable and has an independent use. As mentioned earlier, buildings are effectively treated as not being depreciating assets since capital expenditure in relation to buildings is deducted under Div 43, not Div 40. However, it may be necessary in some cases to identify whether the expenditure relates to a separate depreciating asset (which is deductible under Div 40) or the building itself (which is deductible under Div 43). Again, the question is one of fact and degree which will be determined in accordance with the individual circumstances of a case. In Rulings TR 2007/9 and TR 2004/ 16, the Commissioner suggests the following factors as being relevant in making that determination: • whether the item appears visually to retain a separate identity; • the degree of permanence with which it has been attached; • the incompleteness of the structure without it; and • the extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period. Example 14.1: Separate depreciating assets A retail camping equipment shop specialising in speleological equipment (ie, equipment used in cave exploration) has a fibreglass facade attached to its shopfront. The facade was designed and constructed so that in colour, texture and shape the doorway has the appearance of a cave entrance which customers walk through to enter the shop. The interior of the shop is decorated with various items to continue the cave theme. The fibreglass facade does not form part of the premises. The facade has a separate visual identity and is not necessary to complete the premises. These factors outweigh considerations of the degree of permanence with which the facade is attached and any intention that it remain in place for a considerable period of time.
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The sole purpose of the facade is to create a cave-like atmosphere or ambience that is intended to attract caving equipment customers. Given the nature of the equipment in which the business specialises, the presentation of the cave-like atmosphere is a definable element in the service the business provides and for which its customers are prepared to pay. The facade’s function is not as part of the premises and is so related to the business to warrant it being a separate depreciating asset. The shopfront to which the fibreglass facade is attached merely forms part of the premises and is not a depreciating asset. Source: Adapted from Example 5 in Ruling TR 2007/9.
Example 14.2: Separate depreciating assets Liam owns an investment property which he rents out to students. He recently spent $5,000 installing new kitchen cupboards. Kitchen cupboards form part of the premises and therefore are part of the setting of Liam’s rental income-producing activities. Kitchen cupboards form part of the premises as they are fixed to the premises, intended to remain in place indefinitely and are necessary to complete the premises. Any separate visual identity is outweighed by the other factors. Since kitchen cupboards form part of the premises, they are not depreciating assets.
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Source: Adapted from Example 1 in Ruling TR 2004/16.
Claiming a deduction [14.40] The main provision that provides taxpayers with a deduction in relation to depreciating assets is s 40-25 of ITAA 1997. According to s 40-25(1), the amount of the deduction is equal to the decline in value for an income year of a depreciating asset that is held by the taxpayer any time during the year. The amount of the deduction is reduced for any use of the asset for a non- taxable purpose: s 40-25(2). Where the cost of the depreciating asset is less than $300 and the asset is used predominantly in gaining or producing assessable income that is not income from business (eg, an asset used by an employee for work purposes or an asset used to gain or produce income from property), the cost of the depreciating asset is immediately deductible under s 40- 80(2). Business assets are not included in this exception but may be subject to pooling or an immediate deduction in the case of small and medium-sized businesses: see [14.130] and [14.165] respectively. An immediate deduction is also available
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510 [14.50] PRINCIPLES OF TAXATION LAW 2020 for the cost of assets used for exploration or prospecting for minerals in certain circumstances: s 40-80(1). The immediate deduction is not available, where: • the asset is part of a set and the taxpayer started to hold the set in that income year and the set costs more than $300: s 40-80(2)(c); or • the total cost of the asset and any other identical or substantially identical assets that the taxpayer starts to hold in that income year exceeds $300: s 40-80(2)(d). Example 14.3: Depreciating assets costing less than $300 Kieran purchased a table for an investment property which he rents out to students. The table cost $200. The cost of the table is immediately deductible to Kieran as it cost less than $300 and is used to produce assessable income which is not business income (ie, rental income). In order to claim a deduction under s 40-25, it is necessary to understand when a taxpayer has “held” a depreciating asset, the “decline in value” of the asset and the “taxable purpose” of the asset. We will now consider each of these elements in detail.
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Held [14.50] Under s 40-25 of ITAA 1997, it is the holder of an asset who is entitled to a deduction for the decline in value of a depreciating asset. The table in s 40-40 outlines who will be the holder of an asset in specified circumstances. Generally, the holder of an asset is its legal owner. However, in certain circumstances, it may be the economic owner of an asset, and not the legal owner, who is the holder of the asset and therefore entitled to the depreciation deductions. For example, in a hire-purchase arrangement, it is the lessee who is entitled to depreciation deductions as the economic owner of the asset, and not the lessor, who is the legal owner of the asset. Broadly, the economic owner of an asset is the person who bears all the risks and benefits associated with the asset. Example 14.4: Holder of a depreciating asset Kieran purchased an air conditioner for his rental property which is rented out to students. The decline in value of the air conditioner for the year was $1,000.
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Kieran is entitled to a deduction of $1,000 for the depreciation of the air conditioner as it is used for income-producing purposes. Although the asset is being used by the students, Kieran is the holder of the asset as he is the legal and economic owner of the asset. He continues to bear all of the risks and benefits associated with the asset.
Example 14.5: Holder of a depreciating asset Big Accounting Pty Ltd acquires a car under a hire-purchase agreement from Big Cars Pty Ltd. Under the terms of the agreement, Big Accounting is required to pay monthly instalments for a period of three years at the end of which legal ownership will be transferred to Big Accounting. During the three years, Big Cars maintains legal ownership of the cars. However, the costs and risks of ownership are borne by Big Accounting during this period. The decline in value of the car is $3,000 per year. Big Accounting is entitled to a deduction of $3,000 in respect of the depreciation of the car. Although Big Accounting is not the legal owner of the car, it bears all of the risks of ownership and is the economic owner of the car. As such, it is the “holder” of the car under s 40-40.
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[14.60] Jointly held depreciating assets. Section 40-35 of ITAA 1997 ensures that a taxpayer is still entitled to a deduction for the decline in value of a depreciating asset where the asset is held by more than one person. In this situation, each person is entitled to a deduction for the decline in value of his or her interest in the asset.
Example 14.6: Jointly held depreciating assets Kieran and Rowan purchased a computer together for $5,000 in equal proportions. They both use the computer for their respective income- producing purposes only (ie, no private use). The decline in value of the computer this year was $1,000. Kieran and Rowan would each be entitled to a deduction of $500 in relation to the decline in value of the computer as each has a 50% interest in the computer, and each has used his interest in the computer for income- producing purposes only. However, in the case of depreciating assets held by partnerships, the depreciating assets are deemed to be held by the partnership and not the individual partners: s 40-40. Therefore, the partnership includes depreciation deductions in calculating the partnership’s net income for the year. This is
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512 [14.70] PRINCIPLES OF TAXATION LAW 2020 contrary to the rules regarding CGT assets, where the partner, and not the partnership, reports the CGT consequences in relation to an asset.
Decline in value [14.70] Broadly, the decline in value of a depreciating asset is worked out by apportioning the cost of the asset over the number of years that the asset is expected to be of use. The decline in value of a depreciating asset is calculated from the start time, which is the time the asset is first used or is installed ready for use for any purpose: s 40-60 of ITAA 1997. Where the asset is acquired for use in a business that has not yet commenced, the asset does not start to decline in value until the business commences: Determination TD 2007/5.
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Taxpayers have the option of calculating the decline in value of a particular depreciating asset using either the diminishing value method or the prime cost method: s 40-65. The choice of method is made on an asset-by-asset basis and taxpayers can choose a different method for each of their assets. However, once the choice of method is made, it cannot be changed: Note 1 to s 40-65; s 40-130. The taxpayer can change the method if the asset is replaced (ie, a replacement asset does not have to use the same method as the original asset). The taxpayer does not have a choice of method in the following circumstances: • Assets acquired from an associate: s 40- 65(2). The definition of “associate” is found in s 318 of ITAA 1936 and is discussed at [7.55]. In this situation, the taxpayer must use the same method as was used by the associate. Section 40-140 specifies how the taxpayer is to obtain the relevant information from the associate. See Example 14.9. • The holder of the asset has changed but the user is the same or an associate of the former user: s 40-65(3). The taxpayer is required to use the same method as the former holder. Where the taxpayer does not know or cannot readily find out the former holder’s method, the diminishing value method must be used. • Assets allocated to a low-value pool (see [14.140]): s 40-65(5). The method is specified by subdiv 40-E. • Research and development expenditure deductible under s 73BA of ITAA 1936: s 40-65(6). The taxpayer is required to use the same method as was used under that section. • The asset is in-house software, an item of intellectual property (except copyright in a film), a spectrum licence, a datacasting transmitter licence or a telecommunications site access right: ss 40-70(2) and 40- 72(2). The prime cost method must be used for these assets.
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The diminishing value method (known as the “reducing-balance method” in accounting) provides the taxpayer with greater deductions in the early years of the asset’s life and is considered more appropriate for assets which wear out more rapidly in the early years of use. The prime cost method (known as the “straight-line method” in accounting) provides the taxpayer with equal depreciation deductions each year (where there are no second element costs incurred after acquisition) and is more appropriate for assets which wear out evenly over time. [14.80] The diminishing value method is set out in ss 40-70 and 40-72 of ITAA 1997 as follows: Assets held pre-10 May 2006: Base value ×
Days held 150% × 365 Asset ’ s effectivelife
Assets first held on or after 10 May 2006: Base value ×
Days held 200% × 365 Asset ’ s effectivelife
The prime cost method is set out in s 40-75 of ITAA 1997 as follows:
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Asset value ×
Days held 100% × 365 Asset ’ s effectivelife
The percentage in each of the formulas represents the diminishing value factor. The higher factor does not increase the overall depreciation deductions for the asset or change the effective life of the asset. The higher factor provides for greater deductions in the early years of an asset. The 200% rate was introduced in 2006 as it was thought to more closely approximate the actual decline in the economic value of assets generally due to rapidly advancing technology. [14.90] The elements in the above formulae are broadly: • The base value of an asset is its “opening adjustable value” plus any second element costs incurred in the current year: s 40-70(1) of ITAA 1997. The “opening adjustable value” is the cost of the asset less the decline in value of the asset in previous years: s 40-85. In the first year that the asset is held, its base value will be its “cost”. Note that the depreciation deduction for a particular year cannot exceed the asset’s base value in that year: ss 40-70(3) and 40-72(3). • The cost of a depreciating asset is outlined in detailed rules in subdiv 40-C. It is generally equal to the amount paid to acquire the asset (the “first element” of cost: s 40-180) which can also include acquisition
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514 [14.90] PRINCIPLES OF TAXATION LAW 2020 costs such as customs duty, delivery and installation costs: Ruling IT 2197. Any costs incurred after the acquisition of the asset which contribute to bringing the asset to its present condition and location (the “second element” of cost: s 40-190) can also be included in the asset’s cost. Note that: – The cost of an asset is not limited to amounts paid by the taxpayer and can include the value of any non-cash benefits or the amount of a liability: s 40-185. – Any expenses that are deductible under another provision of the tax legislation (eg, repairs that are deductible under s 25-10) cannot be included in the asset’s cost: s 40-215. – Goods and Services Tax (GST) is not included in the cost to the extent that the taxpayer is entitled to “input tax credits” (a refund of GST paid on the acquisition: see [25.190]): s 27-80. – Where the asset is acquired from a non-arm’s length party and the amount paid for the asset exceeds market value, cost is deemed to be market value: s 40-180(2) Item 8. Whether or not parties are at arm’s length is a question of fact depending on any connection between the parties and any other relevant factors: s 995-1. The terms “arm’s length” and “market value” are discussed at [17.70]. – Where the depreciating asset is a car, the cost of the car for the purposes of calculating the depreciation deduction is limited to the amount specified as the “car limit” for the income year when the taxpayer first started to hold the car: s 40-230. The car limit is $57,581 for the 2019–2020 income year. See [14.125]. – Where the asset’s effective life is recalculated per s 40-110 (due to changed circumstances) and the prime cost method is used, the asset’s “cost” is its opening adjustable value for the change year plus any second element costs incurred that year: s 40-75(2) and (3). See Example 14.11. • The days held are the number of days in the year that the asset is used or installed ready for use for any purpose: s 40-70(1). • The effective life is the number of years that the asset is expected to be of use to any taxpayer for a taxable purpose (ie, it is the “life” of the asset, not its expected “life” for the particular taxpayer). For example, a car rental company may trade-in its cars after two years but the useful life of these cars is five years. The effective life of the car in calculating the car rental company’s depreciation deductions is five years. In most cases, the taxpayer has the option of either estimating the effective life of an asset themselves or using the Commissioner’s determination of effective life: s 40-95(1). The Commissioner’s determination of effective life
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is listed in Ruling TR 2019/5 and Income Tax (Effective Life of Depreciating Assets) Determination 2015 (as amended by subsequent Amendment Determinations). The Commissioner provides the effective lives for a large number of assets and industries. Some examples of the Commissioner’s determination of effective life of assets are included in the Appendix. Taxpayers who choose to use their own estimates of effective life may be at greater risk of audits or penalties if the estimates are found to be unrealistic, while taxpayers who rely on the Commissioner’s determination of effective life will not be subject to penalties even if the effective life is later determined to be incorrect or overly-generous. Taxpayers must determine the effective life of an asset (whether through self- assessment or using the Commissioner’s estimate) in the income year in which the asset’s start time occurs: s 40-95(3). However, taxpayers do not have a choice regarding effective life in the following situations:
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• The asset was acquired from an associate: s 40-95(4). The definition of “associate” is found in s 318 of ITAA 1936 and is discussed at [7.55]. The taxpayer’s effective life will depend on the associate’s choice of method and effective life. Where the associate used the diminishing value method, the taxpayer must continue to use the same effective life. Where the associate used the prime cost method, the taxpayer must use an effective life equal to any period of the asset’s effective life the associate was using that is yet to elapse at the time the taxpayer started to hold the asset. See Example 14.9. • The holder of the asset has changed but the user is the same or an associate of the former user: s 40-95(5). The taxpayer’s effective life will depend on the former holder’s choice of method and effective life. Where the former holder used the diminishing value method, the taxpayer must continue to use the same effective life. Where the former holder used the prime cost method, the taxpayer must use an effective life equal to any period of the asset’s effective life the former holder was using that is yet to elapse at the time the taxpayer started to hold the asset: s 40-95(5)(c) and (d). Where the taxpayer is unable to obtain the relevant information from the holder, the taxpayer cannot self-assess the effective life and must use the Commissioner’s determination of effective life: s 40-95(6). • The asset is an intangible depreciating asset listed in s 40-95(7). The section specifies the effective life of those assets. Where the intangible asset is acquired from a former holder of the asset, the effective life of the asset for the new holder is the number of years remaining in the effective life specified in s 40-95(7) at the start of the income year in which the new holder acquires the asset: s 40- 75(5). See Example 14.10.
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516 [14.90] PRINCIPLES OF TAXATION LAW 2020 Note that: • Certain assets have a statutory “capped life” (ie, a maximum effective life) and taxpayers who use the Commissioner’s determination of effective life cannot exceed the cap even though the Commissioner may provide a longer effective life in the determination than the “capped life”: s 40-102. Taxpayers who self-assess the effective life of an asset may use a longer effective life than the “capped life”.
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• If a taxpayer chooses to self-assess the effective life of an asset, they must estimate the number of years that the asset is expected to be of use for any taxpayer for income-producing purposes (ie, it is the “life” of the asset, not its expected “life” for the taxpayer): s 40-105. In making this determination, the taxpayer is expected to do so having regard to the wear and tear they reasonably expect from their expected circumstances of use and assuming that the asset will be maintained in reasonably good order and condition. A shorter effective life may be used where it is estimated that the asset is likely to be scrapped, sold for no more than scrap value or abandoned at the end of a period: s 40-105(2). • A taxpayer is entitled to recalculate the effective life of a depreciating asset in a later income year if the effective life that the taxpayer has been using is no longer accurate because of changed circumstances relating to the nature of the use of the asset: s 40-110(1). There are also certain circumstances when the taxpayer is required to recalculate the effective life of an asset: ss 40- 110(2) and (3) (eg, the asset’s cost is increased by at least 10%). Where the asset’s effective life is recalculated and the prime cost method is used, the effective life of the asset for the purposes of working out the decline in value is the number of years remaining under the new effective life: s 40-75(2) and (3). For example, if a taxpayer has calculated the decline in value of an asset for four years using an effective life of 10 years but then recalculates the effective life to be eight years, the effective life of the asset for the purposes of calculating the decline in value going forward will be four years. See Example 14.11.
Example 14.7: Decline in value of laptop computer Rani purchased a laptop computer for $3,000. The effective life of the laptop computer is three years. Assume that the computer was purchased on 1 July of Year 1 (after 10 May 2006) and is used 100% for income- producing purposes. Assuming it is not a leap year in each of the three years, the decline in value of the laptop computer under each method will be as follows:
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Prime cost method
Diminishing value method
Year
Decline in value
Calculation
Decline in value
Calculation
1
$1,000
$3,000 × 365/ 365 × (100%/3)
$2,000
$3,000 × 365/365 × (200%/3) • Base value = cost as this is the first year asset is held
2
$1,000
$3,000 × 365/ 365 × (100%/3)
$667
$1,000 × 365/365 × (200%/3) • Base value = opening adjustable value as there are no second element costs incurred this year • Opening adjustable value = Cost –decline in value in previous years = $3,000 –$2,000
3
$1,000
$3,000 × 365/ 365 × (100%/3)
$222
$333 × 365/365 × (200%/3)
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• Base value = opening adjustable value as there are no second element costs incurred this year • Opening adjustable value = Cost –decline in value in previous years = $3,000 – $2,000 –$667 Total deductions
$3,000
$2,889
The prime cost method provides for equal deductions in each year and the cost is fully depreciated at the end of the asset’s effective life. The diminishing value method provides for much higher depreciation deductions in the early years of the asset’s effective life but tapers off towards the end of the asset’s effective life. The taxpayer can continue to claim a depreciation deduction for the asset in accordance with the diminishing value method until the asset’s cost is fully deducted. If the taxpayer uses a low-value pool (see [14.140]), the asset can be added to the low-value pool once it has an opening adjustable value of less than $1,000.
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Example 14.8: Calculating the decline in value of a depreciating asset Kieran purchased a new refrigerator for his rental property on 15 June of Year 1 for $2,000. The refrigerator was delivered to the premises on 20 July. The effective life of a refrigerator is 12 years. Kieran’s depreciation deductions in respect of the refrigerator under both methods are as follows (assume that it is not a leap year): Kieran is not entitled to any depreciation deductions in the first income year as the refrigerator is not used or installed ready for use in that income year. In the second income year Kieran is entitled to depreciation deductions from 20 July when the refrigerator was first used or installed ready for use. Therefore: Days held = 347 Cost = $2,000 Effective life = 12 years Diminishing value method: Base value ×
Days held 200% : s 40-72 × 365 Asset ’ s effectivelife
= $2, 000 × (347 / 365) × (200% / 12) = $317
Where: 200% is used because the asset was first used or installed ready for use after 10 May 2006. Copyright © 2019. Thomson Reuters. All rights reserved.
The base value is equal to the cost as this is the first year the asset is held. Prime cost method: Asset ’ s cost ×
Days held 100% : s 40-75 × 365 Asset ’ s effectivelife
= $2,, 000 × (347 / 365) × (100% / 12) = $158
In the third income year the depreciation deduction is calculated as follows: Diminishing value method: = $1, 683 × (365 / 365) × (200% / 12) = $281
Where: Base value = Opening adjustable value = Cost – Decline in value = $2 2, 000 – $317 = $1, 683
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Prime cost method: = $2, 000 × (365 / 365) × (100% / 12) = $167
Example 14.9: Decline in value of asset acquired from associate Big Toes and Big Hands are wholly owned by Big Head. On 1 January, Big Toes acquired a machine from Big Hands for $100,000. The market value of the machine at the time of transfer was $80,000. Prior to the sale, Big Hands had been depreciating the machine for a period of five years under the prime cost method using an effective life of 15 years. Big Toes and Big Hands are “associates” per s 318 of ITAA 1997. As such, Big Toes does not have a choice of method in calculating its depreciation deductions for the asset: s 40-65(2). It must calculate the decline in value of the machine using the prime cost method. The effective life of the machine for Big Toes will be the remaining years of the effective life used by Big Hands (ie, 10 years): s 40-95(4). Further, the “cost” of the asset will be limited to its market value under s 40-180(2) Item 8. Therefore, assuming it is not a leap year, Big Toes’ depreciation deduction will be calculated as follows: $80, 000 × (181 / 365) × (100% / 10) = $3, 967
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Example 14.10: Decline in value of intangible asset On 1 July, Rosheen acquired a standard patent from Linda (the original holder) for $30,000. Prior to the sale, Linda had held the patent for five years. As the relevant asset is an item of intellectual property, Rosheen does not have a choice of method in calculating the decline in value of the asset. The decline in value must be calculated using the prime cost method per ss 40-70(2) and 40-72(2). The effective life of the asset is specified under s 40-95(7) as 20 years and Rosheen cannot self-assess the effective life of the patent. As Rosheen is not the original holder of the asset, her effective life will be the remaining years of the effective life specified in s 40-95(7) (ie, 15 years): s 40-75(5). Therefore, assuming it is not a leap year, Rosheen’s depreciation deduction will be calculated as follows: $30, 000 × 365 / 365 × 100% / 15 = $2, 000
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520 [14.100] PRINCIPLES OF TAXATION LAW 2020
Example 14.11: Impact of recalculation of effective life on decline in value Big Shoes Pty Ltd acquired a printing machine for $30,000 on 1 July of the previous year. On 1 July this year, Big Shoes incurred expenses of $5,000 in upgrading the machine to take advantage of the latest available technology. The costs qualify as “second element costs”. Last year, Big Shoes depreciated the machine using the prime cost method and an effective life of eight years. As the cost of the asset has increased by more than 10%, Big Shoes is required to recalculate the effective life of the machine per s 40- 110(2). Big Shoes assesses the new effective life of the machine to be 15 years. The effective life of the machine for the purposes of the decline in value calculation going forward will be 14 years per s 40-75(2) and (3). The cost of the asset will be its opening adjustable value plus any second element costs incurred this year: s 40-75(2) and (3). Opening adjustable value = Cost−Decline in value in previous years = $30,000−($30,000 × 365/ 365 × 100%/8) = $30,000−$3,750 = $26,250. Decline in value this year = ($26,250 + $5,000) × 365/365 × 100%/14 = $2,232 (assuming it is not a leap year).
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Taxable purpose [14.100] Section 40-25(2) of ITAA 1997 ensures that a depreciation deduction can only be claimed in relation to depreciating assets used for a taxable purpose. Under that section, the depreciation deduction must be reduced by an appropriate percentage for any decline in value that is attributable to the use of the asset for non-taxable purposes. Generally, an asset will be used for a taxable purpose where it is used in the production of assessable income or in exploration or prospecting, mining site rehabilitation and environmental protection activities: s 40-25(7). Example 14.12: Depreciating assets partly used for a taxable purpose Naresh is an arborist. He purchased a chainsaw on 1 July for $3,000. He estimates that he uses the chainsaw for his own purposes 70% of the time and for work purposes 30% of the time. The effective life of chainsaws is three years and Naresh uses the prime cost method to calculate all depreciation deductions. Assume that it is not a leap year.
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Declinein value = $3, 000 ×
365 100% × = $1, 000 365 3
Naresh must reduce the $1,000 depreciation deduction by 70% as that is the percentage of the asset’s decline in value which is attributable to his use of the chainsaw for a non-taxable purpose (ie, not in the production of his assessable income). Therefore, Naresh’s deduction for the year in relation to the chainsaw would be $1,000−(70% × $1,000) = $300.
Balancing adjustments [14.110] Under subdiv 40-D of ITAA 1997, taxpayers must make an adjustment to their taxable income if there is a balancing adjustment event. A balancing adjustment event occurs under s 40-295, where: • the taxpayer stops holding the depreciating asset; • the taxpayer stops using the depreciating asset or having it installed ready for use for any purpose and expects never to use it or have it installed ready for use again; • the taxpayer has not used the depreciating asset and either stops having it installed ready for use or decides never to use it; or
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• there is a change in the interests or holding of the depreciating asset and it was a partnership asset before the change or becomes one as a result of the change. A balancing adjustment event does not occur simply because the taxpayer splits or merges a depreciating asset: s 40-295(3). The most common balancing adjustment event is the disposal of a depreciating asset but there can also be a balancing adjustment for assets that become redundant. Balancing adjustments effectively adjust for the over or under depreciation of an asset which has been calculated using the asset’s estimated effective life. The balancing adjustment amount is calculated under s 40-285 by comparing the asset’s “termination value” with its “adjustable value”. Where, broadly: • Termination value = Amount received by the taxpayer in relation to the balancing adjustment event or its market value at the time of the event in the case of redundant assets and non-arm’s length transactions: s 40-300; and • Adjustable value = Cost of the asset minus prior year decline in value minus decline in value for the current year up to the date of the balancing adjustment event: s 40-85. Note that the cost of the asset
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522 [14.110] PRINCIPLES OF TAXATION LAW 2020 is reduced by its decline in value over the relevant period, not the depreciation deductions claimed by the taxpayer thus far. Any use of the asset for non-taxable purposes is taken into account under s 40- 290: see [14.115]. Where: • Termination value > Adjustable value, the difference is included in the taxpayer’s assessable income for the year: s 40-285(1); and • Termination value < Adjustable value, the difference is a deduction for the taxpayer that year: s 40-285(2).
Example 14.13: Disposal of a depreciating asset Following on from Example 14.8, assume that Kieran sold the refrigerator on 30 September Year 3 for $1,500. Decline in value calculated using the diminishing value method: Termination value = $1,500 (amount received on disposal) Adjustable value = $2,000−$317−$71 = $1,612 Where: Depreciation for Year 2 = $317 (as calculated in Example 14.8) Depreciation from 1 July to 30 September Year 3 = ($2,000−$317) × (92/365) × (200%/12) = $71
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Termination value ($1,500) < Adjustable value ($1,612). Therefore, Kieran is entitled to a deduction of $112 in relation to the disposal of the refrigerator. Decline in value calculated using prime cost method: Termination value = $1,500 (amount received on disposal) Adjustable value = $2,000−$158−$39 = $1,803 Where: Depreciation for Year 2 = $158 (as calculated in Example 14.8) Depreciation for 1 July to 30 September Year 3 = ($2,000−$158) × (92/365) × (100%/12) = $39 Termination value ($1,500) < Adjustable value ($1,803). Therefore, Kieran is entitled to a deduction of $303 in relation to the disposal of the refrigerator. In either case, Kieran is entitled to a deduction in relation to the disposal of the refrigerator. However, the amount of the deduction will depend on which method Kieran used to calculate his depreciation deductions.
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Depreciating asset used for non-taxable purpose [14.115] Where the depreciation deductions have been reduced because the taxpayer used the depreciating asset for non-taxable purposes, s 40-290 of ITAA 1997 reduces the balancing adjustment amount calculated under s 40- 285. The reduction is calculated as follows: Sum of reductions × Balancing adjustment amount Total decline
Broadly: • The sum of reductions is the sum of the reductions to depreciation deductions due to the use of the depreciating asset for non-taxable purposes; and • The total decline is the total decline in value of the depreciating asset since the taxpayer started to hold it.
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Example 14.14: Disposal of a depreciating asset partly used for income-producing purpose Following on from Example 14.12, assume Naresh bought the chainsaw on 1 July and sold it on 30 June of the following year for $1,500. Termination value = $1,500 (amount received on disposal) Adjustable value = $3,000 (cost)−$1,000 (depreciation until date of disposal from Example 14.12) = $2,000 As Termination value ($1,500) < Adjustable value ($2,000), Naresh is entitled to a deduction of $500 in relation to the disposal of the chainsaw. However, as Naresh used the chainsaw only partly for income-producing purposes, the balancing adjustment amount must be reduced under s 40-290 as follows: $700 ( the total reduction in depreciation deductions )
$1000 ( the total decline in value since Naresh started to hold the chainsaw )
× $500 0 = $350
Therefore, Naresh is entitled to a deduction of $150 on the disposal of the chainsaw.
Interaction with capital gains provisions [14.118] In some cases, a balancing adjustment event may also give rise to a CGT event: see [11.40]. As mentioned earlier, the capital allowances provisions take precedence over the capital gains provisions and any capital gain or loss
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524 [14.120] PRINCIPLES OF TAXATION LAW 2020 on a depreciating asset is disregarded under s 118-24 of ITAA 1997. However, where the asset is only partly used for a taxable purpose, the asset is only partly accounted for under the capital allowances provisions (as we have seen, the decline in value deduction and balancing adjustment amount are reduced for any use of the asset for a non-taxable purpose). In this case, the capital gains provisions have residual operation in relation to the part of the asset that is not used for a taxable purpose and CGT event K7 (see [11.150]) may happen to the asset at the time of the balancing adjustment event.
Roll-over relief [14.120] Taxpayers may be entitled to roll-over relief in relation to a balancing adjustment amount in certain circumstances. Automatic roll-over relief applies where there is a disposal of a depreciating asset that involves a CGT event and one of the following items applies: • the asset is disposed to a wholly owned company; • the asset is disposed by a partnership to a wholly owned company; • the asset is transferred from a trust to a company under a trust restructure; • the disposal occurs because of a marriage or relationship breakdown; or • the asset is disposed of to another member of the same wholly owned group.
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In this situation, the relief depends on the relevant event and is specified in s 40-340(1) of ITAA 1997. Taxpayers may choose roll-over relief where the balancing adjustment event happens under s 40- 295(2) (ie, a change in the holding or interests of a partnership asset) and the transferor and the transferee choose for roll-over relief to apply: s 40-340(3). The roll-over relief is that the balancing adjustment event does not happen and the transferee deducts the decline in value of the asset using the same method and effective life that the transferor was using: s 40-345. Where there is an involuntary disposal of a depreciating asset for one of the reasons specified in s 40-365(2) (eg, the asset is lost or destroyed) and the taxpayer has a replacement asset, the taxpayer can choose to reduce some or all of any amount that is included in the taxpayer’s assessable income (ie, the balancing adjustment amount) as a result of the balancing adjustment event. The amount that is not included in the taxpayer’s assessable income must be applied to reduce the cost of the replacement asset: s 40-365(1).
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Cars [14.125] There are a number of special rules for “cars” which may deny a deduction for depreciation or limit the amount of the deduction. “Car” is defined in s 995-1 of ITAA 1997 as a motor vehicle (except a motor cycle or similar vehicle) designed to carry a load of less than one tonne and fewer than nine passengers. As mentioned earlier, taxpayers cannot claim a deduction for depreciation in relation to a car where the deductions for car expenses have been calculated in accordance with the cents per kilometre method (see Chapter 12) in that year: s 40-55. Under s 40-230, the cost of a car for the purposes of calculating the decline in value is limited to the “car limit” for the financial year in which the taxpayer started to hold the car. The limit does not apply to cars fitted out for transporting disabled people in wheelchairs: s 40-230(2). The “car limit” is specified by the Commissioner each year and, for the 2019–2020 income year, the car limit is $57,581. The car limit is applied after taking into account any GST input tax credits (see [25.230]) that the taxpayer may be entitled to in relation to the car: Determination TD 2006/40.
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Example 14.15: Calculating the decline in value of a car Hoong purchased two new cars on 1 January 2020 for $110,000 (including GST) and $59,000 (including GST) each. He uses the cars entirely for income-producing purposes. The effective life of a car is eight years. Hoong is entitled to input tax credits of $5,235 in respect of the acquisition of each car. As we will see in Chapter 25, the input tax credits for a car are also limited by the car limit and are therefore equal to $57,581/11. In the 2019–2020 income year, Hoong would calculate his depreciation deductions as follows: Car 1 The cost of the car is reduced by the input tax credits of $5,235 to $104,765. As this amount exceeds the car limit, the cost of the car is further reduced to the car limit of $57,581. Hoong’s depreciation deduction in relation to the car is calculated as follows: Diminishing value method: Base value ×
Days held 200% × : s 40-72 8 365
= $57, 581 ×
182 200% × 365 8
= $7,138
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526 [14.130] PRINCIPLES OF TAXATION LAW 2020
Prime cost method: Asset ’ s cost ×
Days held 100% × : s 40-75 8 365
= $57, 581 ×
182 100% × 365 8
= $3, 569
Car 2 The cost of the car is reduced by the input tax credits of $5,235 to $53,765. As this amount does not exceed the car limit, the cost of the car will not be further reduced under s 40-230. Hoong’s depreciation deduction in relation to the car is calculated as follows: Diminishing value method: Base value ×
Days held 200% × : s 40-72 8 365
= $53,765 ×
182 200% × 365 8
= $6, 665
Prime cost method: Asset ’ s cost ×
Days held 100% × : s 40-75 8 365
= $53,765 ×
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182 100% × 365 8
= $3,333
Finally, the calculation of the balancing adjustment amount for a car will depend on the method used for calculating car expenses (see Chapter 12) s 40-285(2) Note 1 and s 40-370. The termination value of the car is adjusted under s 40- 325 where the cost of the car was limited to the “car limit”.
Pooling of assets [14.130] Taxpayers have the choice of claiming deductions for the decline in value of certain assets on a group basis under subdiv 40-E of ITAA 1997. The pooling of assets reduces compliance costs for taxpayers as individual depreciation calculations are not required for each asset. There are two asset pools in subdiv 40-E which may be utilised by taxpayers: • low-value pool: see [14.140]; and • software development pool: see [14.160].
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Low-value pool [14.140] Under s 40- 425 of ITAA 1997, taxpayers have the option of establishing a low-value pool for any “low-cost” or “low-value” assets. A “low-cost” asset is a depreciating asset (except a horticultural plant) whose cost at the end of the income year in which the taxpayer started to use it, or have it installed ready for use, for a taxable purpose is less than $1,000: s 40-425(2). We have already discussed “cost” at [14.90] and “taxable purpose” at [14.100].
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A “low-value” asset is a depreciating asset (except a horticultural plant) held by the taxpayer that has been depreciated using the diminishing value method and has an opening adjustable value of less than $1,000: s 40-425(5). “Opening adjustable value” is discussed at [14.90]. However, the following assets cannot be added to the low-value pool: • Assets that qualify for an immediate deduction under s 40-80(2) –that is assets that cost less than $300 and are used for an income-producing purpose other than in a business: s 40-425(4). • Assets that are deductible under subdiv 328-D –that is in respect of capital allowances for small business entities (see [14.165]): s 40-425(7). • Assets used in research and development activities which qualify for a deduction under s 73BA of ITAA 1936: s 40-425(8). Note that although taxpayers have the option of using a low-value pool, once a taxpayer creates a low-value pool (ie, by allocating a low-cost asset to a low- value pool), all low-cost assets held by the taxpayer in that year and future years must be added to the pool: s 40-430(1). The taxpayer continues to have an option as to whether or not to add low-value assets to the pool on an individual asset basis. Example 14.16: Allocating assets to a low-value pool Tanya runs her own bakery in Perth. Assume that it is not a “small business entity”. Tanya is depreciating her oven and refrigerator using the diminishing value method due to their substantial cost. She depreciates all other assets, such as tables and chairs, using the prime cost method as it is easier. Tanya has also chosen to use a low-value pool. This year, Tanya acquired a new display rack for $200 and a television for customers for $700. She has also determined that the opening adjustable value (ie, the cost less the decline in value in previous years) of the refrigerator is $1,500 and the oven is $900. Tanya must add the display rack and television to her low-value pool as they are low-cost assets. Although the display rack costs less than $300, it is not immediately deductible as Tanya uses it in her business.
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528 [14.145] PRINCIPLES OF TAXATION LAW 2020
The oven is a low- value asset as it has been depreciated using the diminishing value method and has an opening adjustable value less than $1,000. Tanya can choose whether or not to add the oven to the low- value pool. The refrigerator does not qualify as a low-value asset and cannot be added to the low-value pool this year, although it may qualify in future years once its opening adjustable value is less than $1,000. The other assets must continue to be depreciated in accordance with the prime cost method and can never be added to the low-value pool as they will not qualify as low-cost or low-value assets. [14.145] Taxable purpose. As with the general depreciation provisions, depreciation deductions are only available in respect of low-value pool assets to the extent that the assets are used for a taxable purpose. Taxpayers are required to make a reasonable estimate of the taxable use percentage of the asset when the asset is allocated to the low-value pool: s 40-435 of ITAA 1997. The taxable use percentage is the extent to which the asset will be used for taxable purposes over its remaining effective life. The amount that is allocated to the low-value pool in relation to an asset is its cost multiplied by the taxable use percentage.
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Example 14.17: Taxable use percentage of low-cost and low-value assets Paul uses a low-value pool for depreciating assets. This year he purchased a printer for $550. Paul must allocate the printer to the low-value pool as it is a low-cost asset. The effective life of a printer is three years. Paul estimates that he will use the printer 50% for income-producing purposes in the first year, 70% for income-producing purposes in the second year and 30% for income-producing purposes in the third year. The taxable use percentage of the printer will be 50% ((50+70+30)/3). Paul will allocate $275 to his low-value pool this year in relation to the printer. Paul has also reviewed all of his assets that are being depreciated using the diminishing value method. He determined that the opening adjustable value of two of the assets is less than $1,000. Paul has a choice whether to allocate the assets to the low-value pool as they are low-value assets. He decides to allocate one of the assets, a mahogany table, to the low-value pool. The opening adjustable value of the table is $700. Paul determines that the remaining effective life of the table is two years. He will use the table 30% for income-producing purposes in the first year and 100% for income- producing purposes in the second year. The taxable use percentage of the table will be 65% ((30+100)/2). Paul will allocate $455 (65% × $700) to the low-value pool this year in respect of the table.
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Note that the determination of taxable use percentage is done at the time that the asset is allocated to the low-value pool and the legislation does not allow for any change to the value of the asset once it is in the pool to take into account any change of purpose.
Example 14.18: Taxable use percentage of low-cost assets Kerry owns an investment property in Melbourne. She purchased a clothes dryer for the property for $990. She maintains a low-value pool and must allocate the clothes dryer to the low-value pool as it is a low-cost asset. At the time of allocating the asset to the low-value pool, Kerry estimated that the dryer would be 100% used for income- producing purposes over its effective life as the property would be rented out to tenants. Kerry allocated $990 to the low-value pool in relation to the dryer. Due to unforeseen circumstances, Kerry was forced to move into the property the following year and could no longer rent it out to tenants. Kerry must continue to work out the decline in value of the dryer based on her original reasonable estimate of the taxable use percentage of the asset under s 40-435 even though the taxable use percentage has changed. Source: Adapted from former ATO ID 2004/940.
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[14.150] Decline in value. The decline in value of low-value pool assets is calculated in accordance with s 40-440(1) of ITAA 1997 as follows: • Step 1: Multiply the taxable use percentage cost of any low-cost assets allocated to the low-value pool in the current year by 18.75%. • Step 2: Multiply the taxable use percentage of any second element costs incurred that year relating to low-value assets added to the pool in that year or an earlier year by 18.75%. • Step 3: Multiply the closing pool balance for the previous year and the opening adjustable values of low-value assets added to the pool that year by 37.5%. • Step 4: Sum up the amounts in Steps 1, 2 and 3. The result is the decline in value of the low-value pool. The closing pool balance for the current income year is the sum of the closing pool balance for the previous year plus the taxable use percentage of any low- cost and low-value assets added to the pool in the current year, less the decline in value of the pool calculated under s 40-440(1): s 40-440(2).
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530 [14.155] PRINCIPLES OF TAXATION LAW 2020
Example 14.19: Decline in value of low-value pool Nicholas runs his own personal training business. He chooses to use a low-value pool for qualifying assets. In Year 1, he purchased a table for $700 and a printer for $600. He estimates that he will use both of these assets 100% for income-producing purposes over their effective lives. In Year 1, the decline in value of Nicholas’ low-value pool is 18.75% × $1,300 = $244. The full cost of both assets is added to the pool as their taxable use percentage is 100%. The closing pool balance is $1,056 (ie, $1,300−$244). In Year 2, Nicholas purchases a fancy new phone for the business for $750. He also determines that the opening adjustable value of a piece of equipment depreciated using the diminishing value method is $900. Nicholas estimates that the taxable use percentage of the phone over its effective life is 90%. He estimates that the taxable use percentage of the equipment for the remainder of its effective life is 100%. In Year 2, the decline in value of Nicholas’ low-value pool is:
• Step 1: $750 × 90% × 18.75% = $127
• Step 2: Not applicable.
• Step 3: ($1,056 × 37.5%) + ($900 × 37.5%) = $396 + $337.50 = $733.50
• Step 4: Decline in value = $127 + $733.50 = $860.50
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The closing pool balance in Year 2 is [$1,056 + ($750 × 90%) + $900] – $860.50 = $1,770.50.
[14.155] Balancing adjustment events. Where a balancing adjustment event (see [14.110]) happens to an asset in a low-value pool, the taxable use percentage of the asset’s termination value (see [14.110]) is deducted from the closing pool balance: s 40-445(1) of ITAA 1997.
Example 14.20: Disposal of low-value pool asset Following on from Example 14.19, Nicholas disposed of the printer in Year 2 for $300. The decline in value of the low-value pool in Year 2 is calculated as above. However, the closing pool balance in Year 2 will be $1,470.50 ($1,770.50−$300) to take into account the disposal of the printer. The full $300 is deducted from the closing pool balance as the taxable use percentage of the printer was 100%.
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Where the taxable use percentage of the asset’s termination value is greater than the closing pool balance, the closing pool balance is reduced to zero and the excess is included in the taxpayer’s assessable income in that year: s 40-445(2). Example 14.21: Disposal of low-value asset Following on from Example 14.19, assume that Nicholas disposed of the printer in Year 2 for $2,000 to a collector who was willing to pay such a high price. The decline in value of the low-value pool in Year 2 is calculated as per Example 14.19. However, the closing pool balance in Year 2 will be 0 ($1,770.50−$2,000) to take into account the disposal of the printer. The full termination value of the printer is deducted from the closing pool balance as the taxable use percentage of the printer was 100%. However, the deduction cannot take the pool balance below 0. The excess of $229.50 ($2,000−$1,770.50) is added to Nicholas’ assessable income per s 40-445(2).
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Software development pool [14.160] Taxpayers who develop software are generally required to capitalise any expenditure associated with the development of the software. Once the project is completed and the software is used or ready for use in the business, the taxpayer is entitled to claim a deduction for the decline in the value of the asset over the period of its effective life. Tracking all expenditure related to the development of software can be quite onerous and significantly increase taxpayers’ compliance costs. As such, taxpayers have the option of allocating any expenditure incurred in developing “in- house software” to a pool under s 40-450 of ITAA 1997. “In-house software” is defined in s 995- 1 as computer software or a right to use computer software that the taxpayer acquires, develops or has another entity develop that is used mainly in performing the functions for which the software was developed and which is not deductible under another provision of the tax legislation outside Div 44 (eg, the general deduction provision in s 8-1) and Div 328 (the small business provisions). Only expenditure incurred by the entity in developing or having another entity develop in-house software can be added to a software development pool –that is the costs of acquiring in- house software cannot be added to the pool: s 40-450(1). Further, in-house software expenses can only be added to a pool where the software is used solely for a taxable purpose: s 40-450(3). Once a taxpayer chooses to use an in-house software development pool, all such expenditure must be allocated to the pool: s 40-450(2). The taxpayer must
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532 [14.165] PRINCIPLES OF TAXATION LAW 2020 create a separate pool in each income year that the taxpayer incurs expenditure on in-house software development: s 40-450(4). The decline in value of in-house software development pool expenditure is calculated per s 40-455 as follows: • first year expenditure allocated to the pool –no deduction; • second year expenditure in pool – 30%; • third year expenditure in pool – 30%; • fourth year expenditure in pool –30%; and • fifth year expenditure in pool – 10%. This calculation applies to income years starting on or after 1 July 2015. Prior to that date, the decline in value of in- house software development pool expenditure was deducted over four years –no deduction in the first year, 40% deduction in the second and third years and 20% deduction in the fourth year. The taxpayer is required to include in its assessable income any consideration received in respect of the software if the expenditure relating to the software was added to a software development pool: s 40-460.
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Small business entity concessions [14.165] Finally, it should be noted that subdiv 328- D of ITAA 1997 contains a number of concessions in the form of simpler depreciation rules for small business entities. In this context, a “small business entity” is a sole trader, partnership, company or trust that operates a business for all or part of the income year and has an aggregated turnover of less than $10 million. Broadly, “aggregated turnover” is the entity’s turnover plus the annual turnover of any business that is connected or affiliated to the entity. Instead of calculating depreciation deductions under the general depreciation provisions in Div 40, small business entities can choose to claim depreciation deductions in accordance with the provisions of subdiv 328-D: s 328-175(1). Subdiv 328-D does not apply to a depreciating asset to which Div 40 does not apply because of s 40-45 (see [14.20]) although there are some exceptions to this general rule (eg, primary production business assets): s 328-175(2)-(10). Under subdiv 328-D, small business entities can: • claim an immediate deduction for assets costing less than $1,000: s 328-180; and • put all other assets into a general small business pool and treat them as if they are a single asset subject to one rate: s 328-185. The threshold for immediate deduction is increased for assets acquired after 12 May 2015 to:
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• $20,000 if the asset was first used or installed ready for use for a taxable purpose before 29 January 2019; • $25,000 if the asset was first used or installed ready for use for a taxable purpose on or after 29 January 2019 and before 7:30 pm 2 April 2019; or • $30,000 if the asset was first used or installed ready for use for a taxable purpose on or after 7:30 pm 2 April 2019 and before 30 June 2020. See Note to s 328-180(1). Medium- sized businesses (ie, with aggregated annual turnover between $10 million and $50 million) can immediately deduct assets costing less than $30,000 that are first used or installed ready for use for a taxable purpose between 7:30 pm 2 April 2019 and 30 June 2020.
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The general small business pool is effectively treated as a single asset and under s 328-190, small business entities are entitled to a deduction of: • 30% of the value of the assets already in the general small business pool (ie, 30% × opening pool balance); and • 15% of the value of general small business pool assets acquired in the current income year. The opening pool balance is determined in accordance with s 328-195. Note that only the taxable use proportion of the asset’s cost is added to the pool: s 328-205. However, unlike the general low-value pool discussed earlier, small business entities are required to make a reasonable estimate of the taxable purpose of any pooled assets each income year and make an adjustment to the opening pool balance to take into account any change of taxable purpose if necessary: s 328-225. The closing pool balance is determined in accordance with s 328-200 and takes into account the disposal of pool assets by deducting the asset’s termination value from the pool balance. If the reduction results in the pool balance being less than 0, the pool balance is taken to be 0 and the excess is included in the taxpayer’s assessable income: s 328-215(2). In the case of the disposal of an asset which qualified for an immediate deduction, the termination value is included in the taxpayer’s assessable income: s 328-215(4). Where the general small business pool value is low, the deduction is determined in accordance with s 328-210 rather than s 328-190. This is determined by calculating the following amount: • Opening pool balance + Taxable use % of cost of new assets − Taxable use % of termination values of depreciating assets allocated to the pool for which a balancing adjustment event occurred during the year. Where that amount is less than $1,000 but more than 0, the taxpayer can claim an immediate deduction for the total amount and where that amount is less
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534 [14.170] PRINCIPLES OF TAXATION LAW 2020 than 0, the taxpayer must include the amount by which that amount is less than 0 in assessable income: ss 328-210 and 328-215. For income years ending on or after 12 May 2015 and on or before 30 June 2020, the threshold for immediate deduction is increased to $20,000, $25,000 or $30,000 as applicable (see above): Note 2 to s 328-210(1). Taxpayers may choose not to use subdiv 328-D or may cease to qualify as a small business entity in a particular year. In such situations, any pooled assets continue to remain in the pool and deductions are claimed in accordance with subdiv 328-D: s 328-220(1). However, any depreciating assets that the taxpayer starts to hold in that year are not added to the pool and depreciation deductions in relation to those assets are calculated in accordance with the general capital allowances provisions in Div 40: s 328-220(2).
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Capital works deductions [14.170] Division 43 of ITAA 1997 provides taxpayers with a deduction for certain capital expenditure on buildings used for income-producing purposes and other capital works. Section 43-20 specifies the capital works to which the division applies as: • A building or an extension, alteration or improvement to a building begun in Australia after 21 August 1979 or begun outside Australia after 21 August 1990. • Capital works begun after 26 February 1992 (that do not fall within the first category) that are structural improvements or extensions, alterations or improvements to structural improvements in or outside Australia. Examples of structural improvements include sealed roads, sealed driveways, sealed car parks, bridges, pipelines, retaining walls, fences, concrete or rock dams and sports fields. • Capital works being earthworks or extensions, alterations or improvements to earthworks if they are constructed as a result of environmental protection activities can be economically maintained in reasonably good order and condition for an indefinite period, are not integral to the construction of capital works and the expenditure was incurred after 18 August 1992. Very broadly, the expenditure is deductible over a specified period at a rate of either 4% or 2.5% per annum: s 43-25. The exact calculation is complex and depends on the type of capital works, the use of the “construction expenditure area” (eg, residential or non-residential buildings) and when the capital works commenced. The Commissioner’s guidance in relation to the operation of Div 43 is in Ruling TR 97/25. Note that deductions are only available once construction is completed: s 43- 30. The amounts that are deductible must be “construction expenditure”: s
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43-15. “Construction expenditure” is capital expenditure incurred in respect of the construction of capital works but does not include expenses such as expenditure on acquiring land, demolishing existing structures, landscaping or expenditure on plant: s 43-70. Deductions must be claimed within a period of 25 years (where the 4% rate is used) and 40 years (where the 2.5% rate is used). Unlike the capital allowances regime in Div 40, Div 43 does not address the disposal of a building that has been the subject of capital works deductions – that is there is no “balancing adjustment”. The disposal of buildings is captured by the capital gains provisions and any capital works deductions are taken into account by adjusting the cost base or reduced cost base of the building: see Chapter 11. Cost base or reduced cost base is reduced by any Div 43 deductions. Therefore, the taxpayer will have a capital gain if the building is sold for more than its written down value and a capital loss if it is sold for less than its written down value. Additional deductions may be available under s 43-250 where the building is destroyed rather than sold. Where the building is not a capital asset of the taxpayer, no adjustment is made for the capital works deductions claimed (MLC Ltd v DCT (2002) 51 ATR 283) and any undeducted capital works expenditure is transferred to the purchaser who is allowed the deductions under s 43-10.
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Black hole expenses [14.180] In Chapter 12, we saw that non- personal expenses may not be deductible under s 8- 1 of ITAA 1997 if they are incurred before the commencement of a business or production of assessable income, or if they are capital expenses. Some of these expenses may be deductible over a number of years under the capital allowances provisions discussed in this chapter or they may be taken into account when an event happens to the relevant asset under the capital gains provisions discussed in Chapter 11. However, many expenses did not fall within these regimes and were not recognised for tax purposes, which resulted in them being labelled “black hole” expenses. In 2001, subdiv 40-I was introduced to capture these so-called “black hole” expenses for tax purposes. Subdivision 40- I captures two categories of expenses that may not otherwise be recognised by the tax legislation.
Project pools [14.190] Section 40- 830 of ITAA 1997 provides a deduction for capital expenditure associated with a project that the taxpayer carries on for a taxable purpose (ie, to produce assessable income) and mining or transport capital expenditure. Broadly, the expenses are allocated to a “project pool” and are
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536 [14.200] PRINCIPLES OF TAXATION LAW 2020 deductible over the life of the project. Only expenses that do not form part of the cost of a depreciating asset held by the taxpayer or are not deductible under another provision can be added to the project pool: s 40-840. Examples of capital expenses that can be added to a project pool include feasibility studies, environmental studies, site preparation costs, amounts incurred in seeking to obtain a right to intellectual property and amounts related to creating or upgrading community infrastructure for a community associated with the project: s 40-840(2)(d). “Mining capital expenditure” and “transport capital expenditure” are defined in ss 40-860 and 40-865 respectively. The Commissioner’s guidance on project pools is contained in Ruling TR 2005/4.
Business-related costs [14.200] The second category of “black hole” expenses captured by subdiv 40-I of ITAA 1997 is “business-related costs”. Section 40-880 provides taxpayers with a deduction for business expenses that are not deductible because they are capital in nature. Any expenses that are not deductible because they are private or domestic expenses, incurred in gaining or producing exempt or non-assessable non-exempt income, or specifically denied deductions under a particular provision of the legislation (see Chapter 12) are not deductible under s 40-880: s 40-880(5)(h)–(j).
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Taxpayers are entitled to deduct qualifying capital expenses over a period of five years, where the expense relates to the taxpayer’s business that is carried on for the purpose of gaining or producing assessable income. The expenditure is deducted in equal proportions over the five years: s 40-880(2). The key limitation of s 40-880 is that it only applies to expenses that are not otherwise taken into consideration under the income tax legislation. For example, if the expense relates to a depreciating asset, can be deducted under another legislative provision, forms part of the cost of land or is taken into account in calculating the capital gain or loss on a CGT asset, the expense cannot be deducted under s 40-880: s 40-880(5). In this case, the CGT rules take precedence over s 40-880. Example 14.22: Capital expenditure related to depreciating asset Hamish wants to buy a computer that is not available in Australia for his business. After extensive research, he travels to Germany to purchase the computer. Hamish travels to Germany for the sole purpose of purchasing the computer. The travel costs would not be immediately deductible as they constitute a capital expense but would be included as part of the first element of the cost of the computer because they are directed to and result in the purchase of the computer, which is a depreciating asset. The
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travel costs cannot be deducted under s 40-880 due to the operation of s 40-880(5)(a). Source: Adapted from Example 2.23 in Explanatory Memorandum to Tax Laws Amendment (2006 Measures No 1) Act 2006.
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[14.210] Examples of capital expenditure that may be deducted under s 40- 880 of ITAA 1997 include: • expenditure to establish a business structure –for example, legal expenses or registration costs associated with the formation of a company; • expenditure to change from one business structure to another –for example, legal expenses to change from partnership to company; • expenditure to raise equity for a business –for example, costs of issuing a prospectus, legal costs, advertising costs; • expenditure to defend a business against a takeover –for example, legal expenses, advertising costs, mailing costs, consultancy fees; and • costs to stop carrying on a business, including liquidation and deregistration costs. These expenses would not be deductible under s 8-1 as they are capital expenses (relating to the taxpayer’s business structure rather than business process). They do not relate to a depreciating asset and would not form part of the cost base of a CGT asset (see Chapter 11) and therefore s 40-880 is applicable. Note that the business may be a previous or future business of the taxpayer. Section 40-880(7) states that where the expenditure relates to a proposed business, it must be reasonable to conclude that the business is proposed to be carried on within a reasonable time. This is an objective test that is to be determined on a case-by-case basis. The taxpayer may demonstrate their commitment by having a business plan, establishing business premises, undertaking research on the business and investing in assets. Example 14.23: Capital expenditure relating to proposed business Brewster Pty Ltd carries on a mobile ice cream business. The company spent $5,000 on research into the market for soft drinks with the purpose of establishing a new business. The research indicated that a mobile soft drink business is unlikely to be profitable and, consequently, the new business was not established. Brewster Pty Ltd is entitled to a deduction of $1,000 per year over the next five years as the expenses are capital expenditure relating to a proposed
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business to be carried on for the purpose of gaining or producing assessable income. Source: Adapted from Example 2.3 in Explanatory Memorandum to Tax Laws Amendment (2006 Measures No 1) Act 2006.
Example 14.24: Capital expenditure relating to proposed business June Pty Ltd incurred expenditure on due diligence into a business that it proposed to acquire and carry on. However, the vendor withdrew from the sale before it could be finalised. The expenditure is deductible over five years as a business-related cost. Source: Adapted from Example 2.4 in Explanatory Memorandum to Tax Laws Amendment (2006 Measures No 1) Act 2006.
The Commissioner’s views as to the operation and scope of s 40-880 are contained in Ruling TR 2011/6.
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Start-up expenses [14.215] From 1 July 2015, qualifying individuals and small business entities (see [14.165]) can claim an immediate deduction for expenditure related to a proposed business or proposed structure that would otherwise be deductible over five years under s 40-880: s 40-880(2A). Expenses that may be immediately deductible under this provision include certain government fees and charges, costs associated with raising capital and cost of advice or services related to the proposed business or proposed structure. Individuals can claim an immediate deduction for start-up expenses if they are not carrying on a business and are not connected with, or an affiliate of, an entity that carries on a business that is not a small business entity.
Questions [14.220] 14.1 On 1 June 2018, Rogan purchased a new scooter for $6,000 for use in his business. The Commissioner has assessed the effective life of scooters as three years. Rogan decided to upgrade to a new scooter and sold the old one to a reputable second-hand dealer for $3,000 on 31 August 2019. Rogan estimates that he used the scooter for business purposes 90% of the time.
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Advise Rogan of his income tax consequences arising on the disposal of the scooter under both the diminishing value method and the prime cost method. Assume that Rogan does not qualify as a small business entity. 14.2 Jack and Jill jointly own and run a bed and breakfast business. The business is run through their partnership, J & J Bed and Breakfast. Jack and Jill also own an investment property together which they purchased in equal proportions. During the year, they undertook the following transactions: • Purchased furniture for their bed and breakfast business for $3,000 on 21 December 2019. The furniture is expected to last for seven years. • Purchased a printer for their bed and breakfast business for $700 on 30 April 2020. The machine is expected to last for three years. • Purchased an air- conditioner for their investment property for $2,000 on 15 March 2020. The air conditioner is expected to last for eight years. Jack and Jill contributed to the purchase price of the air conditioner equally. Advise Jack and Jill of their income tax consequences arising out of the above information under both the diminishing value method and the prime cost method (if relevant) for the year ended 30 June 2020. Assume that the business does not qualify as a small business entity. 14.3 Gil has had a long- running dispute with his landlord regarding his tenancy agreement for his store’s premises. Although he has a 10-year lease over the premises, the landlord is trying to get him to vacate the premises early. The premises are integral to the business as Gil has a post office licence which is area specific and Gil would not be able to lease any other premises in the area due to availability and zoning. Advise Gil of his tax consequences in relation to any legal fees incurred in defending his tenancy agreement. 14.4 Acme Pty Ltd acquired a machine from its parent company for $500,000 on 1 January of this year. The market value of the machine at that time was $300,000. The parent company has owned the machine for three years and calculated its depreciation deductions using the prime cost method and an effective life of eight years. Calculate the decline in value of the machine for Acme this income year. Assume that it is not a leap year and Acme is not a small business entity. 14.5 Following on from 14.4, Acme sold the machine to an unrelated party for $400,000 on 1 December of this year. Advise Acme of its tax consequences on disposal of the machine. 14.6 An extract of the asset register of Alpha Pty Ltd (“Alpha”) for the 2018– 2019 income year is as follows:
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540 [14.220] PRINCIPLES OF TAXATION LAW 2020 Asset
Cost
Opening adjustable value
Method
Effective life
Decline in value for this period
Closing adjustable value
Desktop Computer
1,350
1,350
Diminishing Value
3 years
450
900
Furniture
5,000
3,000
Prime Cost
10 years
500
2,500
Filing Cabinets
1,200
1,080
Prime Cost
10 years
120
960
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All depreciable assets are for 100% business use and Alpha uses a low-value pool for all eligible assets. The closing value of the low-value pool at 30 June 2019 was $5,300. Alpha purchased a printer on 5 June 2020 for $700. Advise Alpha of the income tax consequences arising out of the above information for the 2019–2020 income year assuming Alpha is not a small business entity. 14.7 Jacaranda Pty Ltd is a new company operating in Perth, West Australia. The company signed a commercial lease for a period of several years with an option to further extend the lease at its discretion. The company incurred various expenses in making the leased premises suitable for its business. The expenses relate to the leased premises and are considered a capital expense. Advise Jacaranda as to its income tax consequences arising out of the above information.
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15 Offsets
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Key points.................................................................................................... [15.00] Introduction................................................................................................ [15.10] Types of tax offsets.............................................................................. [15.20] Tapered offsets.................................................................................... [15.30] Refundable offsets............................................................................... [15.40] Transferable offsets............................................................................. [15.50] Carried forward offsets........................................................................ [15.60] Tax offsets to recognise taxes already paid............................................. [15.70] Tax offsets for shareholders and superannuation fund members............................................................................... [15.70]
Dividend tax offsets.................................................................................. [15.80] Superannuation benefit offsets............................................................... [15.90] Tax offsets for income subject to foreign tax................................... [15.100] Concessional tax offsets provided as subsidies.................................... [15.110] Concessional tax offsets vs concessional deductions..................... [15.120] Concessional tax offsets to cap income tax rates............................ [15.130] Common concessional offsets................................................................. [15.140] Dependant offset................................................................................ [15.150] Private health insurance offset.......................................................... [15.160] Low income rebate and low and middle income offset................... [15.170] Zone rebate........................................................................................ [15.180] Overseas forces rebate and overseas civilian tax offset.................. [15.190]
Concessional offsets recently phased out or in the process of being phased out...................................................... [15.200] Order of taking offsets............................................................................. [15.210] Questions................................................................................................... [15.220]
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Key points [15.00] • Tax offsets are a partial remission or cancellation of the income tax that would otherwise be payable by a taxpayer. • Because offsets are deducted from income tax payable, they are of equal value to all taxpayers, as opposed to a deduction, which benefits a taxpayer at the taxpayer’s highest marginal tax rate and thus benefits high-income taxpayers more than low-income taxpayers. • The largest group of tax offsets are known as concessional offsets. • Concessional offsets, such as the dependency offset, low income tax offset and medical expenses rebate, provide a subsidy to taxpayers who undertake certain activities or responsibilities. • Some concessional offsets are tapered or reduced as a taxpayer’s income increases. • Certain offsets, such as the franking credit, compensate a taxpayer for tax already paid. • To prevent double taxation, taxpayers may receive an offset for foreign tax paid.
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Introduction [15.10] We saw in Chapter 3 that there were three steps to determining how much income tax a taxpayer must remit to the Australian Taxation Office (ATO): 1. determine taxable income: • add up the assessable income; • subtract deductions; 2. determine the “basic” tax liability: • multiply the taxable income × the tax rate or rates; 3. reduce the basic tax liability by tax offsets to which the taxpayer is entitled. Tax offsets are in effect a partial remission or cancellation of the income tax that would otherwise be payable by a taxpayer. Over the years, they have had a variety of names in the income tax laws. The current term “offsets” was first used in the law in 1997. Prior to that, they were known as tax “rebates” or tax “credits”. Several older parts of the law have been amended to replace “rebates” and “credits” with the term “offsets”. However, the term “rebate” continues to be used in a number of sections, particularly in the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). A full list of available offsets is found in s 13-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).
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Types of tax offsets [15.20] There are two types of tax offsets: • offsets to provide recognition for other taxes previously levied on income received by a taxpayer; and • concessional offsets provided as subsidies for various types of activities carried out by or responsibilities assumed by taxpayers. Offsets intended to provide recognition for other income tax previously levied on income fall into two categories. The first deals with distributions from companies where the distributed profits were taxed in the hands of the companies when realised by the entities. The offset on distributed profits prevents double taxation of the profits in Australia. The second deals with foreign source income that was subject to tax in the jurisdiction from which it derives. A foreign tax offset provides taxpayers a credit for foreign taxes previously paid on the same income. Generally, offsets may only be claimed against income tax payable (excluding Medicare levy and Higher Education Loan Program (HELP) liability) in the year in which they arise. However, in a limited number of circumstances, offsets may be refundable, transferable to another person or able to be carried forward to be used in future years.
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Tapered offsets [15.30] To reduce the value of a concessional (subsidy) tax offset to higher- income taxpayers, the government may make the offset a “tapering” tax offset, which reduces by a specified percentage for each dollar of taxable income a taxpayer has in excess of a predetermined threshold. An example of a tapering offset which is contained in our income tax regime is the low income tax offset. The maximum offset is $445 for the 2019–2020 income year, reduced by 1.5 cents for every dollar of income exceeding $37,000. Example 15.1: Tapered offset: Low income tax offset Edward has a low income that qualifies for the low income tax offset (still technically called a “rebate” in the law). His taxable income in the year ending 30 June 2020 is $40,000. Edward is entitled to the following rebate: $445 –(($40,000 –$37,000) × 0.015) = $400
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544 [15.40] PRINCIPLES OF TAXATION LAW 2020
Refundable offsets [15.40] Tapering can be used to reduce the value of tax offset subsidies for higher- income persons. However, it cannot address the problems of low- income persons with tax liabilities less than the amount of the offset. The offset reduces the basic tax liability, but some or all of the subsidy will be lost where the tax offset exceeds the basic tax liability or where the taxpayer has no basic tax liability. A similar problem arises in respect of corporate taxpayers that are in a loss position and unable to use additional offsets. To address this problem, the government sometimes uses “refundable” tax offsets. A refundable tax offset will be paid out in cash to a taxpayer to the extent the offset exceeds the taxpayer’s income tax liability. This ensures that lower-income persons with small tax liabilities can enjoy the full benefit of a tax offset. At this time, only a small number of offsets have been made refundable.
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Examples of refundable tax offsets contained in the income tax regime include: • the private health insurance tax offset for individuals (found in s 61-205 of the ITAA 1997) which helps subsidise the cost of private health insurance. Section 67-23 of the ITAA 1997, Item 5 makes this offset a refundable offset; • the research and development (R&D) tax offset for companies (under Div 355) which provides an incentive for companies to undertake approved R&D activities for the benefit of Australia. The tax offset is refundable when an eligible entity has an aggregated turnover less than $20 million; • the Junior Minerals Exploration Incentive (JMEI) provides an option for eligible companies to distribute losses from greenfield mineral exploration expenditure to shareholders as a refundable tax offset. The rule applies for three years, from the 2017–2018 year through to the 2020–2021 year, with a cap on the total funding available for the offset in each year.
Transferable offsets [15.50] An alternative to a refundable tax offset to provide assistance to a taxpayer unable to fully utilise an offset is a “transferable” offset that can be transferred to another taxpayer who (hopefully) has a tax liability that can absorb the offset. Example 15.2: Transferable offset Sonya is married to Russell, and they lived together for the whole 2018– 2019 income year. Russell, who is a veteran, received a service pension.
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Sonya and Russell were both over pension age and their combined taxable income was less than the maximum threshold. They were both eligible for the low-income aged persons and pensioners tax offset (often referred to as the “senior Australians and pensioners tax offset”) available under s 160AAAA of the ITAA 1936. Sonya’s taxable income was $24,800 and Russell’s was $10,200. Any tax offset that Russell does not use will be automatically transferred to Sonya and taken into account when her tax liability is calculated.
Carried forward offsets [15.60] A third approach that can be used to save the value of an excess tax offset is to allow the taxpayer entitled to the offset that cannot be used to “carry forward” the offset and apply it against a tax liability in future years. Most entitlements to carry forward unused offsets have been removed and at present there are only two types of tax offset that can be carried forward, an offset that arises in some circumstances in the company imputation rules and an offset for “early stage investors in innovation companies”.
Tax offsets to recognise taxes already paid
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Tax offsets for shareholders and superannuation fund members [15.70] There are two types of offsets used to recognise taxes already paid on income received by a taxpayer. The first type is an offset provided, where income is distributed from an entity that has paid tax on profits when they were realised by the entity. The second type is an offset provided, where income is sourced overseas and has already been taxed in the foreign country from which it derives. Two types of tax offsets are provided to persons who receive distributions from separate entities that have been subject to tax. These offsets are provided to shareholders of companies and members of superannuation funds. In both of these cases, entities in which a taxpayer holds an interest are subject to tax. However, as the entities are merely legal creatures, the true economic burden of the tax paid by a company or superannuation fund is borne by the taxpayers with interests in the company or superannuation fund. The tax offsets for some types of dividends paid by companies and for benefits paid by superannuation funds recognise this by effectively treating the tax paid by the companies and superannuation funds as if it had been paid by the investors with interests in the companies and funds.
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546 [15.80] PRINCIPLES OF TAXATION LAW 2020
Dividend tax offsets [15.80] As explained in Chapter 21, companies maintain an account that records the taxes they have paid and the amount of retained earnings that have already been subject to tax at the company level. When these taxed profits are distributed to shareholders as dividends, the shareholders are entitled to an offset equal to the tax that has been paid at the company level. The effect of the formula is to treat the company as a type of agent of the shareholder. Profits distributed by the company are adjusted to the pre- company tax amounts and fully assessed in the hands of the shareholder as if they had been earned directly by the shareholder and not through an intermediary company. The resulting tax liability is reduced by a tax offset equal to the taxes paid by the company on the profit that has been distributed as if the company tax were a prepayment of tax on behalf of the shareholder: s 207-20 of the ITAA 1997.
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The combination of rules that: • require companies to establish an account that shows whether dividends were paid from fully taxed income; • require shareholders to “gross- up” dividends paid from fully taxed income to the original pre-company tax amount; and • provide shareholders with a tax offset equal to the company tax that was paid on the profits that are distributed, is known as the imputation system. It is described in detail in Chapter 21. Imputation offsets are treated as refundable offsets as a result of s 67-25 of the ITAA 1997, which means shareholders who are entitled to imputation offsets may claim a refund of any offsets that exceed their income tax liability for a year.
Superannuation benefit offsets [15.90] A superannuation fund is a savings vehicle (normally a trust) that invests retirement savings for its members. Amounts contributed to a superannuation fund by an employer on behalf of employees are exempt from tax in the hands of the employees but are subject to tax when received by the superannuation fund. Income derived from the investment of those contributions is also subject to tax when derived by the superannuation fund. Most superannuation benefits paid to persons aged 60 or older are exempt from tax, but other superannuation benefits are taxable in the hands of recipients. The taxation of benefits paid from superannuation funds and other types of retirement income is described in Chapter 18. To prevent double taxation when the previously taxed income is later distributed to recipients in the form of taxable superannuation benefits,
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ss 301-20–301-115 of the ITAA 1997 provide the recipients with superannuation benefits tax offsets that compensate for the tax which was borne by the superannuation fund and, in some cases, provide additional concessional tax reductions. Any unused tax offset for superannuation benefits is not refundable or transferable and cannot be carried forward.
Tax offsets for income subject to foreign tax [15.100] It was explained in Chapter 4 that residents of Australia are subject to tax on income from Australian and non- Australian sources while non- residents are only assessable on Australian-sourced income. This basic system is used by many countries –residents are taxed on worldwide income and non-residents on local source income. This means that income derived by Australian residents in other countries may be subject to tax in the source countries as well as in Australia. To prevent double taxation of this income, Australia provides residents with a tax offset equal to the foreign tax levied on the income (subject to a cap of the Australian tax otherwise payable, where the foreign tax is higher than the Australian tax): s 770-10 of the ITAA 1997. The foreign income tax offset system is described in more detail in Chapter 22. Any unused foreign income tax offset is not refundable or transferable and cannot be carried forward.
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Concessional tax offsets provided as subsidies [15.110] The largest group of tax offsets in the income tax laws are concessional measures, inserted in the income tax legislation to provide direct subsidies for particular groups of taxpayers or for taxpayers undertaking activities the government wishes to subsidise. The tax forgone as a result of these concessional offsets is treated as the equivalent of a direct government grant or expenditure and is recorded in a “Benchmarks and Variations Statement” (previously titled the “Tax Expenditures Statement”) published annually by the Treasury. Concessional tax offsets fall into two broad categories. One type of offset is used to “cap” the tax imposed on a particular type of income. When this type of offset operates, the ordinary tax rules apply to a taxpayer and then the offset operates to in effect cancel the tax payable above the concessional cap rate. The second type of tax offset applies without regard to tax rates, providing a fixed credit against tax payable.
Concessional tax offsets vs concessional deductions [15.120] A number of concessional tax offsets such as the dependency offset and the former medical expenses rebate were once provided as concessional
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548 [15.120] PRINCIPLES OF TAXATION LAW 2020 deductions. Taxpayers were allowed to deduct a wide range of personal expenses when calculating their taxable income. These concessions were strongly criticised for their “upside-down” effect –a term used to describe the fact that they provided the greatest benefit to those with highest incomes and the least benefit to those with lower incomes. In contrast, a tax offset can provide the same benefit for taxpayers with different incomes who incur similar personal expenses because it is not affected by the taxpayers’ tax brackets. It is simply a remission of tax based on a percentage of the eligible expenses.
Example 15.3: Concessional tax deductions vs concessional tax offsets Assume a high-income taxpayer facing a 45% tax rate, a low-income taxpayer facing a 19% tax rate and a very low-income taxpayer (with a taxable income less than $18,201) all incur $4,000 in eligible personal expenses that qualify for a concessional deduction when calculating taxable income or as a tax offset equal to 30% of the expense. The value of a concessional deduction of $4,000 is: High-income taxpayer: saves $4,000 × 45% = $1,800 of tax Low-income taxpayer: saves $4,000 × 19% = $760 of tax Very low-income taxpayer: saves $4,000 × 0% = $0 of tax In contrast, the value of a concessional offset of $4,000 × 30% is: High-income taxpayer: saves $4,000 × 30% = $1,200 of tax Copyright © 2019. Thomson Reuters. All rights reserved.
Low-income taxpayer: saves $4,000 × 30% = $1,200 of tax Lowest-income taxpayer: saves $4,000 × 30% = $1,200 of tax (which may be refunded, as explained below, if the tax savings exceeds the tax payable, as is the case with this taxpayer). To prevent the upside-down effect of concessional deductions, the government gradually shifted all concessional deductions to tax offsets. A tax offset avoids the upside-down effect of a deduction by providing the same value concession to high-income taxpayers (facing a high marginal tax rate) and low-income taxpayers (facing a lower marginal tax rate). A simple offset may still suffer from two shortcomings, however. First, in some cases, the government may not wish to provide the same value offset to high-income persons and low-income persons. Instead, it may wish to provide a larger subsidy to the low- income person and a smaller subsidy for higher- income persons and perhaps no subsidy at all for the very highest-income persons. Second, an ordinary offset may provide no relief for lowest-income persons whose income
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tax liability is less than the value of the offset. The government has developed two modifications of simple offsets to address these problems: tapered offsets and offsets that are refundable or transferable or which may be carried forward and used in later years (see [15.30]–[15.60]).
Concessional tax offsets to cap income tax rates [15.130] The individual income tax rate scale ranges from 19% to 45% with a zero rate on the first $18,200 of taxable income. However, the legislature has decided to apply maximum rates on some particular types of income lower than the rates that might normally apply. It would be too complicated to set a range of rate scales for different types of income. Instead, the ordinary income tax rate scale is applied to all of a taxpayer’s income and an income tax offset is then provided to reduce the tax payable on the special types of income chosen for concessional treatment.
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An example of a tax offset to set a maximum rate on a particular type of income is the tax offset to set a rate cap for payments received by retiring employees in respect of their unused long service leave entitlements: s 83- 85 of the ITAA 1997. Another offset intended to provide a reduced rate to a particular type of income recently adopted is the offset in subdiv 328- F of the ITAA 1997 which is designed to provide unincorporated small businesses with a benefit similar to the reduced 27.5% income tax rate available to small companies. The concessional offset is a non-refundable tax offset of 8% of income tax payable on “total net small business income” (which excludes net capital gains and personal services income), capped to a maximum of $1,000. The aggregated turnover of the business must be less than $5 million. The offset is not available to individuals taxed in the capacity of a trustee, or to minors except in relation to any business income from small business activities which they actually undertake themselves. The Government also legislated for the small company tax rate to have further staged reductions to 25% by the 2021–2022 year and for the unincorporated small business offset to rise to 16% by that year.
Common concessional offsets [15.140] The Tax Benchmarks and Variations Statement published annually by the Treasury (see [15.110]) lists over 300 tax expenditures. While some of these tax expenditures are in the form of tax exemptions, tax deductions and deferrals of tax liability, many are in the form of offsets. It is, therefore, not possible to detail all offsets potentially available to a taxpayer. However, there are some offsets which are more commonly available to resident individual
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550 [15.150] PRINCIPLES OF TAXATION LAW 2020 taxpayers or which have recently been topical. Three examples of concessional offsets are explained below: • dependency offset: see [15.150]; • zone rebate: see [15.180]; and • overseas forces rebate: see [15.190]. Two further offsets (to be one combined offset in five years) are listed in a concessional subdivision of the tax legislation but are not considered concessions in the government’s separate Tax Benchmarks and Variations Statement: • low income tax offset and the low and middle income tax offset available from the 2018–2019 year (the low income tax offset is commonly called LITO but technically still called a “rebate” in the law; however, both offsets have been merged into a new “low income tax offset” from the 2022–2023 year): see [15.170]. Note that two of these offsets are still called “rebates”, which is a sign that they are longstanding concessions that have not yet been amended to use current terminology. The list of all “offsets” in s 13-1 of the ITAA 1997 includes amounts that are called “offsets” and those called “rebates” in the actual operative legislative provisions. The ATO website uses the term “offset” when referring to entitlements that are offsets or rebates in the operative legislative provisions.
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Dependant offset [15.150] At one time, the ITAA 1936 contained a number of offsets for various dependants of a taxpayer. These were consolidated in 2012 into a single dependency offset under Div 61-A of the ITAA 1997 which is formally known as the Dependant (Invalid and Carer) Tax Offset (DICTO) and referred to by the ATO as the Invalid and Invalid Carer Tax Offset. Former rebates for support of a non-student child or student dependant or for support provided by a sole parent have been retained as notional entitlements in Div 961 of the ITAA 1997, however, for taxpayers entitled to a zone rebate or overseas forces rebate. The dependant offset is a single non-refundable offset available in respect of a specified dependant (spouse, relative or spouse’s relative) who is genuinely unable to work due to disability or carer obligations and so is in receipt of a specified disability support, special needs disability support or invalidity service pension. The dependency offset is available to taxpayers who contribute to the maintenance of a specified dependant invalid or carer dependant (a dependant who cares for an immediate relative of the taxpayer or the taxpayer’s spouse), where the sum of the adjusted taxable income of the taxpayer and (if not the
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dependant in respect of which the offset is being paid) taxpayer’s spouse is $100,000 or less. The offset is payable only where the relevant dependant is an Australian resident, or where the dependant is the taxpayer’s spouse or child who is a non-resident and the taxpayer had a domicile in Australia during the year. The taxpayer will not be entitled to the offset in respect of a spouse, where either the taxpayer or spouse receives another benefit known as the Family Tax Benefit (Part B). The amount of the offset may also be reduced where the dependant has adjusted taxable income (see below). The dependant offset is a tapering offset but differs from most other tapering offsets because the gradual reduction in the offset is not based on the income of the taxpayer eligible for the offset. Instead, the offset reduces as the income of another person, namely the dependant supported by the taxpayer, rises. The maximum amount of DICTO for 2019–2020 is $2,755 and is indexed annually in accordance with the consumer price index (CPI).
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The maximum offset allowable is reduced by $1 for every $4 by which the adjusted taxable income of the dependant exceeds $282 (exclusive of the disability support, special needs disability support or invalidity service pension received by the dependant, as the case may be), so that for 2019–2020 no offset is payable where the adjusted taxable income of the dependant is $11,346. “Adjusted taxable income” is not the same as taxable income for income tax purposes. “Adjusted taxable income” has the same meaning as it has for family tax benefit purposes. Adjusted taxable income rather than taxable income is used to calculate entitlement to the dependency offset because the offset is intended to provide assistance for persons with more limited economic capacity and taxable income does not necessarily reflect economic capacity. For example, a person who is paid entirely by way of taxable fringe benefits will have no taxable income but may have a very high economic capacity. Similarly, a person receiving tax-free pensions may have a higher economic income but a low taxable income. Thus, for example, the calculation of “adjusted taxable income” includes the full gross value of reportable fringe benefits. The adjusted taxable income of a taxpayer is determined as follows: The sum of: • taxable income; • reportable employer superannuation contributions; • deductible personal superannuation contributions; • adjusted fringe benefits (generally being the grossed- up value of reportable fringe benefits); • certain tax-free government pensions or benefits;
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552 [15.160] PRINCIPLES OF TAXATION LAW 2020 • “target foreign income” (foreign source income that is not liable to tax in Australia or received as a fringe benefit); • net financial investment loss; and • net rental property loss. Less: • any child support provided to another person. Example 15.4: Dependency offset Kate has her invalid father Edmond living with her and supports him throughout the income year. For the 2019–2020 financial year, he earned $1,400. The maximum dependency offset for 2019–2020 is $2,755. Kate will be entitled to a rebate of: $2,755 –(($1,400 –$282) × 0.25) = $2,475.50
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Private health insurance offset [15.160] The private health insurance offset found in s 61-205 of the ITAA 1997 was adopted to subsidise taxpayers paying private health insurance premiums. By virtue of s 67-23 of the ITAA 1997, it is a refundable offset. It is also means- tested with the value of the offset reduced above one income threshold and removed completely above a higher income threshold. A lower percentage of the premium is allowed as an offset, where income is greater than $90,000 in the case of single taxpayers and $180,000 in the case of families in 2017–2018 and no offset is available, where income is greater than $140,000 for singles and $280,000 for families. The value of the offset is very gradually reducing with the amount of the offset lowered each year by an indexation factor. Until 2014, the rebate rate was 30% of the amount of private health insurance premiums. The standard rebate rate from 1 April 2019 to 31 March 2020 for a single person on base income is 25.059% of the private health insurance premiums.
Low income rebate and low and middle income offset [15.170] Section 159N of the ITAA 1936 provides a tapered rebate for lower- income taxpayers. The rebate is a maximum of $445 reduced by 1.5 cents for every dollar of income exceeding $37,000. A further low and middle income tax offset set out in s 61-105 of the ITAA 1997 applies for three years, from 2018–2019 to 2021–2022. It provides a maximum
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benefit of: (i) $255 for taxpayers with income up to $37,000; (ii) $255 plus 7.5% of income exceeding $37,000 for taxpayers with income of more than $37,000 and up to $48,000; (iii) $1,080 for taxpayers with income of more than $48,000 and up to $90,000; and (iv) $1,080 less 3% of income exceeding $90,000 for taxpayers with income of more than $90,000 and up to $126,000. From the 2022–2023 year, the existing low income tax offset and the low and middle income tax offset will be merged into a new low income tax offset (s 61-110 of the ITAA 1997) in an amount of $700 for taxpayers with income of up to $37,500 with tapering at specified rates up to income of $66,667. Example 15.5: Low income rebate and low and middle income offset Jenny has a taxable income for the 2019–2020 income year of $40,000. She will be entitled to a low income rebate determined as follows: $445 –(($40,000 –$37,000) × 0.015) = $400 She will also be entitled to a low and middle income tax offset of $255 + (0.075 × $3000) = $480 for a total of $400 + $480 = $880.
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Zone rebate [15.180] Section 79A of the ITAA 1936 provides taxpayers who live in remote areas with a zone rebate. The zone rebate was originally designed to recognise the disadvantages to which taxpayers are subject because of the uncongenial climate conditions, isolation and high cost of living in certain parts of Australia. To qualify for the rebate, a taxpayer must generally have lived or worked within the zone for 183 days or more in the income year, although there are exceptions to this rule. Remote areas are classed as either Zone A or Zone B. There are also special areas within these zones. The ATO provides an Australian zone list on their website. From 1 July 2015, the government removed the rebate for “fly in-fly out” and “drive in-drive out” workers whose “usual place of residence” is outside a qualifying zone. The amount of the rebate is dependent upon a number of factors, including the zone, whether the taxpayer lives in a special area within the zone, and the family circumstances of the taxpayer. The rebates for the 2018–2019 income year range from a basic Zone B rebate of $57 plus 20% of any notional rebate for dependants to a Special area Zone A rebate of $1,173 plus 50% of any notional rebate for dependants. From 2014– 2015, the notional rebates on which the uplift is based are the Dependant (Invalid and Carer) Tax Offset in the ITAA 1997 and the rebates which were formerly payable for support of
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554 [15.190] PRINCIPLES OF TAXATION LAW 2020 a non-student child or student dependant, or for support provided by a sole parent (see [15.150]). From 1 July 2012, a recipient can claim the additional dependant rebate uplift in respect of only one of the zone rebate, overseas forces rebate and overseas civilian tax rebate.
Overseas forces rebate and overseas civilian tax offset [15.190] Section 79B of the ITAA 1936 provides a rebate to eligible taxpayers if they served in a specified overseas locality as a member of the Australian Defence Force and income relating to that service was not specifically exempt from tax. The operation of s 79B is discussed in Ruling TR 97/2. Section 23AB(7) provides a similar offset for specified civilians. For the 2018–2019 income year, the overseas forces rebate is $338 plus 50% of any notional rebate for dependants. From 2014–2015, the notional rebates on which the uplift is based are the Dependant (Invalid and Carer) Tax Offset in ITAA 1997 and the rebates that were formerly payable for support of a non- student child or student dependant, or (except in the case of the overseas civilian tax offset) the former rebate for support provided by a sole parent (see [15.150]).
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From 1 July 2012, a recipient can claim the additional dependant rebate uplift in respect of only one of the zone rebate, overseas forces rebate and overseas civilian tax rebate.
Concessional offsets recently phased out or in the process of being phased out [15.200] In recent years, budget pressures have prompted governments led by both major political parties to cut back on a number of spending programs, including “spending” by way of tax expenditures that result in tax forgone by way of concessional tax offsets. Recently terminated offsets include: • a mature age worker tapered offset (subdiv 61-K of the ITAA 1997), terminated after 30 June 2014; • an education tax offset (s 61-610 of the ITAA 1997) was designed to subsidise parents with school-age children, available from mid-2008 until mid-2011; • a net medical expenses tax offset (s 159P of the ITAA 1936), which provided a taxpayer with an offset for net medical expenses incurred in relation to himself or herself or in respect of a dependant who was a resident and continued to provide relief for a small number of
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taxpayers for expenses relating to disability aids and attendant or aged care until 30 June 2019.
Order of taking offsets [15.210] We have seen that simple offsets will be lost to the extent they exceed a taxpayer’s income tax liability for the year, while some offsets may be carried forward to be used in future years, transferred to another person or even refunded in cash if they are not fully used in the year in which entitlement to the offset arises. To ensure these benefits are not lost, taxpayers would prefer to use up simple offsets first and apply offsets that can be carried forward, transferred or refunded last. However, the law prescribes in s 63-10 of the ITAA 1997 an ordering rule for applying offsets. The section contains a table of all offsets and states that taxpayers must apply offsets in the order set out in the table. The list requires taxpayers to apply all offsets that are neither refundable nor entitled to be carried forward to future years before any offsets that can be refunded or carried forward.
Questions [15.220]
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15.1 What is a tax expenditure? What do you consider the purpose of tax expenditures? 15.2 What do you think are the largest measured tax expenditures for the most recent tax year? (HINT: Visit the website of the Treasury to find the latest Tax Benchmarks and Variations Statement.) 1 5.3 “Adjusted taxable income” determines a taxpayer’s eligibility to claim certain offsets such as the dependency offset. It also determines the extent (ie, the quantum) of a taxpayer’s claim. How does “adjusted taxable income” differ from “taxable income”? Why would certain offsets be based on “adjusted taxable income” and not “taxable income”? 15.4 Leah has a salary sacrifice arrangement with her employer. Her package results in an annual salary of $65,000 and reportable employer superannuation contributions of $15,000. Leah also has an investment property from which she derived rental income of $25,000 and had deductible outgoings of $30,000. Calculate Leah’s adjusted taxable income. 15.5 Kevin has an invalid brother, Jo, who lives with him. Jo receives a disability support pension. What is Kevin’s allowable rebate for the current tax year under the following scenarios?
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556 [15.220] PRINCIPLES OF TAXATION LAW 2020 • Jo has no adjusted taxable income and Kevin has adjusted taxable income of $80,000; • Jo has adjusted taxable income of $1,500 and Kevin has adjusted taxable income of $80,000; • Jo has adjusted taxable income of $2,000 and Kevin has adjusted taxable income of $160,000. 15.6 Consult the ATO Australian zone list to determine whether the following places are considered remote areas. Which zone do they fall in?
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• Toowoomba • Groote Eylandt • Katherine • Kalgoorlie • Mt Isa
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Part 4 Timing Issues
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When determining income tax payable, the taxation formula is applied to the relevant financial year. In Australia, the financial year generally runs from 1 July until 30 June the following year. Therefore, it is necessary to determine what amounts, whether income or deductions, fall within the financial year. Chapter 16 deals with issues of tax accounting. Tax accounting is primarily concerned with income and expense recognition. The relevant rules are a combination of common law and statutory principles. In relation to income, Div 6 includes income in the year in which it is “derived”. Derived income is determined by reference to accounting and common law principles. A taxpayer will use either the cash or accruals basis for determining what income is derived in a relevant year, the method selected being determined according to the accounting method which provides a substantially correct reflex of the taxpayer’s true income. While the meaning of “derived” is different depending on whether the taxpayer operates on a cash or accruals basis, the meaning of “incurred” for the purposes of recognising deductions has the same meaning under both methods. The chapter also deals with the reconciliation of financial accounts to taxation law in order to determine the tax payable by the business entity. In addition to the general timing rules for income derived and losses or outgoings incurred, Div 70 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997) contains a specific regime which applies to taxpayers who both carry on business and have trading stock. This Division is discussed in Chapter 17. Students may be familiar with accounting for trading stock which takes into account net profits and losses on disposal of trading
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558 PRINCIPLES OF TAXATION LAW 2020
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stock. Income tax accounting for trading stock does not employ the same method. Rather, Div 70 applies a de facto formula to produce an overall result that properly reflects the taxpayer’s activities with trading stock during the income year. Chapter 17 outlines the formula to be applied along with special rules which may be relevant to a taxpayer.
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16 Tax accounting
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Key points.................................................................................................... [16.00] Introduction................................................................................................ [16.10] Derivation of income.................................................................................. [16.20] Meaning of “derive”............................................................................. [16.20] Timing of derivation............................................................................. [16.30] Cash v accruals accounting................................................................. [16.40]
SBE taxpayers.......................................................................................... [16.50] Large firms and businesses..................................................................... [16.60] Switching between cash and accruals basis.......................................... [16.70] Payment before earning activity has commenced............................. [16.90] Sales under a “lay-by method”............................................................ [16.95] Dividend income –when derived...................................................... [16.100] Derivation of income –delay because of dispute............................ [16.110] Timing –deductions and deductibility................................................... [16.120] Expenses............................................................................................ [16.120] Expense of an earlier income year........................................................ [16.140] Incurred after business ceases to operate............................................ [16.150] Relevant to reduction of future expenses............................................. [16.160] When no income is being generated.................................................... [16.170] Prepaid expenses................................................................................... [16.180] Amounts specifically excluded.............................................................. [16.182] SBE taxpayers........................................................................................ [16.185] Not satisfying the 12-month rule –non-business expenditure.................................................................................... [16.186] Provisions........................................................................................... [16.190] Long service leave and annual leave.................................................... [16.190] Bad debts................................................................................................ [16.220] Insurance companies............................................................................. [16.230] Questions................................................................................................... [16.250]
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560 [16.00] PRINCIPLES OF TAXATION LAW 2020
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Key points [16.00] • Financial accounts, such as profit and loss statements and balance sheets, are prepared according to the relevant accounting standards. When a tax return is being prepared, the accounting reports need to be reconciled with taxation law accounting requirements. • Taxpayers are required to use either accruals accounting or cash accounting for taxation purposes, and there are taxation implications of changing between cash and accruals accounting. • Small business entity taxpayers have a choice in recognising the derivation of income on the cash or accruals basis. • The term “derivation of income” is not defined in the Income Tax Assessment Acts. • Taxpayers are taken to have received the derived amount as soon as it is applied or dealt with in any way on their behalf or as they direct. • Dividend income is derived by the shareholder and treated as income when it is actually paid. • The taxation law treatment of an expense differs from the financial accounting treatment of the deductibility of the expense. • Taxpayers accounting on a cash basis can still claim a deduction for expenses that have been incurred but not paid for by the end of the financial year. On an accruals basis, once the liability to pay the expense or outgoing has been incurred, it can be deducted from assessable income. • A deduction is not available for a provision for bad debts, long service leave and holiday pay. Bad debts are covered by a specific deduction provision: s 25-35 of ITAA 1997. Section 26-10 confirms that a deduction for long service leave may only be claimed in the year paid. • Deductions by an insurance company for a provision to meet future claims may be based on an estimate of claims likely to be made and is deductible from assessable income. • Sections 82KZL– 82KZMG of ITAA 1936 regulate the timing of the deductibility of prepaid expenses and prevent a taxpayer claiming a deduction for the prepayment of expenses.
Introduction [16.10] Tax accounting is based on financial events happening over a financial year. It is quite different from financial accounting. One of the most important tasks that an accountant undertakes is to reconcile the financial accounting statements to tax accounting requirements contained in both the statutory and common law. Many financial accounting treatments for recognising income and deductions are not acceptable for taxation purposes. Those items of difference
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Figure 16.1: Recognition of income and expenses Timing issues
Timing See [16.30]
Cash or accruals basis See [16.40]
SBE taxpayers See [16.50]
Deductions and deductibility
Larger firms and businesses See [16.60]
Switching between bases See [16.70]
Provisions
Annual and long service leave See [16.190]
Expenses
Earlier in income year See [16.140]
Where business ceases operation See [16.150]
Relevant to deductions of future expenses See [16.160]
Bad debts See [16.220] Where no income is generated See [16.170]
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Insurance See [16.230] Prepaid expenses See [16.180]
are discussed in this chapter. The questions at the end of the chapter provide examples of the difference between financial accounting and tax accounting for companies. For taxation purposes, what has happened between 1 July and 30 June the next year is taken into account when determining the taxation liability for the individual or entity. What happens when the taxpayer is due to be paid assessable income on 30 June, but it is not actually received until 1 July? In which financial year is the income said to have been “derived”, that is, taken into account as assessable income? Tax accounting is different from financial accounting and this, coupled with the concept of a financial year, leads to uncertainty.
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562 [16.20] PRINCIPLES OF TAXATION LAW 2020 Income tax payable must be determined according to the provisions of the ITAA 1997. As a starting point, s 4-10 of ITAA 1997 states: 4-10 How to work out how much income tax you must pay (1) You must pay income tax for each financial year. (2) Your income tax is worked out by reference to your taxable income for the income year. The income year is the same as the financial year, except in these cases: (a) for a company, the income year is the previous financial year; (b) if you have an accounting period that is not the same as the financial year, each such accounting period or, for a company, each previous accounting period is an income year.
There are many areas in taxation law where the method used to account for income or deductions differs from the Generally Accepted Accounting Principles (GAAP). The important areas of difference are examined in this chapter and outlined in Figure 16.1.
Derivation of income Meaning of “derive”
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[16.20] The term “derived” is not defined in either Income Tax Assessment Act, but the following quote from Gibbs J in Brent v FCT (1971) 125 CLR 418 at 570 provides an excellent definition: The Act does not define the word “derived” and does not establish a method to be adopted as a general rule to determine the amount of income derived by a taxpayer, although particular situations not relevant to the present case are dealt with. The word “derived” is not necessarily equivalent in meaning to “earned”. “Derive” in its ordinary sense, according to the Oxford English Dictionary, means “to draw, fetch, get, gain, obtain (a thing from a source)”. It has become well established that unless the Act makes some specific provision on the point the amount of income derived is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which “is calculated to give a substantially correct reflex of the taxpayer’s true income” (Commissioner of Taxes (South Australia) v Executor, Trustee and Agency Company of South Australia Limited (Carden’s Case) (1938) 63 CLR 108 at 152-4; 1 AITR 416 at 441-2).
Timing of derivation [16.30] An important step in calculating the taxpayer’s assessable income is determining when that income has been “derived” in a tax year. In other words, when does a taxpayer derive income? Is it when they render an account or tax invoice or when the customer or client actually pays the money?
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Sections 6-5(4) and 6-10(3) of ITAA 1997 state that in working out whether you have derived an amount of ordinary income or statutory 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. The two cases, Henderson v FCT (1970) 119 CLR 612 (see Case Study [16.2]) and Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 (see Case Study [16.3]), provide excellent examples of how the courts have dealt with the issue of derivation of income. The timing of the derivation of income will be dependent on whether the taxpayer is operating on a cash basis or an accruals basis.
Cash v accruals accounting [16.40] Sections 6-5 and 6-10 of ITAA 1997 leave it open to taxpayers to calculate their assessable income on a cash basis or an accruals basis. The distinction is also referred to as the “receipts method” or the “earnings method”. For accounting purposes, all financial statements are prepared on an “accruals” basis, but for taxation purposes tax returns can be prepared on an accruals basis as well as on a “cash” basis.
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The assumption is individuals will account on a cash basis. In relation to business, it is a question of fact. However, case law supports the contention that only professional practices and small-to medium-sized businesses should account on a cash basis if it is considered to be appropriate from a cash flow perspective. If you are taken to have received an amount of income as soon as it is applied or dealt with on your behalf or as you direct (s 6-5(4) of ITAA 1997), the question we ask is whether it is derived when received in cash or on an accruals basis. Figure 16.2: Cash and accruals accounting Derivation of income Recognition of when income is received: • On a cash basis • On an accruals basis
Accruals basis When invoice sent to customer or client
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Cash basis When cash actually received from customer or client
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Example 16.1: Cash v accruals basis – timing Marieke places $10,000 with her bank in a term deposit for one year at 4.5% interest. The term deposit matures on 1 July and $450 is paid in interest by the bank by crediting Marieke’s account with the money. If Marieke accounted for the interest of $450 on a cash basis, it would be included in the current year, but if she accounted on an accruals basis, then it would be included in the previous year as the interest accrued to her.
There is nothing in the statutory law that compels taxpayers to adopt an accruals method or cash method to calculate the amount of taxable income they have gained in a particular financial year. However, from a practical perspective, accountants and lawyers should have regard to the Australian Taxation Office (ATO) public ruling, TR 98/1. The approach taken by the ATO in the ruling is that trading income should be returned on an accruals or earnings basis and income from non-trading activities such as specialised knowledge and skill; investment income and rent and royalties could be returned on a cash or receipts basis.
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Case study 16.1: Recoverable debt The issue of using the correct method of accounting arose in the case of Barratt v FCT (1992) 23 ATR 339 where the taxpayer was not able to sue for the recovery of a bad debt until six months after the service had been provided to the customer. The taxpayer was carrying on the business of a pathology practice and the Medical Practitioners Act 1938 (NSW) had the effect of rendering fees not recoverable as a debts for a period of at least six months after the service. The taxpayer used the cash method of accounting on the basis that they could not recover the non-payment of fees for at least six months after the provision of the service. The ATO contended that due to the size of the practice and the case law on this point that the most appropriate method of accounting was the accruals method. The Full Bench of the Federal Court held that the appropriate method was indeed the accruals method and that the concept of a “recoverable debt” did not justify the use of a cash basis of accounting.
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SBE taxpayers [16.50] Any business eligible as a Small Business Entity (SBE) can account on a cash or an accruals basis. The SBE system replaced the Simplified Tax System (STS) from 1 July 2007. The only test to be applied is that the entity must have an average turnover of less than $10 million (previously $2 million). The Government encourages small businesses to account on a cash basis as this is better for cashflow purposes when calculating tax payable and GST owing to the ATO.
Large firms and businesses [16.60] In Henderson v FCT (1970) 119 CLR 612 (see Case Study [16.2]), the High Court established the legal principle that with large professional firms the appropriate method to be used in calculating taxable income is the accruals system. It is however acceptable for small professional practices and small businesses to use the cash system as it provides the best cashflow advantage when businesses are first started because their assessable income is based only on cash received. Any income tax payable can be met from the cash received.
Switching between cash and accruals basis
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[16.70] If a small business grows into a large business, then it may be appropriate for that business to change from accounting on a cash basis to an accruals basis for taxation purposes. The change would occur at the start of a new financial year. Example 16.2: Impact of changing from cash to accruals basis In Year 1, ABC Pty Ltd accounted on a cash basis and its taxable income was $200,000. In Year 2, ABC Pty Ltd accounted on an accruals basis and its taxable income was $600,000. Cash ($)
Invoice/accruals ($)
Year 1
200,000
500,000
Year 2
800,000
600,000
What is the effect of the $200,000 of cash that is not included in ABC’s Year 2’s taxable income? Is this amount subject to income tax and, if so, how? Case Study [16.2] provides the answer.
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566 [16.80] PRINCIPLES OF TAXATION LAW 2020
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Case study 16.2: Changing from cash to accruals basis Henderson v FCT (1970) 119 CLR 612 illustrates what happens when taxpayers change the method they use to calculate their taxable income. In this case, the change was from a cash basis to an accruals basis. The taxpayer, Mr Henderson, was a partner in an accounting practice and calculated the partnership income for the year ended 30 June 1964 on a cash basis, then prepared the partnership’s tax return on that footing. Mr Henderson returned his income on the same basis. The Commissioner accepted these returns and assessed Mr Henderson for income tax on the basis of them. Fees outstanding at the end of that year were not brought in as assessable income in that year. If the partnership income were computed for the year ending 30 June 1965 upon an earnings (accruals) basis and the relevant earnings were confined to the earnings of that tax year, those fees outstanding, which amounted to a considerable sum in the order of $179,000, if no other action was taken, would be collected without ever being subject to income tax. The High Court held that where the professional accounting practice employed more than 295 people, the correct method was the accruals basis of accounting and not the cash basis. The cash basis was accepted as appropriate for small professional practices, as was the situation in Commissioner of Taxes (South Australia) v Executor, Trustee and Agency Company of South Australia Limited (Carden’s Case) (1938) 63 CLR 108, where a single doctor was conducting a medical practice. The fact that changing from a cash to an accruals method resulted in income from an earlier year that had not been collected in that year, and was not subject to income tax in the current year, made no difference to the finding of the High Court. According to Barwick CJ at 647: [T] he whole purpose of calculating your taxable income each year is to provide a true “reflex of income” for that period. It is not a two year period or any other period. The earnings of a prior year are subject to income tax in that year. In this case the earnings on a cash basis that are not included in the next year because of calculating assessable income on an accruals basis is not subject to income tax. The uncollected fees earned in a prior year cannot be included in the assessable income of the next year. They are simply untaxed earnings.
For the Commissioner’s views on the treatment of the outstanding debts and the CGT consequences: see ID 2014/1. [16.80] If a taxpayer kept changing from cash to accruals system and then back again in order to derive tax-free income, then the ATO could assert that
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the taxpayer was engaged in tax avoidance under Pt IVA of ITAA 1936 and could impose penalties for such conduct.
Payment before earning activity has commenced [16.90] The question of recognising income may arise when a business receives a prepayment for goods or services and the goods or services which will be provided over a period of time and over more than one financial year. Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 illustrates the way in which the income is said to have been derived in these circumstances.
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Case study 16.3: Derivation of income where prepayment occurs In Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314, the taxpayer, Arthur Murray, was in the business of providing dancing lessons to the public. Students would pay for five, 15 or 30 hours of tuition over a period of time but not exceeding one year unless they paid for a lifetime of lessons. Payment was to be made by instalments or a lump sum and the contract did not provide for a refund in the case of students not wanting to complete their course of classes, but, in some instances, refunds were made to students. The company, on receipt of payment, would credit the amount to an account styled “Unearned Deposits –Untaught Lessons Account”. When the lessons were given, amounts were then transferred to an account styled “Earned Tuition Account”. The company would not include amounts that represented fees in advance in its assessable income for tax return purposes. Income was only recognised when the lesson had been given and the income had been earned. The Commissioner assessed the taxpayer on the total of the income received prior to the end of the financial year. In the joint judgment of Barwick CJ, Kitto and Taylor JJ at 318: [A]ccording to established accounting and commercial principles, in the case of a business either selling goods or supplying services, amounts received in advance of the goods being delivered or the services being supplied are not regarded as income. We have not been able to see any reason which should lead the courts to differ from accountants and commercial men on the point.
Nothing in the Act [ITAA 1936] is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community – and we are bound by the case stated to accept that it does –it applies the provisions of the Act according to their true meaning.
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568 [16.95] PRINCIPLES OF TAXATION LAW 2020
Sales under a “lay-by method” [16.95] The situation may also arise where retail stores “sell” goods on an instalment basis and the legal title to the goods is not transferred nor the physical possession until full payment has been received. These arrangements are referred to as “lay-by sales”. The question arises as to what stage the taxpayer derives the income. In this case, the income is only derived when legal title passes to the customer and not when the contract is entered into. In the meantime, the income is held in a suspense account and only recognised as income when the full payment has been made and the goods delivered or the customer defaults on the arrangement.
Dividend income –when derived [16.100] Dividends are assessable income pursuant to s 44(1) of ITAA 1936 leading to the question of when dividends are recognised as income. The dividend is treated as income in the hands of the shareholder when actually paid, not when declared by the directors. The reason for this is because the directors can rescind the decision to pay the dividend at any time up until payment. The authority for this statement is the case of Brookton Co-operative Society v FCT (1981) 147 CLR 441.
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Example 16.3: Derivation of dividend income Company XYZ Ltd declares a dividend of 25 cents per share on 4 May 2019. Your client is due to receive a dividend of $550. The dividend is paid on 15 July 2019. The question is whether the client has derived the $550 in the 2018–2019 financial year or the 2019–2020 financial year. According to the decision in Brookton Co-Operative Society v FCT, the dividend is regarded as income when paid and not when it is declared. The income is derived in the 2019–2020 financial year. The income is recognised on a cash basis, not an accruals basis.
Derivation of income –delay because of dispute [16.110] If a taxpayer is owed money for goods sold, but the amount of money is subject to a dispute, then the question arises as to what stage that money should be brought to account as assessable income: when the dispute has been resolved or when the goods have been sold. In the case of BHP Billiton Petroleum v FCT (2002) 51 ATR 520, this exact issue was decided by a
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Full Bench of the Federal Court. The main legal issue decided in this case is set out in Case Study [16.4].
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Case study 16.4: Income derived in the case of a legal dispute In BHP Billiton Petroleum v FCT (2002) 51 ATR 520, the two taxpayers, BHP Billiton and Esso Australia, were involved in the production of petroleum products in the Bass Strait. The taxpayers entered into contracts for the sale of gas (or ethane) to six buyers. The buyers agreed to pay an annually determined amount for the gas. Monthly statements were to be issued and payment was to be made within 15 days of receipt by the buyer. There was provision in the 12th month for an adjustment to be made to ensure that the amount to be paid reflected the annual contract amount. Following the replacement of the royalty and excise regime with the petroleum resource rent tax (the PRRT) from 1 July 1990, the sellers notified the buyers that they intended to pass on the effect of the PRRT directly to the buyers (the pass-on amount). The pass-on amount could only be determined some time after gas was delivered. The buyers did not pay the pass-on amounts. The matter was subject to dispute and arbitration, including a (lapsed) appeal to the Supreme Court of Victoria. It was eventually settled, with the parties agreeing not only to settle the claim for the pass-on amounts for the past, but also to settle claims that would arise in the future. The settlement thus involved the payment of two lump sums, one for the past claim and one for the future claim. The assessability of the second lump sum payable (ie, that paid for release for future pass-on amounts) was not the subject of dispute. The Commissioner assessed the taxpayers on the basis that they had derived the additional income, namely the pass-on amounts at the time the gas was invoiced monthly, even though the amounts were in dispute. The Federal Court, per Hill and Heerey JJ at 539, held that the additional amounts of income were only derived when the dispute had been settled. Their conclusion was: It is clear that there is no Australian authority which requires the conclusion that where there is a bona fide dispute a taxpayer on an accrual basis is obliged to account for trading income that is the subject of dispute in the year where goods are sold, if the taxpayer is a trader in goods or in the year when services are rendered, if the taxpayer derives income from services performed. As should by now be clear a principle which requires the taxpayer to account for disputed income in the year goods are sold conflicts with accounting practice. That practice regards income to be derived when the dispute is concluded, whether through arbitration, litigation or settlement.
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The only justification for the principle for which the Commissioner here contends is one that proceeds on the fiction that a successful litigant was always going to be successful and was always going to receive the amount which the arbitral or litigation result achieves. The court should be slow to adopt a fiction in preference for reality in a case such as the present. The deferral of derivation until the conclusion of the dispute (or perhaps receipt if that occurs earlier) avoids the difficulties which arise where the accounts of the year in which the trader sells goods cannot be reopened and where the availability of a deduction for a bad debt may be the subject of doubt. It avoids too the unfairness to a taxpayer in being required to pay tax immediately where recoverability of what is owed to the taxpayer and which is the fund out of which the tax might be expected to be paid, is, as a result of a bona fide dispute, outside the control of the taxpayer. It accords with the common sense solution arrived at in both the United States and Canada where the tax law does not permit reopening of the tax accounts.
The Commissioner’s submission that in the present case the taxpayer’s derived income at the time gas was delivered to purchasers for the purpose of the ITAA 1936 should be rejected. Because the parties accept that no different result flows from the Petroleum Resource Rent Tax Assessment Act 1987 (Cth), it follows that the taxpayer likewise derived the consideration receivable from the sale of gas only when the dispute between the buyers and the taxpayers themselves was settled. The appeals should accordingly be allowed with costs.
Timing –deductions and deductibility
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Expenses [16.120] In order to claim an expense or outgoing as a deduction pursuant to s 8-1 of ITAA 1997, the question arises as to whether it is necessary to have paid for that expense or whether it is sufficient that the liability to pay has been incurred. Another consideration is whether an expense that relates to a previous financial year or a future financial year can still be claimed as a deduction in the current financial year. The taxation law treatment of the recognition of an expense even when not paid or the timing of the deduction of that expense differs from the financial accounting treatment of the deductibility of the expense. These differences are discussed in detail below. The starting point for deductions is s 8-1. 8-1 General deductions (1) You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
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16: Tax accoUntinG [16.130] 571 (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature; or (c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or (d) a provision of this Act prevents you from deducting it.
The term “incurred” does not have the opposite meaning to “derived” when looking at income. If a taxpayer is accounting on a cash basis, then he or she can still claim a deduction for expenses that have been incurred but not paid for, a hybrid approach and, similarly, if accounting on an accruals basis, then once the liability to pay the expense or outgoing has been incurred, it can be deducted from assessable income. The loss or outgoing must be incurred in gaining or producing the taxpayer’s assessable income. It is not necessary to match the loss or outgoing with the income earned in the same income year, at least where a continuing business is involved. The financial accounting “matching principle” has no relevance to the taxation treatment of the deductibility of expenses. The expense may be relevant to any of the following circumstances:
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• • • •
an earlier income year; when a business has ceased to be owned by the taxpayer; the reduction of future expenses; or deductible when no income is generated but may be in the future.
[16.130] Ruling TR 97/7 is relevant to understanding what is meant by the term “incurred” and the timing issue concerning the deductibility of expenses. Taxation Ruling –TR 97/7 –Income tax: section 8-1 –meaning of “incurred” – timing of deductions … Incurred
4. There is no statutory definition of the term “incurred”.
5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below.
6. The courts have been reluctant to attempt an exhaustive definition of a term such as “incurred”. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred:
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572 [16.140] PRINCIPLES OF TAXATION LAW 2020 (a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is “completely subjected” to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum; … Accounting practice
8. The principles set out above relating to the interpretation of the word “incurred” derive from cases where taxpayers operated on an earnings basis. However, the cases have not generally sought to limit the meaning of the word “incurred” by reference to the nature of a taxpayer’s accounting system.
9. In these circumstances, subject to the propositions outlined above, a taxpayer who uses a cash receipts based accounting system need not necessarily have paid or borne a loss or outgoing in order for that loss or outgoing to have been “incurred” for the purposes of section 8-1.
Expense of an earlier income year
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[16.140] Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 illustrates the taxation principle that an expense is deductible in a later year when the event that gave rise to the expense occurred in an earlier year. Case study 16.5: Expense of earlier year deductible in later year In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer, a manufacturer of conveyor belts, installed a conveyor belt for NWCC. In July 1981, it sold its business. In August 1981, NWCC sued the taxpayer, claiming that the conveyor belt was defective. In 1989, the taxpayer settled the action by paying NWCC $325,000 and claimed the amount as a deduction in the year of income ending 1989. The Federal Court held that the expense was deductible and followed the decision in AGC (Advances) Ltd v FCT (1975) 132 CLR 175. The Federal Court held a great deal of injustice would follow if in the present case Placer was unable to claim a deduction for the cost of the compensation and legal fees payable as a result of having sold a defective conveyer belt some years before the business ceased to
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operate. The expenses were deductible and the High Court decision in AGC (Advances) Ltd v FCT was followed and the High Court’s view of the decision in Amalgamated Zinc (De Bavay’s) Ltd v FCT (1935) 54 CLR 295 was accepted as correct. The following quote from the joint judgment of Davies, Hill and Sackville JJ at 258 provides an excellent statement of the taxation law as it currently stands:
On the facts of the present case the occasion of the loss or outgoing ultimately incurred in the year of income was the business arrangement entered into between Placer and NWCC for the supply of the conveyor belt which was alleged to be defective. The fact that the division had subsequently been sold and its active manufacturing business terminated does not deny deductibility to the outgoing. A finding to the contrary would lead to great inequity. Many businesses generate liabilities which may arise in the considerable future. Such liabilities are sometimes referred to as “long tail liabilities”. To preclude deductibility when those liabilities come to fruition on the basis that the active trading business which gave rise to them had ceased would be unjust.
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Incurred after business ceases to operate [16.150] It is possible to claim, as a deduction in the current financial year, expenses that were incurred many years before and for a business that is no longer owned by the taxpayer. In FCT v Jones (2002) 49 ATR 188, the High Court held that the interest expense on a loan taken out when a business was operational was still deductible even when the business was no longer owned by the taxpayer. Case study 16.6: Expense incurred in earlier year by former business owner In FCT v Jones (2002) 49 ATR 188, a loan was taken out to finance a business owned by Mr and Mrs Jones. When the taxpayer’s husband became ill and eventually died, the proceeds from the sale of the business did not cover the loan and Mrs Jones had an ongoing liability to the financial institution. The loan was secured against the family home and at one stage was refinanced in order to take advantage of a lower interest rate. The taxpayer, Mrs Jones, continued to pay the interest on the loan out of her salary as a nurse and claimed a deduction pursuant to s 8-1 of ITAA 1997. The ATO denied the deduction on the basis that the business was no longer owned by the taxpayer.
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The Federal Court held that the interest expense was deductible even though the business was not still owned by the taxpayer. They followed the precedent of both AGC (Advances) Ltd v FCT (1975) 132 CLR 175 and Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 in that expenses are still deductible even when the business ceases to operate. The fact that the loan was refinanced did not break the nexus between the expense and the business operations that were used to gain the assessable income in the first place. Mrs Jones had an obligation to keep paying the interest on the loan until the loan had been fully repaid, otherwise she would have lost the family home.
Relevant to reduction of future expenses [16.160] W Nevill & Co Ltd v FCT (1937) 56 CLR 290 illustrates the taxation law principle that an expense is still deductible in the current financial year even though it results in a reduction of expenses in future years. There is no need in tax accounting to match the expense to the benefit derived by the action of the taxpayer which may only occur in a future financial year.
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Case study 16.7: Current-year deduction where expense reduces future expenses In W Nevill and Co Ltd v FCT (1937) 56 CLR 290, Mr William Nevill was managing director of the taxpayer company. Due to his bad health, he thought it advisable that someone should be brought into the business to help him in its management. On 11 July 1930, the company employed Mr King as joint managing director of the company with Mr Nevill for a term of five years from 1 July 1930 at a remuneration of £1,500 per annum together with a certain percentage of the profits. When the joint managing director arrangement did not work efficiently, Mr King was asked to resign. He was prepared to resign from the ninth day of March 1931, on the basis that the company pay him the sum of £2,500 as follows: £1,500 cash and the balance of £1,000 by 10 equal monthly instalments of £100 terminating December 1931 to be covered by 10 promissory notes of the company. The money and promissory notes were paid and the company claimed a deduction for the total amount in the year in which the expense was incurred. The High Court held that the expense was deductible, even though it was incurred to reduce future deductions. The wording of s 8-1 of ITAA
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1997 does not discuss taxable income but assessable income and a reduction in expenses increases assessable income. The payment to the retiring managing director was not of a capital nature as it was not used to buy plant or equipment or provide a permanent improvement to the business. The payment should be apportioned between the two financial years and not deducted in the year in which the obligation to pay was incurred.
When no income is being generated [16.170] Steele v DCT (1999) 197 CLR 459 is an important precedent for holding that expenses may be deductible even though no income is derived at the time the expense is incurred but where, as a result of the expense, the taxpayer may generate income in the future. The High Court decision reinforces the fact that the “matching” of expenses to the gaining of assessable income is not required for taxation purposes before an expense is deductible pursuant to s 8-1 of ITAA 1997.
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Case study 16.8: Expenses deductible where no income generated Mrs Steele purchased a large area of land to be used as the site of a motel. A large amount of money was borrowed to buy the land and the interest expense was claimed by Mrs Steele even though the motel had not been built many years after the land had originally been purchased. A small amount of income was generated from agisting horses on the land. The main question was whether the interest expenses could be deductible pursuant to s 8-1 of ITAA 1997 (s 51(1) of ITAA 1936), even though the interest was incurred in purchasing a capital asset that did not generate the volume of assessable income that was originally contemplated by the taxpayer. The High Court held that the interest expense was deductible even though the capital asset was not used as intended and the volume of assessable income was not produced as originally intended. The High Court was of the opinion that the positive limbs must be applied to the expense before the Court then looks at the application of the negative limbs. Finally, the High Court dismissed the notion that the expense must be contemporaneous to the gaining of the assessable income.
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576 [16.180] PRINCIPLES OF TAXATION LAW 2020
Prepaid expenses [16.180] Sections 82KZL–82KZMG of ITAA 1936 regulate the timing of the deductibility of advance expenditure. These provisions were introduced to prevent a taxpayer claiming a deduction for the prepayment of expenses in a current financial year of, say, five years worth of expenses. For example, prior to these provisions being introduced, a business could have prepaid a five- year lease of a motor vehicle for a business with one payment and claimed a deduction for the entire amount. If the annual lease cost was $12,000, then instead of claiming only this amount, if the entire lease payments were paid at once ($12,000 × 5 = $60,000), then a deduction for $60,000 was claimed. Where expenditure covers a period of more than one tax year, the general principle is that the taxpayer must apportion that expenditure over the eligible service period of the expenditure. There are however exceptions to this general principle. The two main exceptions are amounts of expenditure which are specifically excluded from the apportionment rule and certain payments made by SBEs and non-business taxpayers.
Amounts specifically excluded [16.182] In some situations, it is necessary to pay for expenses, such as insurance premiums, and annual fees, such as licences and registration fees, over a 12-month period. These types of expenses are excluded from the 12- month rule by virtue of s 82KZL(1).
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Section 82KZL(1) states that the following types of expenditure are excluded from the 12-month prepayment rules: • amounts of less than $1,000; • amounts required to be incurred by a court order or law of the Commonwealth, State or Territory; • payments of salary or wages (under a contract of service); • amounts that are capital, private or domestic in nature; and • certain amounts incurred by a general insurance company in connection with the issue of policies or the payment of reinsurance premiums.
Example 16.4: Amount required to be incurred under a State law John operates a cartage business and paid $1,200 on 31 December 2019 to register his truck for 12 months from 1 January 2020 to 31 December 2020. The truck is used exclusively for business purposes. Although the registration fee is over $1,000 and it covers a period spreading across more than one income year, it is excluded expenditure. This is because it
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is required to be incurred under a State or Territory law. The prepayment rules do not apply to this type of expenditure and the fee is deductible in the year it is incurred.
SBE taxpayers [16.185] SBE taxpayers and non- business taxpayers, such as passive investors, are provided with specific treatment in that they can pay for a service up to 12 months and obtain an immediate deduction: s 82KZM of ITAA 1936. Example 16.5: Prepaid expense that is immediately deductible The Jacobs Trust is a small business entity. On 1 June 2020, it made a payment of $24,000 to cover the lease of its business premises for a 12- month period commencing on 1 July 2020 and ending on 30 June 2021. As the eligible service period for the expenditure does not exceed 12 months and ends on or before the last day of the income year following the year in which the payment was made, the prepayment satisfies the 12- month rule. The Jacobs Trust can therefore choose to claim an immediate deduction of $24,000 in the 2019–2020 income year.
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Not satisfying the 12-month rule –non-business expenditure [16.186] If the non-business expenditure’s eligible service period is more than 12 months or it ends after the last day of the next income year, you must use the following formula to work out your deduction: Expenditure ×
Number of days of eligible service period in the income year Total number of days of eligible service period
Example 16.6: Deduction for non-business expenditure with eligible service period >12 months Tom Pty Ltd is a small business entity. On 31 May 2019, it paid $15,000 for business advertising to cover the period 1 June 2019 to 30 June 2020 (396 days). Because the eligible service period is longer than 12 months, the prepayment does not satisfy the 12-month rule. Tom Pty Ltd cannot claim an immediate deduction for the prepayment. Instead, the deduction
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for the expenditure must be apportioned over the eligible service period as follows: 2018 (1June 2018 to 30 June 2018) $15, 000 ×
30 = $1,139 395
2018 − 19 (1July 2018 to 30 June 2019) $15, 000 ×
365 = $13, 861 395
The total deduction allowed proportionately over the 2018– 2019 and 2019–2020 income years will be $15,000.
Provisions Long service leave and annual leave [16.190] The two cases, FCT v James Flood Pty Ltd (1953) 88 CLR 492 and Nilsen Development Laboratories Pty Ltd v FCT (1981) 11 ATR 505, relate to the deductibility of provisions for future expenses, such as long service leave and annual leave for employees. In both cases, the High Court held that the provision was not deductible as there was no actual liability at the time of making the provision.
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Case study 16.9: Holiday and sick pay as future expenses In FCT v James Flood Pty Ltd (1953) 88 CLR 492, the taxpayer carried on business as a motor-body builder and general engineer. The company was a party to the variation of an award made by the Commonwealth Court of Conciliation and Arbitration. The award as varied provided: Annual Leave. Period of Leave. 13A. (a) Except as hereinafter provided a period of fourteen consecutive days’ leave shall be allowed annually to an employee after twelve months’ continuous service (less the period of annual leave) as an employee in any one or more of the occupations to which this award applies.
When the company lodged its tax return for the year ending 30 June 1947, the return was accompanied by a manufacturing account which showed, under the heading “Manufacturing overhead”: “holiday and sick pay etc. £1,888 8s 2d”. In answer to a request for further information by the Commissioner, the company stated that, of the sum of £1,888 8s
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2d, £578 10s 2d represented holiday and sick pay which had accrued, but which had not been paid in the year of income. The Commissioner disallowed the sum of £579 as a deduction from assessable income. The High Court held that in order for an expense, loss or outgoing, to be incurred (pursuant to s 8-1 of ITAA 1997), it does not require the amount to be actually paid, but it does require a liability to meet the payment that is fixed and cannot be changed. In this case, the liability to pay holiday pay was subject to contingencies, such as an employee leaving before 12 months of service. The time to claim a deduction is when the employee takes his or her holiday leave and the money is paid and that usually occurs in the later financial year. [16.200] In Nilsen Development Laboratories Pty Ltd v FCT (1981) 11 ATR 505, the High Court confirmed its earlier decision in FCT v James Flood Pty Ltd (1953) 88 CLR 492 that provisions for leave were not deductible until actually paid in a particular financial year. The situation relating to the deductibility of a provision for long service leave and annual leave has been put beyond doubt by the enactment of s 26-10 of ITAA 1997. [16.210] Statutory solution. Section 26- 10 of ITAA 1997 confirms that a deduction for leave, such as long service leave, annual leave and sick leave, may only be claimed in the year paid. Pursuant to s 26-10:
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26-10 Leave payments (1) You cannot deduct under this Act a loss or outgoing for long service leave, annual leave, sick leave or other leave except: (a) an amount paid in the income year to the individual to whom the leave relates (or, if that individual has died, to that individual’s dependant or legal personal representative); or (b) an accrued leave transfer payment that is made in the income year.
A provision or an allowance for the anticipated expense is not deductible.
Bad debts [16.220] Provisions for bad debts are not allowable deductions. Provisions are usually book entries, for financial accounting purposes, made in respect of anticipated or possible future loss contingencies. At the time of making the provision, it is not yet possible to say that a loss or outgoing has been “incurred”, as the relevant “triggering” event has not yet occurred. Bad debts are now covered by a specific deduction, s 25-35 of ITAA 1997.
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Insurance companies [16.230] Insurance companies incur liabilities at the time that certain events occur but of which the insurance company may not become aware until some time in the future. It has been necessary for insurance companies to make an estimate of future liability, usually by reference to historical experience or educated estimates. Case study 16.10: Insurance companies –estimated future deductions In RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610, the taxpayer set aside amounts to cover unreported third party claims. These amounts were estimates of the likely cost of claims arising out of accidents occurring before the end of the income year, but not yet reported. The Commissioner disallowed the deduction. The Supreme Court of Victoria held that the estimated cost was deductible. The fact that the amount was estimated and that it may have to be adjusted in light of later events does not bar the claim for a deduction. Once the event had occurred, the accident out of which absolute liability arose, s 8-1(1) of ITAA 1997 applied, which was not dependant on a notice of the claim.
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[16.240] Commercial Union Assurance v FCT (1977) 7 ATR 435 was similar to RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610 and affirmed the right to be able to claim a deduction based on an estimate of claims likely to be made. In this case, the provision was deductible even though it included an estimate of damages to be paid by policy holders that had not notified the insurance company within the stipulated time limit. Case study 16.11: Deduction for an insurance provision for future claims As was the situation in RACV Insurances Pty Ltd v FCT (1974) 4 ATR 610 (see Case Study [16.10]), the taxpayer, Commercial Union Assurance Co of Australia Ltd, claimed a deduction for the provision of insurance claims that had not been notified but would have to be met, even though, as a condition precedent of the policy, the insured was required to notify the taxpayer company within a specified time. The Commercial Union Assurance Company did pay claims even if they were not notified within the time limit. The Commissioner accepted the provision that was based on notified claims as a deduction, but disallowed this extra provision on the basis that it did not follow the situation in RACV Insurances Pty Ltd v FCT.
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The Victorian Supreme Court confirmed the correctness of the decision in RACV Insurances Pty Ltd v FCT and held that a provision for future claims, even where the insurance policy document required notification of a claim within a time limit, was also deductible. The issue of whether a provision could include potential claims from earlier years when the premiums had been paid was also held to be deductible, based on the authority of AGC (Advances) Ltd v FCT (1975) 132 CLR 175.
Questions [16.250] 16.1 Your client is a small IT consulting business consisting of a husband and wife as the principals and two employees. From the time the business was established, 1 July 2015, it has been accounting for tax purposes on a cash basis. For the current financial year, your client has decided to account on an accruals basis as the size of the business is increasing. As at 30 June it has $40,000, which was paid to it from the previous financial year, and this amount was not included in its assessable income for that year. Must it be included in the current financial year?
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Would your answer be different if your client had deliberately told the customer not to pay its account for $40,000 until after 30 June? 16.2 Your client is a medium-sized building company and has provided you with its accounting records for the current financial year. Included in the accounting figures are the following amounts. How would you treat them for tax purposes? (a) Provision for long service leave for 10 employees –$25,000. The actual amount paid during the year was $12,000. (b) Insurance premium on the plant and equipment –$22,500, paid on 1 June for 12 months. (c) As at 30 June, there is an outstanding electricity account for $1,500 and telephone account for $4,500. (d) A maintenance contract on the computer equipment for 12 months –$12,000. The payment was made in the current year but ends in May of the following year. (e) The sum of $165,000 was paid to the sales manager on 30 June as compensation for the early termination of his employment contract. The employment contract had one year to go; it would have ended on 30 June of the following year.
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582 [16.250] PRINCIPLES OF TAXATION LAW 2020 (f) Interest expense of $56,000 on a loan that has five years to run that was originally used to purchase a computer repair business which ceased to operate on 30 June 2019.
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16.3 For the year ended 30 June, BBNT Pty Ltd, a lawn mower manufacturer, reported an operating (accounting) profit of $750,000. The company does not elect to be taxed as a SBE taxpayer. In coming to this profit figure, the financial accountant had taken into account the following items: (a) $30,000 has been claimed as a deduction being the amortisation of goodwill arising from the acquisition of a business two years earlier. (b) A provision has been raised for future warranties equal to 2% of sales. During the year, the sales amounted to $5 million. (c) Depreciation on the buildings was $50,000. However, for tax purposes, only $25,000 is tax deductible. (d) The company spent $75,000 on legal expenses opposing an application by Heavy Mowers Pty Ltd to extend its patent on a brand of mower. If the patent was not extended, then BBNT could produce a similar mower. (e) The company borrowed $200,000 on 1 January of the current year to cover the purchase of new plant. The loan is repayable in 10 years. The cost of borrowing was $2,500, and this amount was written as a deduction in the company financial accounts when it was paid. (f) Because of a shortage of working capital, the company was forced to sell off some land for $300,000 in February of the current year. The land had been bought in October 1995 at a cost of $180,000. The company only brought to account in its financial statements the difference between the current market value of $220,000 and the proceeds, namely $300,000, as their accounting gain on sale. (g) The directors also advised the financial accountant to make a provision for: (i) bad and doubtful debts of $30,000; (ii) annual leave and long service leave of $60,000. (h) The company also purchased for the managing director a new car at a cost of $120,000. The car was purchased by the company on 1 July of the current year. The effective life of the car is 7.5 years. For accounting purposes, the financial accountant has claimed depreciation in the accounts of $12,000 being 10% of the cost. (i) The company also needed to acquire a series of parts to hold as stock on hand. At the end of the year, the company had closing stock of $146,000. Of this figure, the directors believed
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16: Tax accoUntinG [16.250] 583
that $85,000 represented obsolete stock and wished to write off this amount. The financial accountant had not done this in deriving the profit of $750,000 as he was unsure of how to account for it in the financial accounts. The obsolete stock had been scrapped at the end of the year and taken to a metal recycler. The company has carry forward losses of $150,000. There has been no change in the ownership of the company between the start of the loss year and the end of the current year other than 35% of the shares were sold year to a Perth-based (unrelated) company. The company received the following dividends: • Cash dividend from BHP Ltd of $23,000 fully franked. • Dividend from Intergroup Ltd of $7,800 which was 75% franked. The company had elected to reinvest the dividend and receive shares instead of cash. • Cash dividend from Microsoft Inc, a US company, of A$8,200. An amount of A$1,447 had been withheld as tax by the US Internal Revenue Service. • Dividend of $3,000 unfranked from Golden Beach Pty Ltd which was declared on 5 May of the previous year by the directors but not actually paid until 5 July of the current year. The company accountant had only brought to account as income the actual cash when received in respect of the above dividends. It did not account for any dividends due. The company directors come to you as the taxation adviser of the company and wish to know what the taxable income is for the company and the tax payable. The company wishes to maximise its tax deductions. 16.4 You are the tax accountant for Computer Consultants Pty Ltd, a large company with a turnover of $24 million. You have been asked to review the 30 June accounts for the company. After you conducted your review, you notice the following items had been claimed as a tax deduction in the financial reports: • Provision for long service leave $60,000 (an amount of $21,000 was actually paid). • Maintenance contract fee of $60,000 (this related to the period May of the current year to May in the following year). • Provision for bad debts $40,000 (this was an estimate only by the marketing staff and no legal action has been taken). You are required to write a report to the directors explaining the correct taxation treatment of the above items. In your report, you should refer to the sections of the Act and any relevant case law.
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584 [16.250] PRINCIPLES OF TAXATION LAW 2020 16.5 When are taxpayers allowed to account for their taxable income on a cash basis and when are they required to account for their taxable income on an accruals basis? Could a business with a turnover of $20 million account on a cash basis? 16.6 If your client is required to pay interest on a loan that was used in a business that was sold last year, are they still entitled to claim a deduction for the interest expense even though they are not able to match the expense to the derivation of assessable income from the business? 16.7 Would it be tax effective if your client paid for the lease payments on their photocopier for the next two years in one lump sum just before the end of the financial year? 16.8 If you are accounting on a cash basis in your accounting practice and a client came in to pay their account on 30 June, but you did not bank it until the next day, namely 1 July, when are you taken to have derived that income? Would it make any difference if you were accounting on an accruals basis? 16.9 If your client owns a small business selling designer clothes and sells dresses on a “lay-by” system, when are they said to have derived their income? Is it when the final payment is made or when the first payment has been made? 16.10 Ms Lei is a sole practitioner accountant. Her practice also acts as an agent for a local energy supplier accepting payments. The income is small with five regular employees, including her son and daughter who each work 30 hours a week. The regular employees do not have professional accounting qualifications, so Ms Lei takes responsibility for all work that is completed. Occasionally, where there are difficult tax questions, Ms Lei hires an accountant to do work for the practice. Except for three regular clients who are billed on a quarterly basis, all others are billed when work is complete. Should Ms Lei account for her income on a cash or accruals basis? 16.11 Samuel is the sole shareholder, director and employee of a company. Roger’s company owns and hires out a digger and truck. The business rents the digger and truck out at a fixed rate per hour. The rate is for the backhoe, the truck and Samuel’s labour. The business never rents the backhoe or truck out without Samuel’s labour. For the purposes of taxation, the company has always returned the income from its business on the basis of cash received. The business does not usually extend credit and requests payment on completion of a job. The company maintains simple books of account, recording income when received. For purposes other than taxation, the business records income on a receipts basis, although the business accounts do record debtors and creditors. For taxation purposes, should the business account for the income on a cash or accruals basis?
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17 Trading stock Key points.................................................................................................... [17.00] Introduction................................................................................................ [17.10] Meaning of trading stock........................................................................... [17.20] Common items of trading stock.......................................................... [17.30] Accounting for trading stock..................................................................... [17.50] Acquisitions.......................................................................................... [17.60]
Non-arm’s length transactions................................................................ [17.70]
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Disposals.............................................................................................. [17.80]
Disposals in the ordinary course of the taxpayer’s business.......................................................................... [17.90] Disposals outside the ordinary course of the taxpayer’s business........................................................................ [17.110] Year-end adjustments........................................................................ [17.120] Value of trading stock at start of year................................................... [17.130] Value of trading stock at end of year.................................................... [17.140] Comprehensive example................................................................... [17.210] Trading stock on hand.............................................................................. [17.220] Special rules.............................................................................................. [17.240] Asset of taxpayer becomes trading stock......................................... [17.250]
Item ceases to be trading stock but continues to be owned by taxpayer....................................................................................... [17.260] Lost or destroyed stock..................................................................... [17.270] Small business entities............................................................................ [17.280] Interaction with other income tax rules................................................. [17.290] Questions................................................................................................... [17.300]
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586 [17.00] PRINCIPLES OF TAXATION LAW 2020
Key points [17.00] • Taxpayers who are carrying on a business may have a class of assets known as trading stock which are subject to a special statutory tax accounting regime in Div 70 of ITAA 1997. • The trading stock provisions outline what constitutes trading stock and the timing and quantum of any assessable income or deduction amounts in relation to trading stock. • The definition of “trading stock” is very broad, and it is necessary to determine the taxpayer’s purpose in holding an item to determine whether it is trading stock of the taxpayer. • The timing of income and deductions in relation to trading stock will generally depend on whether the stock is “on hand” for the taxpayer. • The assessable income or deduction amount in relation to trading stock may be altered by special rules, where the taxpayer and the other party to the transaction do not deal with each other at arm’s length. • Taxpayers will have an assessable income amount or a deduction amount at the end of the financial year, depending on the value of trading stock at year-end as compared to the value of trading stock at the start of the year. • Taxpayers have a choice of three methods in valuing trading stock at year-end unless the stock is obsolete. • Special rules govern the tax consequences for a taxpayer, where assets owned by the taxpayer become trading stock or an item of trading stock ceases to be trading stock but continues to be owned by the taxpayer.
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Introduction [17.10] Chapter 16 discusses how income and deductions are generally taken into account for tax purposes, that is, on a cash or accruals basis. In this chapter, we look at the statutory tax accounting regime for a particular class of assets known as “trading stock”. If an asset is classified as trading stock, the timing and quantum of income and deductions relating to trading stock are governed by Div 70 of ITAA 1997. The trading stock provisions essentially match the cost of trading stock with the revenue from its sale. Where the stock remains unsold at year-end, the taxpayer has simply converted one asset (cash) to another (stock). The taxpayer should not be entitled to a deduction in this case as there has been no change in the taxpayer’s economic position. The trading stock provisions provide for an adjustment at year-end to take into account any unsold stock at that time. The trading stock provisions in Div 70 are very similar to the accounting treatment of trading stock. However, there are some differences, such as the methods for valuing stock at year-end.
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Note that there are concessional trading stock rules for small business entities under Div 328. These rules are discussed at [17.280]. Figure 17.1 provides an overview of the tax rules applicable to transactions involving trading stock.
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Figure 17.1: Overall guide
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588 [17.20] PRINCIPLES OF TAXATION LAW 2020
Meaning of trading stock [17.20] “Trading stock” is defined in s 70-10 of ITAA 1997 as follows: Trading stock includes: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and (b) livestock; but does not include a Div 230 financial arrangement.
Note that: • It is clear from the expression “includes” that this is not an exhaustive definition as to what constitutes trading stock. There may be items which do not satisfy this definition but are nonetheless treated as trading stock for tax purposes. However, given the wide definition of “trading stock” in para (a), it is likely that this would only occur in rare instances.
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• “Anything” can be trading stock. In FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452, the High Court suggested that the term “anything” should have the widest possible meaning and includes intangibles. The definition is certainly wide enough to encompass the accounting concept of “inventory” and the ordinary commercial meaning of trading stock. • As “anything” can be trading stock, the key to determining when an item will constitute trading stock is in the purpose for which it is held. An item must be held for the purpose of manufacture, sale or exchange to constitute trading stock. The test is focused on the holding of the asset and will therefore depend on the individual taxpayer at a particular point in time and on the individual asset. • An item does not have to be held directly for manufacture, sale or exchange and items held indirectly for this purpose (eg, spare parts or consumables) can constitute trading stock. • Items held for hire to customers will not be trading stock as they are not held for “manufacture, sale or exchange”: Cyclone Scaffolding Pty Ltd v FCT (1987) 19 ATR 674; Ruling TR 98/8. • An item can be trading stock of a taxpayer even if the taxpayer is not its legal owner: see [17.220].
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Example 17.1: Meaning of “trading stock” Tom is a chair manufacturer. He holds chairs in his factory for sale to retail customers. He takes one of the chairs for use in his office. Simon is Tom’s accountant. He purchases one of Tom’s chairs for use in his office. The chairs held at the factory are trading stock for Tom as they are being held for the purpose of sale. However, the chair which Tom takes for use in his own office, while trading stock at one time, ceases to be trading stock as it is not held for the purpose of manufacture, sale or exchange once Tom uses it for other purposes. The chair purchased by Simon, although trading stock for Tom, is not trading stock for Simon as it is not held by Simon for the purpose of manufacture, sale or exchange. For an item to constitute trading stock, it must be held for the relevant purpose in the ordinary course of the taxpayer’s business. It is therefore necessary to determine whether the taxpayer is carrying on a business and the nature of that business: see Chapter 8.
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Example 17.2: Meaning of “trading stock” TS Pty Ltd builds houses which it rents to residential customers. Due to cashflow problems, it decides to sell 10% of the houses in its latest development project. The houses are not trading stock for TS Pty Ltd. Although they are held for the purpose of sale, this is not in the ordinary course of TS’s business. TS’s ordinary business is to build houses to produce rental income: see ARM Constructions Pty Ltd v DCT (1987) 18 ATR 407. The only item that is clearly trading stock per the definition is livestock. “Livestock” is defined in s 995-1(1) as not including animals used as beasts of burden or working beasts in a business other than a primary production business. Generally, all animals used in a primary production business will be trading stock: FCT v Wade (1951) 84 CLR 105. “Primary production business” is defined in s 995-1 and includes activities such as maintaining animals for the purpose of selling them or their bodily produce and taking or culturing pearls or pearl shell. Examples of livestock include bees kept for use in a honey production business (Determination TD 2008/26) and horses owned by a horse breeder: Ruling TR 2008/2. Examples of livestock that are not trading stock include birds for display in a tourist park (ATO ID 2009/25) and dogs used as guard dogs in business premises (ATO ID 2011/18).
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590 [17.30] PRINCIPLES OF TAXATION LAW 2020 The only item that is definitely not trading stock per the definition is a Div 230 financial arrangement.
Common items of trading stock [17.30] In FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452, the High Court found that land constituted trading stock, where the land is held by a land developer for the purpose of sale in the ordinary course of business. In that case, the taxpayer was in the business of land development, and the Court found that the taxpayer’s undeveloped land constituted trading stock as it was held for the purpose of sale in the ordinary course of business. It did not matter that the land was not in a condition ready for sale at that time. In FCT v St Hubert’s Island, the High Court also confirmed that raw materials (items which are used to make something else) and partly finished goods would constitute trading stock of a manufacturer. However, a distinction has been drawn between goods and services. Unbilled work in progress of a professional services firm generally does not constitute trading stock: Henderson v FCT (1970) 119 CLR 612. Example 17.3: Work in progress not trading stock Tom’s accountant, Simon, has been assisting Tom with the preparation of his monthly accounts. As at 30 June, Simon had spent approximately 10 hours working on Tom’s accounts, but had yet to bill Tom for this work.
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The unbilled work is “work in progress” for Simon, but does not constitute trading stock. Intangibles (non-physical items), such as shares, may also constitute trading stock if they are held with the relevant purpose: Investment & Merchant Finance v FCT (1971) 2 ATR 361; Patcorp Investments Ltd v FCT (1976) 6 ATR 420. Spare parts held by a business for performing repairs will also generally constitute trading stock as they are held for the purpose of exchange in the ordinary course of business. However, spare parts would not constitute trading stock, where they are used to repair items used by the taxpayer in his or her business or are used in the repair of goods which are still owned by the taxpayer (eg, goods leased to customers). Example 17.4: Spare parts as trading stock Tom, the chair manufacturer, includes a complex spring system which he acquires from another business in the chairs that he manufactures. He
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offers a one-year warranty on the spring systems as they can sometimes prove problematic. He holds some extra spring systems in stock for performing repairs. He uses these spring systems for repairs on chairs sold to customers, whether or not they are still under warranty. If they are no longer under warranty, he charges the customer for the cost of the new spring system. He also uses the spring systems to repair chairs used in his own business and to repair chairs that are leased to customers. The spring systems used to repair the chairs owned by customers constitute trading stock. The spring systems used to repair the chairs owned by Tom, that is, the chairs used in his own business, and the chairs leased to customers, will not constitute trading stock as the chairs are still owned by Tom.
The Commissioner provides some guidance in Ruling TR 93/ 20 on when computer spare parts will constitute trading stock. In this Ruling, he suggests that if it is possible to track the use of each spare part individually, this should be done to determine whether the part constitutes trading stock. However, where it is not possible to track spare parts individually, the Commissioner suggests that taxpayers may treat a whole pool of spare parts as trading stock if at least 80% of the pool is used as trading stock.
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There are limits as to the amount of spare parts that can be accumulated by a taxpayer and treated as trading stock. The taxpayer should only hold a sufficient amount of spare parts for the business to continue operating efficiently and any excess would be treated as a capital asset: Ruling IT 333; Guinea Airways v FCT (1950) 83 CLR 584.
Case study 17.1: Spare parts as trading stock In Guinea Airways v FCT (1950) 83 CLR 584, the taxpayer had accumulated a large stockpile of spare parts in order to avoid shipping delays. The High Court found that the excessive amount was not trading stock, but capital assets. [17.40] Items used by a service provider in the course of providing services (consumables) will also constitute trading stock in certain circumstances. In Ruling TR 98/8, the Commissioner suggests that such items would constitute trading stock, where: • the taxpayer is carrying on a business; • the items are supplied in the course of providing services;
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592 [17.50] PRINCIPLES OF TAXATION LAW 2020 • the items are separately identifiable things before and after the services are provided (ie, the items are not used up or significantly changed in the provision of the services); and • ownership of the items passes to the customers.
Example 17.5: Consumables as trading stock Tom has a chair repair business. He holds timber, springs and glue which he uses to repair chairs. The timber and springs would constitute trading stock as they are separately identifiable items before and after Tom repairs a chair. The glue would not constitute trading stock as it is no longer separately identifiable after Tom uses it to repair a chair. Packaging materials held by a taxpayer may also constitute trading stock in certain circumstances. In Ruling TR 98/ 7, the Commissioner suggests that packaging items would constitute trading stock, where they are disposed of in conjunction with “core goods” (what the taxpayer sells) and are so closely associated with the core goods that they form part of the core goods or are necessary to bring the core goods into the form, state or condition in which they are sold.
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Example 17.6: Packaging materials as trading stock Lee owns a takeaway shop selling fried rice and noodles. He holds plastic containers, forks, chopsticks and serviettes, which he provides to customers at the time of sale. The plastic containers constitute trading stock as they are related to the “core good” (the rice or noodles) and are a necessary part of the sale. The forks, chopsticks and serviettes are not trading stock as they are not related to the core goods and are not a necessary part of the sale. Source: Adapted from Example 2, Ruling TR 98/7.
Accounting for trading stock [17.50] A taxpayer will have tax consequences arising: • from the acquisition of trading stock: see [17.60]; • from disposals of trading stock: see [17.80]; and • at year-end: see [17.120].
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Acquisitions [17.60] The acquisition of trading stock by a taxpayer is a deduction under s 8-1 of ITAA 1997 as the expense of acquiring trading stock is “necessarily incurred in carrying on a business to gain or produce assessable income”. Although the taxpayer is acquiring a business asset, the expense is not treated as a capital expense due to the operation of s 70-25. Although the cost of acquiring trading stock is deductible under s 8-1, the timing of that deduction is governed by s 70-15. The cost of acquiring trading stock will be deductible: • when the trading stock is “on hand”: see [17.220]; or • when an amount is included in the taxpayer’s assessable income in relation to the disposal of the trading stock.
Non-arm’s length transactions
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[17.70] Where the buyer and the seller do not deal with each other at “arm’s length” and the amount of the expense is greater than the “market value” of the trading stock, the amount of the deduction for the acquisition of the trading stock is taken to be market value: s 70-20 of ITAA 1997. Section 995-1 does not provide a definition of “arm’s length” but suggests that in determining whether a transaction is at arm’s length, any connection between the parties and any other relevant circumstances must be taken into account. It has been suggested that in determining whether a transaction is at arm’s length, it is necessary to consider whether the outcome of the dealings between the parties is a matter of real bargaining: Granby Pty Ltd v FCT (1995) 30 ATR 400; Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123. For example, a transaction between members of the same corporate group may be a non-arm’s length transaction, but whether or not it is actually a non-arm’s length transaction will depend on the individual circumstances. If the transaction is conducted on the same terms as a transaction with unrelated entities, it is unlikely to be a non-arm’s length transaction. The term “market value” is also not defined in the tax legislation. A generally accepted definition of “market value” is the price that would be agreed to in an open and unrestricted market by a willing but not anxious purchaser and seller who are aware of current market conditions: Spencer v Commonwealth (1907) 5 CLR 418. Note that where the non-arm’s length transaction is not caught by s 70-20 (eg, where the transaction amount is below market value), the purchaser may be deemed to acquire the trading stock at market value if it is a disposal of trading stock for the vendor which is considered to be a disposal outside the ordinary
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594 [17.70] PRINCIPLES OF TAXATION LAW 2020 Figure 17.2 provides a guide to the tax consequences that arise upon the acquisition of trading stock.
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Figure 17.2: Acquisitions of trading stock
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Disposals [17.80] The tax consequences of a disposal of trading stock will depend on whether the disposal is in or outside the ordinary course of the taxpayer’s business.
Disposals in the ordinary course of the taxpayer’s business [17.90] Gross receipts received by a taxpayer will be assessable as ordinary business income under s 6-5 of ITAA 1997. The timing as to when the gross receipts must be included in the taxpayer’s assessable income is stipulated by s 70-5(2)(b). The gross receipts from the disposal of trading stock will be assessable when the trading stock ceases to be “on hand”: see [17.220]. [17.100] Non-arm’s length transactions. Where there is an adjustment to the purchaser’s deduction under s 70-20, because the transaction was not at arm’s length (see [17.70]), s 70-20 provides that the amount that is included in the taxpayer’s assessable income will also be market value. Note that where the non-arm’s length transaction is not captured by s 70-20 (eg, where the purchaser is not acquiring trading stock or the transaction amount is less than market value), the non-arm’s length transaction may be treated as a disposal outside the ordinary course of the taxpayer’s business: see [17.110]. The terms “arm’s length” and “market value” are discussed at [17.70].
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Disposals outside the ordinary course of the taxpayer’s business [17.110] The tax consequences of a disposal of trading stock outside the ordinary course of the taxpayer’s business are governed by s 70-90 of ITAA 1997. A common example of a disposal of trading stock outside the ordinary course of a taxpayer’s business is where trading stock is disposed of as part of the sale of a business. In Pastoral & Development Pty Ltd v FCT (1971) 2 ATR 401, the Federal Court suggested that a sale of trading stock between related parties at an extremely low or high price (a non-arm’s length transaction) may also be considered a disposal outside the ordinary course of business. A gift or donation of trading stock will also be a disposal outside the ordinary course of business (a deduction may be allowed under s 30-15, where the conditions for deductibility in that section are satisfied: see Chapter 13). Where trading stock is disposed of outside the ordinary course of the taxpayer’s business, the taxpayer must include the market value of the trading stock on the day of disposal in assessable income. Any amount actually received by the taxpayer is treated as non-assessable, non-exempt income under s 70-90(2). Under s 70-95, the purchaser is deemed to acquire the trading stock for the same value, that is, market value. “Market value” is discussed at [17.70].
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596 [17.110] PRINCIPLES OF TAXATION LAW 2020 Under s 70-105, disposals of trading stock due to the death of the taxpayer are treated in a manner which gives rise to similar tax consequences as a disposal outside the ordinary course of a business. Figure 17.3 provides a guide to the tax consequences arising upon the disposal of trading stock.
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Figure 17.3: Disposals of trading stock
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Year-end adjustments [17.120] As the cost of acquiring trading stock is deductible once the trading stock is on hand for the taxpayer, an adjustment is required at year-end to take into account any unsold trading stock which is held by the taxpayer at that time. The year-end adjustment ensures that taxpayers are only allowed a deduction for the cost of acquiring trading stock when there is an actual economic decline or “outgoing”. Where the trading stock is “on hand” at year-end, the taxpayer has simply converted one asset (cash) to another (trading stock).
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Under s 70-35 of ITAA 1997, taxpayers are required to compare the “value” of trading stock on hand at the start of the year and at the end of the year. Where the: • value of trading stock at year-end is greater than the value of trading stock at the start of the year, the difference is included in the taxpayer’s assessable income; or • value of trading stock at year-end is less than the value of trading stock at the start of the year, the difference is a deduction for the taxpayer. The “value” of stock at year-end is ascertained by working out which items of trading stock are on hand at year-end and prescribing an amount to each item of trading stock in accordance with one of three methods set out in the legislation (see [17.140]). The legislation does not require that taxpayers undertake a physical stocktake, but this is generally the best method for accurately determining what items of trading stock are on hand at year-end. Taxpayers who maintain accurate records of all purchases and disposals and undertake regular checks throughout the year to account for any losses or errors will not need to perform a year-end stocktake. See further Determination TD 93/125. Small business taxpayers can choose not to perform a stocktake under the concessions discussed at [17.280].
Value of trading stock at start of year [17.130] Under s 70-40 of ITAA 1997, the value of a taxpayer’s trading stock on hand at the start of the year must equal the value of its trading stock at the end of the previous income year. In Hua Wang Bank Berhad v FCT (No 19) [2015] FCA 454, the Federal Court confirmed that the value of trading stock at the end of the previous income year must have been taken into account for tax purposes to be used as the value of trading stock at the start of the following year. For example, if the taxpayer did not lodge a tax return for a particular year, the value of trading stock at the start of the following year will be nil as the trading stock value at the end of the previous year has not been taken into account for tax purposes.
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598 [17.140] PRINCIPLES OF TAXATION LAW 2020
Value of trading stock at end of year [17.140] The taxpayer has three choices when determining the value of trading stock on hand at the end of the year. Under s 70-45 of ITAA 1997, the stock can be valued at: • cost: see [17.150]; • market selling value: see [17.170]; or • replacement value: see [17.180]. The taxpayer can use a different method for valuing different items of trading stock with the only restriction being that the year-end value must be used for the value of the particular item of trading stock at the start of the following year. There is also no restriction on the taxpayer changing valuation methods from year to year. The taxpayer does not have to use one of these three methods in valuing obsolete stock: see [17.190]. The amount of any GST input tax credits (see Chapter 25) is excluded from the value of stock under all three methods: s 70-45(1A).
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[17.150] Cost. The meaning of “cost” in this context is not provided in the legislation, and the courts have held that cost should be determined in accordance with relevant accounting principles: Philip Morris Ltd v FCT (1979) 10 ATR 44; FCT v Kurts Development Ltd (1998) 39 ATR 493. In the case of manufacturers, the courts in Philip Morris Ltd v FCT (1979) 10 ATR 44 and FCT v Kurts Development Ltd (1998) 39 ATR 493 suggested that the “direct cost method” is not appropriate and taxpayers should use the “absorption cost method” to determine the cost of trading stock. In IT 2350, the Commissioner states that under the “absorption cost method”, the following three elements should be taken into account in determining the cost of trading stock manufactured by a taxpayer: • material costs (the cost of materials used to manufacture the particular item of trading stock); • direct labour costs (the cost of labour used directly in the manufacturing operations); and • production overhead costs (all production costs excluding material costs and direct labour costs). The “direct cost method” would only include the first two elements in the cost of an item of trading stock. Production overhead costs are also known as factory overheads, indirect manufacturing costs, manufacturing overheads or manufacturing expenses. These costs fall into two categories –variable production overheads which vary with the volume of production (eg, factory light and power, stores and
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17: TraDinG stocK [17.160] 599
most indirect labour) and fixed production overheads which remain constant and do not vary with the volume of production (eg, factory rent, insurance and depreciation). It is necessary to determine the extent to which production overhead costs relate to manufacturing and non-manufacturing purposes and only the portion relating to the manufacturing operations should be included in the product cost under the absorption cost method. Expenses on marketing, storage, advertising, selling, distribution, finance, research and development, general administration, employee benefits (eg, cafeteria, training, recreational facilities) and income tax are generally not considered production overhead costs. Costs associated with strikes, rework, scrap and spoilage are also not considered to be production overhead costs.
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The determination as to which expenses are to be included as production overhead costs is not a straightforward issue. In FCT v Kurts Development Ltd (1998) 39 ATR 493, for example, the Full Federal Court held that infrastructure and external costs of the subdivision formed part of the cost of individual allotments of land. In the case of retailers and wholesalers, the Commissioner adopts the view in Ruling TR 2006/8 that the “absorption cost method” is the appropriate methodology for determining the “cost” of trading stock. As such, the cost of each item of trading stock includes all direct and indirect expenditure incurred in bringing the item to its present location and condition up to the time that the item is located in its final selling location. Examples of expenses that would be included in the “cost” of trading stock under this method include the purchase price of the stock; any import duties and taxes that are not subsequently recoverable; inwards transport and handling charges; adjustments and assembly costs incurred in preparing the trading stock for sale; costs incurred in operating a purchasing department; and administrative costs associated with receiving and inspecting the trading stock. Any distribution centre and off-site storage costs should also be apportioned and included as relevant. Where the deduction for the acquisition of trading stock is taken to be market value under s 70-20 of ITAA 1997 (ie, a non-arm’s length transaction), the “cost” of the trading stock for the purposes of the year-end valuation will also be taken to be its market value: s 70-20, Note 1. [17.160] Where it is not possible for the taxpayer to determine which individual item of trading stock is on hand and which item has been disposed of, the High Court in Australasian Jam v FCT (1953) 88 CLR 23 held that taxpayers should use the first-in-first-out (FIFO) method for determining cost. Other methods, such as the last-in-first-out method (LIFO), are not acceptable in determining cost.
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600 [17.160] PRINCIPLES OF TAXATION LAW 2020
Example 17.7: Cost of trading stock A retail company purchases 1,000 cans of soup for sale to customers. It purchased the cans as follows:
• 1 July: 200 cans for $0.50 each;
• 1 December: 700 cans for $0.60 each;
• 1 March: 100 cans for $0.55 each.
At 30 June, 600 cans of soup were still on hand. Assume that there were no cans of soup on hand at the start of the year. The taxpayer is unable to accurately determine which cans of soup have been sold and which have not. The value of the remaining cans of soup (trading stock on hand at year-end) using the cost method would be (100 × $0.55) + (500 × $0.60) = $355. Under the FIFO method, it is assumed that all of the cans purchased for $0.50 and 200 of the cans purchased for $0.60 have been sold. In Australasian Jam v FCT (1953) 88 CLR 23, the High Court also accepted that taxpayers could use a “standard or average cost” method for determining the cost of trading stock. However, the standard or average cost must be determined using reasonable values.
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Case study 17.2: Cost of trading stock In Australasian Jam v FCT (1953) 88 CLR 23, the taxpayer had determined the standard cost of its trading stock (jars of jam) in one income year and continued to use that standard cost for valuing its trading stock over the next 30 years. The High Court accepted the method used by the taxpayer, but found that the values used were not reasonable. The Court accepted the Commissioner’s valuation of the taxpayer’s trading stock, which had also been determined using the standard cost method, although the standard cost had been calculated using updated amounts.
Example 17.8: Average cost of trading stock Following on from Example 17.7, the taxpayer could also determine the cost of the cans of soup on hand at year-end using the average cost. The average cost of the cans of soup would be [(200 × $0.50) + (700 × $0.60) + (100 × $0.55)] /1,000 = $0.58. The value of the taxpayer’s stock at year- end would be 600 × $0.58 = $348.
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17: TraDinG stocK [17.190] 601
Note that the FIFO basis or average cost method should only be used, where the taxpayer is unable to determine which items of trading stock have been sold and which items remain on hand: Ruling IT 2289. Where the taxpayer is able to make that determination, the actual cost of the item should be used. [17.170] Market selling value. Market selling value is the amount for which the taxpayer could sell the trading stock in the ordinary course of its business in its ordinary market: Australasian Jam v FCT (1953) 88 CLR 23. For example, the market selling value of a wholesaler would be the amount for which it could sell the stock in the wholesale (not retail) market. Further, the value is to be determined in accordance with the taxpayer’s normal selling arrangements and not, for example, under sale conditions. The note to s 70-45 of ITAA 1997 confirms that “market selling value” may not be the same as “market value”. “Market value” is discussed at [17.70].
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[17.180] Replacement value. The replacement value of trading stock is the amount the taxpayer would have to spend to replace the stock. Again, the amount must be the relevant amount for the taxpayer: Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 1017. For example, the replacement value for a wholesaler would be the amount for which it could purchase the stock, and not, for example, the amount it would pay if it acquired the stock in the retail market. In Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 1017, the Court stated that while actual replacement is not necessary and only notional replacement is required, there may be situations where replacement value is not an option for the taxpayer as replacement must be possible and not defy business reality. The Commissioner suggests that taxpayers can only use replacement value, where the items are available in the market and are substantially identical to the replaced items: Determination TD 92/198. For example, an antiques dealer is unlikely to be able to take into consideration replacement value in valuing its year-end trading stock as antiques are unique and not readily available in the market. [17.190] Obsolescence. Under s 70- 50 of ITAA 1997, taxpayers may value trading stock at a value lower than the three methods provided by s 70-45, where: • the stock is obsolete; and • the value used by the taxpayer is reasonable. In Ruling TR 93/23, the Commissioner suggests that stock will be obsolete, where it is or it is going to be out of use, out of date, unfashionable or outmoded. In para 5 of the Ruling, the Commissioner suggests the following factors as being relevant in making that determination: (a) the age of the stock on hand; (b) the quantities of the stock on hand which, according to the operating and sales budgets, are expected to be used or sold during the year and in the future;
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602 [17.200] PRINCIPLES OF TAXATION LAW 2020 (c) the length of time since the last sale, exchange or use of an item of the stock; (d) industry experience/taxpayer expertise in relation to the same kind or class of trading stock; (e) the price at which the last sale of the stock was made, the price of the stock on the taxpayer’s price list and the price at which the taxpayer is prepared to sell the stock; and
(f) if the stock is spare parts:
(i) the past movements of the stock and the expected future movements of the stock compared with the total number of units in existence which might require that stock; and
(ii) the approximate date by which the last of those units can be expected to have gone out of use.
The Commissioner suggests that the accurate value of obsolete stock will generally be the value of the stock at which it is reasonable to assume that it will be sold in the future, or its scrap value if the stock will not be sold. The stock may have a nil valuation, where it cannot be sold or be used for any other purpose. [17.200] New livestock from reproduction. Where the taxpayer has new livestock through natural reproduction, the cost of the livestock is, of course, zero. Section 70-55 of ITAA 1997 allows taxpayers to value such livestock at any cost up to their market value subject to prescribed minimum values.
Comprehensive example
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[17.210] The following example illustrates the application of the rules regarding the acquisition, disposal and year-end adjustments of trading stock. Example 17.9: Comprehensive example Tom is a chair manufacturer. He sells chairs directly to the public through a catalogue. His books of account provide the following information: 1 July
30 June
Completed chairs ready for sale
$3,000
$1,000
Partly completed chairs
$1,500
$3,000
Timber
$700
$500
Springs
$1,000
$600
Total purchases of timber during the year = $3,000 Total purchases of springs during the year = $1,000 Total sales of chairs during the year = $20,000
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17: TraDinG stocK [17.220] 603
Tom’s income tax consequences in relation to the chairs are as follows:
• The chairs are trading stock as Tom holds them for the purpose of sale in the ordinary course of his business: s 70-10 of ITAA 1997.
• The partly completed chairs and the timber and springs are also trading stock under s 70-10, as confirmed by FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452.
• The acquisition of timber and springs during the year is a deduction under s 8-1 and the expenses are deductible when the springs and timber are on hand or an amount is included in Tom’s assessable income in relation to their disposal: s 70-15.
• The $20,000 received for the sale of chairs must be included in Tom’s assessable income under s 6-5 once the chairs are no longer “on hand”: s 70-5(2)(b).
• Tom has a year-end adjustment under s 70-35 of $1,100, being the difference between the value of his stock on hand at year-end and the value of his stock on hand at the start of the year. The difference is a deduction as the value of Tom’s stock at year-end is less than the value at the start of the year.
Trading stock on hand
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[17.220] It is very important for a taxpayer to determine when trading stock is “on hand”. Whether or not trading stock is on hand determines: • when a taxpayer includes gross receipts on sale of trading stock in assessable income; • when a taxpayer can claim a deduction for the acquisition of trading stock; and • the value of trading stock at year-end. There is no guidance in the legislation as to when trading stock is “on hand”. It is generally accepted that trading stock will be on hand, where the taxpayer has dispositive power over the stock: Farnsworth v FCT (1949) 78 CLR 504; FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277; All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874; see also Ruling IT 2670. A taxpayer has dispositive power, where the taxpayer has the power to dispose of the stock. Generally, legal ownership will provide dispositive power, but this is not always the case. Whether or not a taxpayer has dispositive power will depend on the individual facts of a case and no single factor (eg, possession, ownership or control) will be determinative. Taxpayers may have dispositive power without having physical possession of the items.
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604 [17.220] PRINCIPLES OF TAXATION LAW 2020
Case study 17.3: Trading stock not “on hand” In Farnsworth v FCT (1949) 78 CLR 504, the taxpayer was a fruit grower who had delivered her fruit to a packing house, where it would be processed with other fruit prior to being packed and sold. The taxpayer’s fruit was not separately identifiable once it was delivered to the packing house and the taxpayer received progressive payments based on estimated sales. The High Court found that the fruit that had been delivered to the packing house was no longer trading stock on hand of the taxpayer. The Court noted that the taxpayer no longer had direct power or control over the disposal of her fruit. The fact that the taxpayer no longer had possession, control and risk in relation to her trading stock meant that she no longer had dispositive power over the trading stock. As the taxpayer did not have dispositive power over the stock, it was no longer “on hand”.
Case study 17.4: Trading stock “on hand”
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In FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277, the taxpayer was a car dealer who had cars from the manufacturer under a floor-plan arrangement. Under the arrangement, the taxpayer had possession of the cars, risk and control over the cars and the right to sell them. However, the taxpayer did not actually have ownership of the cars. It only had the right to acquire the cars, which it did once it had found a buyer for a car. The High Court found that the cars were trading stock of the taxpayer, even though it did not have ownership of the cars because, under the terms of the floor- plan arrangement, the taxpayer had the power to dispose of the cars even though it did not have ownership over them. Case study 17.5: Trading stock “on hand” In All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874, the taxpayer was a wholesaler of frozen goods. At year-end, some of its frozen goods were on ships at sea en route to Australia. The Full Federal Court found that the frozen goods were trading stock on hand of the taxpayer as the taxpayer had dispositive power over the goods. In this case, the fact that the taxpayer did not have possession of the goods did not matter because, under the terms of the shipping agreement, the taxpayer had control, risk and ownership of the goods once they were placed on the ship (CIF contract). Therefore, the taxpayer had the power to sell the goods even while they were still at sea.
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17: TraDinG stocK [17.250] 605
[17.230] Where the trading stock is land or buildings on land, the Full Federal Court in Gasparin v FCT (1994) 28 ATR 130 held that the time when the land or buildings cease to be trading stock is the date of settlement of the contract of sale as that is the time when dispositive power over the land or buildings is lost. The Commissioner has issued a number of rulings and determinations as to when a particular item of trading stock is “on hand”. The Commissioner suggests that: • goods sold under a lay-by arrangement which are still in the seller’s possession are trading stock on hand of the seller: Ruling TR 95/7; • goods sold under a conditional contract are trading stock on hand of the buyer if they are in the buyer’s possession at year-end. However, they revert to being trading stock of the seller if they are returned: Ruling TR 97/15; and • goods provided to prospective purchasers or retailers for display purposes only remain trading stock of the wholesaler until the purchaser or retailer enters into a contract of sale or consignment for the goods: Determination TD 95/48.
Special rules
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[17.240] Whether an item constitutes trading stock of the taxpayer depends on the taxpayer’s purpose in holding the asset. Therefore, the characterisation of an asset can change over time depending on the taxpayer’s purpose in holding that asset, even though there is no change in ownership. There are special rules that govern the tax consequences for a taxpayer, where an asset which was previously owned by the taxpayer becomes trading stock (see [17.250]) or where an item of trading stock ceases to be trading stock, but continues to be owned by the taxpayer: see [17.260].
Asset of taxpayer becomes trading stock [17.250] Where an asset that is owned by a taxpayer becomes trading stock, the taxpayer is deemed to have disposed of the asset and re-acquired an item of trading stock under s 70-30 of ITAA 1997. The taxpayer has a choice under the section as to whether the deemed disposal and re-acquisition is done at “cost” or at “market value”. “Cost” is determined in accordance with s 70-45 (see [17.150]): s 70- 30(3). Where the item was originally acquired for no consideration, its cost is determined in accordance with s 70-30(4). The tax consequences arising upon the deemed disposal will depend on the taxpayer’s holding of the asset prior to the change.
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606 [17.250] PRINCIPLES OF TAXATION LAW 2020 Where the asset was held as a depreciating asset prior to becoming trading stock, a balancing adjustment may be required under Div 40 to account for the deemed disposal: see Chapter 14. Where the asset was held as a CGT asset prior to becoming trading stock, the tax consequences will depend on whether the deemed disposal was done at “cost” or “market value”. Where the taxpayer elects for the deemed disposal to be done at “cost”, any CGT consequences arising on the deemed disposal are disregarded: s 118-25. Where the taxpayer elects for the deemed disposal and re-acquisition to take place at “market value”, CGT Event K4 happens to the taxpayer at that time under s 104-220. The tax consequences for the taxpayer will be: • a capital gain where the market value of the asset on the day it becomes trading stock is greater than the cost of the asset; or • a capital loss where the market value of the asset on the day it becomes trading stock is less than the cost of the asset. Upon the deemed re-acquisition of the asset, the taxpayer will be entitled to a deduction under s 8-1 for the cost of acquiring the trading stock –this will either be “cost” or “market value” depending on the taxpayer’s election in relation to the deemed disposal. If the stock is still on hand at the end of the year, the taxpayer will have to include the value of the trading stock in the value of its trading stock on hand at year-end.
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Example 17.10: Asset of the taxpayer becomes trading stock Declan owns a block of land, Blackacre, which he purchased in Year 1 for $200,000. Since that time, Declan has become involved in a number of land development activities and in Year 3 he decided to venture Blackacre into the business. The value of Blackacre at that time was $500,000. In Year 4, Declan sold Blackacre for $700,000. In Year 3, a capital asset of Declan’s became trading stock. At that time, Declan is deemed to have disposed of Blackacre for either cost or market value and is deemed to re-acquire it on the same day for the same value. Declan’s tax consequences on the disposal of Blackacre in Year 4 will depend on his choice of method in Year 3. Option 1: Declan chooses “cost” Year 3 Declan would claim a deduction under s 8-1 for the cost of acquiring trading stock ($200,000). However, that amount would be reflected in the value of Declan’s trading stock at year-end as Blackacre is still on hand at that time. Therefore, under the trading stock rules, Declan effectively
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has no tax consequences from the asset becoming trading stock in Year 3. (The capital gains tax provisions may give rise to separate tax consequences for Declan.) Year 4 Declan includes the $700,000 received for the sale of Blackacre in his assessable income. As Blackacre is no longer on hand at year-end, Declan will effectively receive a deduction of $200,000 in that year as that amount is included in the value of his trading stock on hand at the start of the year, but not in the value of his trading stock on hand at the end of the year. Therefore, Declan is in a net income position of $500,000 in Year 4. Option 2: Declan chooses “market value” Year 3 Declan would have a capital gain of $300,000 under s 104-220 as the cost of the asset ($200,000) is less than its market value on the day of the deemed disposal ($500,000). Declan would claim a deduction of $500,000 under s 8-1 for the “cost” of acquiring trading stock (Declan is deemed to have reacquired Blackacre for $500,000 which is the market value at that time). However, that amount would be reflected in the value of his trading stock at year-end as Blackacre is still on hand at that time. Therefore, Declan has a capital gain of $300,000 on the asset becoming trading stock in Year 3 and no further tax consequences under the trading stock provisions.
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Year 4 Declan includes the $700,000 received for the sale of Blackacre in his assessable income. As Blackacre is no longer on hand at year- end, Declan will effectively receive a deduction of $500,000 in that year as that amount is included in the value of his trading stock on hand at the start of the year, but not in the value of his trading stock on hand at the end of the year. Therefore, Declan is in a net income position of $200,000 in Year 4. Essentially, the two options merely result in a timing difference. However, as an individual who has owned the CGT asset for more than 12 months, Declan would be entitled to discount the $300,000 capital gain on Blackacre to $150,000 (assuming he has no capital losses) and Option 2 would therefore provide Declan with a better overall tax outcome. Where the taxpayer is a company, the two options only result in a timing difference as companies cannot discount a capital gain: see Chapter 11.
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608 [17.260] PRINCIPLES OF TAXATION LAW 2020
Item ceases to be trading stock but continues to be owned by taxpayer [17.260] Where a taxpayer ceases to hold an item as trading stock, but continues to own it, the taxpayer is deemed to have disposed of the item and re-acquired it for “cost” under s 70-110 of ITAA 1997. An item of trading stock would generally cease to be trading stock when the taxpayer’s purpose in holding the asset changes. Section 70-110 provides the example of a sheep grazier who takes a sheep from stock for personal consumption. The taxpayer will have to include the “cost” of the trading stock in assessable income under s 6-5 in the income year in which he or she ceases to hold the asset as trading stock. Upon re-acquisition, the cost of the trading stock will become the asset’s cost base if the taxpayer holds it as a CGT asset or its cost under Div 40 if the taxpayer holds it as a depreciating asset. Example 17.11: Item ceases to be trading stock of taxpayer Michael owns a bookstore specialising in first-edition books. He purchased a first-edition copy of The Chronicles of Narnia by CS Lewis for $12,000 for the store. The book did not sell and, after a few months, he decided to remove the book from the shelf and keep it for himself.
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The acquisition of the book is the acquisition of an item of trading stock as Michael sells books in the ordinary course of his business. Therefore, the $12,000 is deductible under ss 8-1 and 70-15 as the book is on hand. When Michael takes the book from the store for himself, it ceases to be trading stock and Michael is deemed to have disposed of it for cost under s 70-110. As such, Michael must include $12,000 in his assessable income for the year. Although Michael is also deemed to have acquired the book for its cost ($12,000), the $12,000 is not deductible as the book is for Michael’s private or domestic use (see Chapter 12). The $12,000 may form part of the cost base of the book should there be capital gains tax consequences at a later point in time. Each year the Commissioner publishes a Taxation Determination, which provides the amounts that the Commissioner will accept as reasonable estimates of the value of goods taken from trading stock for private use by taxpayers in certain businesses such as a bakery, butcher, restaurant, etc. The relevant Determination for the 2018–2019 income year is TD 2019/2. At the time of writing, the relevant Determination for the 2019–2020 income year had yet to be published.
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17: TraDinG stocK [17.290] 609
Lost or destroyed stock [17.270] Any lost or destroyed stock is effectively taken into account through the year-end adjustment as the stock is not “on hand” at that time and is not included in the value of the trading stock at year-end. Any amount received as compensation for lost or destroyed stock (eg, insurance proceeds) is included in the taxpayer’s assessable income under s 70-115 of ITAA 1997.
Small business entities [17.280] A “small business entity” can choose not to account for changes in the value of stock for an income year, where the difference between the opening value of stock on hand and a reasonable estimate of stock on hand at year-end is less than $5,000: s 328-285. As with other taxpayers, the value of trading stock at year-end becomes the value of trading stock at the start of the following year: s 328-295. In this context, a “small business entity” is a sole trader, partnership, company or trust that operates a business for all or part of the income year and has an aggregated turnover of less than $10 million: s 328-110. Broadly, “aggregated turnover” is the entity’s turnover plus the annual turnover of any business that is connected or affiliated to the entity. Taxation Ruling TR 2019/1 provides guidance as to when a company carries on a business for the purposes of s 328-110.
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Where the “small business entity” chooses to account for changes in the value of trading stock, the general trading stock rules discussed in this chapter apply.
Interaction with other income tax rules [17.290] An asset that is trading stock may also qualify as a CGT asset and be subject to tax under the CGT rules discussed in Chapter 11. This is prevented from happening by s 118-25 of ITAA 1997, which provides that any capital gain or loss arising is disregarded if, at the time of the CGT event, the CGT asset is classified as trading stock. Similarly, an item of trading stock may also qualify as a depreciating asset and be subject to the capital allowances regime discussed in Chapter 14. This is prevented from happening by s 40-30(1)(b), which excludes an item of trading stock from the definition of “depreciating asset”. However, an item of trading stock that is a financial arrangement under Div 230 will be subject to tax under those provisions and not the trading stock provisions: s 70-10.
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610 [17.300] PRINCIPLES OF TAXATION LAW 2020
Questions [17.300] 17.1 Consider whether the following are trading stock: (a) Bees kept for use in a honey production business. (b) Horses used in the city horse carriage tour business. (c) Horses owned by a horse- training business for racing in competitions. (d) Horses owned by a race horse breeder. (e) Undeveloped land owned by a land developer. (f) Motherboards owned by a computer manufacturer for making computers. (g) Partly finished computers of a computer manufacturer. 17.2 Rumpole is a share trader who owns shares as trading stock because they are held for sale in the ordinary course of his business. He decided to purchase shares in various blue- chip companies as a long- term investment to provide for his children’s education in the future. The children are currently three and five years old. Are the shares in the blue-chip companies trading stock for Rumpole?
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17.3 Best Juice is a juice retail company in Australia. The company purchases exotic juices from various wholesalers and sells the juices to the public through various pop-up outlets. The company started operations during the last financial year and had no stock on hand at the start of the year. During the year, the company undertook the following transactions: • 1 August: Purchased 3,000 bottles of juice for $1 each; • 1 December: Purchased 5,000 bottles of juice for $1.50 each; • 1 February: Purchased 3,000 bottles of juice for $1.10 each. The company has determined that at 30 June, it has 1,000 bottles of juice in stock. However, it is unable to determine when these bottles were purchased. At 30 June, the bottles of juice could be purchased by the company for $1.30 each and the company sells the bottles for $2.50 each. Advise Best Juice as to how it should value its stock on hand at 30 June if it wishes to minimise its tax liability for the year. 17.4 Isabelle lives in Melbourne, Australia. She has a little shop in the city selling colourful umbrellas. Isabelle only sells colourful umbrellas because she thinks that people need to see lots of colours on a rainy day. She purchases these umbrellas from various suppliers in other countries. During the year, Isabelle had the following transactions:
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17: TraDinG stocK [17.300] 611
(a) Purchased $7,500 worth of umbrellas on 20 June from an overseas supplier. The umbrellas were loaded on to a ship the next day and under the terms of Isabelle’s agreement, she takes ownership, control and risk of the umbrellas only once they are delivered to her in Melbourne and she deems them to be of acceptable quality. Isabelle received the umbrellas on 2 July and returned $500 worth of umbrellas the same day. (b) Gave away 10 umbrellas to family and friends as gifts. The umbrellas cost $10 each and Isabelle sells them for $100 each. (c) Took an umbrella home for her own use as it was raining heavily, and she had forgotten to bring her umbrella to work. The umbrella cost $10 and Isabelle would have sold it for $100. (d) On 15 June, Isabelle decided to have an “all stock must go” sale so that she could buy new umbrellas for the new financial year. She sold all of her remaining stock (100 umbrellas) for $50 each. The umbrellas had cost $10 each. Advise Isabelle as to her income tax consequences arising from the above information. 17.5 Best Blinds manufactures and sells blinds and curtains to the general public. The company’s books of account provide the following information:
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1 July
30 June
Completed blinds and curtains ready for sale
$15,000
$7,000
Partly completed blinds and curtains
$10,000
$5,000
Material to manufacture curtains and blinds
$4,000
$8,000
Thread to prepare curtains and blinds for installation (not separately identifiable once the curtains and blinds are installed)
$1,500
$2000
Total purchases of material during the year = $3,000 Total purchases of thread during the year = $1,000 Total sales of blinds and curtains during the year = $100,000
Advise Best Blinds of its income tax consequences arising from the above information.
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Part 5
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Investment and Business Entities To this point, the book has focused on the tax formula as it applies to individual taxpayers, whether they are an employee or a sole trader. However, once a student is able to determine income tax payable for an individual taxpayer, it is then possible to understand the basic concepts which apply to other entities, such as superannuation funds, partnerships, companies and trusts. In addition to the unique issues raised by various structures, taxpayers may undertake international transactions. Both the structure adopted and the types of transactions undertaken, whether domestic or international, add a new level of complexity to income tax. Part 5 of this book considers the various structures recognised for tax purposes, some of which pay tax as a separate entity while others are treated as having distributed the taxable income to the underlying taxpayers. It also considers the international tax rules which may affect taxpayers, whether individuals or other types of entities. The taxable income of the various structures will be determined in the same way as an individual. However, in addition to applying the taxation formula, there are unique rules which apply to specific entities recognised for taxation purposes. Part 5 discusses these rules. Chapter 18 examines superannuation and other retirement savings and explains that, while a superannuation fund is a type of trust, there are specific tax rules which apply. In particular, complying superannuation funds are taxed concessionally as well as having their own legislative regime. Chapter 19 considers partners and partnerships and explains that while a partnership lodges a separate tax return, it does not pay income tax.
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614 PRINCIPLES OF TAXATION LAW 2020
Rather, the net income or loss of a partnership is taken into account at partner level, with the partner including the net income of the partnership in his or her taxable income or offsetting the loss against other income. In addition to this basic principle, Chapter 19 explains that there are special rules in relation to salaries paid to partners, interest on capital contributions, superannuation payments, trading stock, capital gains and dividends.
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Another structure often adopted by taxpayers is a trust. Chapter 20 examines the taxation of trusts and beneficiaries. Like partnerships, trusts are also required to lodge a separate tax return but do not pay income tax. Rather, it is the beneficiaries, where presently entitled, who pay the income tax or, where the beneficiaries are not presently entitled, the trustee pays the income tax on the beneficiary’s share of the net trust income. Again, there are special rules which need to be considered in relation to trusts and beneficiaries and Chapter 20 discusses these. In particular, it outlines the different status of beneficiaries, the different types of trusts, the consequences of a trust receiving dividends or capital gains, the distribution of trust income to minors and differences between the taxation laws and accounting principles in determining the net income of a trust. The final structure considered is that of companies. Chapter 21 looks at the taxation of companies and shareholders. Companies are treated as a completely separate entity and taxed as such. In other words, a company pays tax on its net income at a flat rate. Further, a company cannot distribute net losses but instead carries them forward to later years. A company distributes its net income to its shareholders by way of dividends. Dividends are subject to the dividend imputation regime. An imputation regime is contrasted with a classical regime, which taxes the company on its net profits and then taxes the shareholders on the dividends. The imputation system does not impose double taxation on the company’s net income but rather provides a grossing up and credit mechanism to ensure that the profits are effectively taxed at the shareholder’s marginal tax rate. International transactions add a further layer of complexity to the simple income tax payable formula. Chapter 22 considers the principles which govern cross-border transactions. It looks at foreign income of Australian residents, taking into account the ways in which double taxation is avoided either via an exemption or a credit. It also examines the accruals regime which prevents the deferral of tax where income is not repatriated to Australia. Chapter 22 further looks at Australian source income of foreign residents, particularly the withholding tax regime. In addition to
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PART 5: INVESTMENT AND BUSINESS ENTITIES 615
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the allocation and taxing rules, the international tax regime contains anti- avoidance provisions which prevent non-arm’s length transfer pricing and appropriate debt-to-equity levels under the thin capitalisation regime. Finally, the overriding effect of the tax treaties (also known as double tax agreements) to which Australia is a party is considered.
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18
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Taxation of superannuation Key points.................................................................................................... [18.00] Introduction................................................................................................ [18.10] Types of superannuation funds................................................................. [18.20] Complying and non-complying superannuation funds...................... [18.30] Taxed and untaxed funds.................................................................... [18.40] The three stages of taxation of an investment in superannuation........ [18.50] Stage 1: Taxation of contributions........................................................... [18.60] Concessional contributions................................................................. [18.70] Concessional contribution caps.......................................................... [18.80] Non-concessional contributions.......................................................... [18.90] Non-concessional contribution caps................................................. [18.100] Co-contribution scheme.................................................................... [18.110] Low-income superannuation tax offset............................................ [18.120] Age limits for superannuation contributions.................................... [18.125] Stage 2: Taxation of superannuation funds........................................... [18.130] Taxation of contributions received by the fund................................ [18.140] Taxation of superannuation fund’s earnings.................................... [18.150] Stage 3: Taxation of superannuation benefits paid to members......... [18.160] Preservation age and access to superannuation.............................. [18.170] Taxation of benefits paid as a lump sum................................................ [18.180] Taxed funds........................................................................................ [18.180] Untaxed funds.................................................................................... [18.190] Taxation of benefits paid as an income stream..................................... [18.200] Types of income streams.................................................................. [18.200] Taxation of income streams.............................................................. [18.210] Transition to retirement accounts..................................................... [18.215] Death benefits.................................................................................... [18.220]
Entitlement to receive a death benefit.................................................. [18.225] Taxation of a death benefit.................................................................... [18.230] Questions................................................................................................... [18.240]
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618 [18.00] PRINCIPLES OF TAXATION LAW 2020
Key points
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[18.00] • Income tax concessions are provided to encourage people to save for retirement rather than rely on government pensions. • Only complying superannuation funds are eligible for tax concessions. • Income tax impacts three stages of a superannuation investment: – contributions stage; – investment stage; – payment of benefits stage. • Contributions are treated as concessional and non- concessional contributions. • The Superannuation Guaranteed Contribution is the minimum contribution an employer is required to contribute to an employee’s superannuation fund. • Contributions that are tax deductible (concessional contributions) are taxed on receipt by the superannuation fund at a concessional rate. • Caps apply to limit the tax concessions that are available. • The government has implemented a scheme whereby the government contributes additional funds to low-income earner’s superannuation accounts. • Income earned by the superannuation fund is taxed at concessional rates. • Income earned on funds supporting a superannuation income stream is tax free. • Income tax treatment of benefits paid to superannuation fund members is influenced by: – the member’s age; – whether the payments are taken as a lump sum or income stream; – payments made as a result of the member’s death; – the status of the superannuation fund as a taxed or untaxed fund; and – whether the benefits are paid from funds that were or were not part of the taxable income of the superannuation fund.
Introduction [18.10] “Superannuation” is the name given to investments contributed by employees, employers (on behalf of employees) and the self-employed to be later drawn on to fund retirement. With an ageing population, legislation has been employed to provide tax concessions to encourage people to fund their own retirement. Over the years, there have been countless changes to these concessions but in general, the concessions are aimed at reducing the income
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tax imposed on both the investments into the superannuation fund and the earnings of the fund (see Figure 18.1). Superannuation is therefore a very important area of income tax law in Australia, but it is also a very important part of the Australian economy as superannuation funds hold and invest assets in excess of $2.9 trillion. These superannuation funds are also rapidly increasing in size due to the 9.5% superannuation guarantee charge on wages being paid by employers into employee superannuation funds. The government has announced that this will be eventually increased to 12% over time, so the amount being invested in superannuation will continue to grow. Also, adding to the value of assets held in superannuation is the fact that retirees are able to leave their investments in the superannuation environment with earnings on those investments subject to tax at only 15%. However, when tax concessions are provided, it is also necessary for the legislation to provide boundaries in which the benefits are available. This is needed to reduce the opportunity for exploitation of the concessions, which would result in an excessive loss of government revenue. Consequently, legislation governing the control of superannuation funds and the taxation of superannuation investments has become very complex.
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The superannuation provisions of Income Tax Assessment Act 1997 (Cth) (ITAA 1997) were significantly revised in 2007 (Tax Laws Amendment (Simplified Superannuation) Act 2007 (Cth)) with the purported aim of simplifying the taxation of superannuation transactions. These provisions are contained in Pt 3-30 of ITAA 1997 and deal with the taxation of the contribution stage, the taxation of the earnings of the superannuation fund and the taxation of benefits provided to members. In this chapter, the taxation of superannuation is dealt with by first providing an overview of the nature of funds that can accept superannuation contribution and then examines the taxation implication of the three stages of the superannuation investment stream: • Stage 1: Taxation of contributions; • Stage 2: Taxation of superannuation funds; and • Stage 3: Taxation of superannuation benefit payments.
Types of superannuation funds [18.20] Superannuation funds are set up in the form of a trust and are regulated by the Australian Prudential Regulation Authority (APRA). These funds can be very large with many thousands of members and mainly consist of industry funds (run by employer associations) and retail funds (run by financial institutions). In addition, funds can be set up as Self-Managed Superannuation
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620 [18.30] PRINCIPLES OF TAXATION LAW 2020 Figure 18.1: Superannuation overview Taxation of superannuation
Tax concession available to complying funds
3 stages of taxation
1. Contributions
2. Taxation of superannuation fund’s income
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3. Taxation of benefits paid to members
Concessional contributions
Taxed at 15%
NonConcessional contributions
Not taxed
Taxed on income at 15%
Lump sum
Income stream
Death benefit
Funds (SMSFs) which may only have one or a few members. SMSFs are regulated by the Australian Taxation Office (ATO) which currently regulates about 600,000 SMSFs with assets of around $750 billion. For income tax purposes, it is important to classify superannuation funds as either: • complying and non-complying superannuation funds; and • taxed and untaxed superannuation funds.
Complying and non-complying superannuation funds [18.30] The tax concessions discussed in this chapter are only applicable to money invested in a complying superannuation fund. Superannuation
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funds are regarded as complying when they have both complied with various government regulations and have elected to be complying superannuation funds. In contrast, non-complying funds do not meet the regulatory requirement, and investments in these funds are not eligible for tax concessions. In general, most industry and retail superannuation funds that are widely available to employees will be complying funds. If in doubt, taxpayers can check whether a superannuation fund is a complying fund by checking the APRA website or the Government supported “Super Fund Lookup” website. An SMSF, as their name suggests, is a fund where the taxpayer initiated the creation of the trust which operates as a superannuation fund, and the fund is managed by the taxpayer themselves. Taxpayers that operate an SMSF need to be fully aware of the relevant regulations to ensure that their fund is regarded as a complying superannuation fund. These requirements include completing necessary reporting obligations, appointing an approved auditor for a yearly audit and complying with certain investment requirements.
Taxed and untaxed funds
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[18.40] Most superannuation funds are liable to pay tax on their assessable income and as such they are known as taxed funds. Untaxed funds are not liable to income tax as they have been established as Constitutionally Protected Funds (CPFs). There are only a very small number of untaxed funds, and they include, for example, funds setup for state government employees and the judiciary.
The three stages of taxation of an investment in superannuation [18.50] Taxation of an investment stream normally affects one or more of the following three stages: 1. Earnings of the funds which are subsequently made available for investment. 2. Earnings that are realised while funds are invested. 3. Return of the investment to the taxpayer. However, the taxation of these three stages can vary quite significantly depending on the type of investment and whether it is eligible for the con cessions provided for certain superannuation funds. For example, taxation of an investment stream made outside the superannuation industry is normally taxed as follows (see Example 18.1):
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622 [18.50] PRINCIPLES OF TAXATION LAW 2020 1. The taxpayer’s assessable income is taxed when earned, and any amount remaining after personal expenses may then be available for investment. For example, if the taxpayer is on the top marginal tax rate of 47% (including Medicare levy) and earns an additional $1,000, they will first pay tax of $470 leaving $530 to invest if they choose to do so. 2. Once funds are invested, any income earned from that investment (eg, interest or dividends) will also be taxed at the marginal tax rate (in some cases, concessional tax treatment such as franking credits on dividends, or the 50% discount on capital gains, may reduce the tax). 3. The invested funds are capital in nature and are not taxed on withdrawal. In contrast, investments in superannuation are treated differently for tax purposes, and it is this difference that makes superannuation a significant tax- sheltered investment. To understand how investments in superannuation are treated, it is necessary to understand the tax consequences for transactions carried out through the three stages of investment (see Example 18.1): 1. Contributions to the superannuation fund. These contributions may be made by an employer, employee, employee on behalf of their spouse or a self-employed person on their own behalf. In some cases, these contributions are tax deductible, which means that the funds available for investment are greater.
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2. Taxation of the income of the superannuation fund. The primary sources of assessable income of the superannuation funds are from the receipt of contributions to the fund and from investment earnings. 3. Taxation of benefits distributed to members. The tax treatment of funds withdrawn from superannuation differs depending on the tax treatment when the funds were invested into the superannuation scheme. As a general rule, the legislation aims to only tax the invested stream once, either on entry or exit but not both. The following example shows the tax sheltering effect of contributions to a superannuation fund via a salary sacrifice compared to a private investment that is made from after-tax income. As the example shows the superannuation investment grows more rapidly, but it also needs to be remember that investments into a superannuation fund are not available to the taxpayer except at death, retirement or disability. Example 18.1: Comparison of the taxation of an investment in superannuation and a private after-tax investment The following example is based on an employee earning $100,000 per annum with a marginal tax rate of 39% (including Medicare levy). The comparison is between increasing superannuation contributions by $15,000 per year through salary sacrifice or a private investment from the
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same amount of gross wage (before tax). A return of 5% per annum is assumed for both investments. A superannuation fund is taxed at $0.15/$1 on contributions via salary sacrifice and is also taxed at the same rate on earnings from investments. Option 1: Private investment –year 1 Income
$15,000
Less income tax ($15,000 × 39%)
−$5,850
Available to invest Interest income at 5%/yr ($9,150 × 5%) Less tax on interest ($457 × 39%)
$9,150 $457 −$178
Net after-tax return
$279
Closing value end of year 1
$9,429
Accumulated value after 20 years (no tax due)
$254,655
Option 2: Salary sacrifice contribution to superannuation –year 1 Income
$15,000
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Contributed by employer therefore no tax for employee Contributed to superannuation fund
$15,000
Less tax on contribution ($15,000 × 15%)
−$2,250
Available for investment by superannuation fund
$12,750
Earnings on invest at 5% ($12,750 × 5%)
$637
Less superannuation tax ($637 × 15%)
−$96
Net growth after-tax Closing value end year 1
$0
$541 $13,291
Closing value after 20 years (no tax due if withdrawn after age 60)
$406,233
Difference in value at 20 years from private investment
$151,578
Even at relatively low rates of return and an average marginal tax rate, it can be seen that the investment in superannuation via a salary sacrifice has considerably faster growth than the personal after-tax investment. The principle reason for the better performance of the superannuation investment is that more funds are invested each year because there is less tax on the $15,000
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624 [18.60] PRINCIPLES OF TAXATION LAW 2020 before it is available to be invested. This effect can be seen more clearly from Figure 18.2. The same outcome would have been achieved had the employee made their own equivalent tax-deductible concessional contributions into their superannuation account. As a general rule, the superannuation legislation aims to provide tax concessions by only taxing the income stream once provided the funds are returned to be used to support the taxpayer’s retirement. For example, if the contributions to superannuation are tax deductible, then they become the taxable income of the superannuation fund (lower tax rates apply) and in turn are tax free when withdrawn after 60 years of age. If the funds are withdrawn before age 60, some additional tax is payable to account of the lower tax paid when the funds were contributed. Where the contributions are made from after- tax income (no deduction allowed), they are not taxed when contributed to the superannuation fund and are also tax free when withdrawn as they were taxed when first earned by the taxpayer. Figure 18.2: Graph comparing the growth of an investment in superannuation compared to a personal after-tax investment for a taxpayer with a marginal tax rate of 47% Compare private and super investment growth 450000 400000 350000 300000 250000 200000 Copyright © 2019. Thomson Reuters. All rights reserved.
150000 100000 50000 0 Start End
0
1
1
2
3
4
5
6
7
8
9
Invest
10 11 12 13 14 15 16 17 18 19 20 Super
Stage 1: Taxation of contributions [18.60] Example 18.1 shows that in this first stage that there are significant differences between a private investment’s ability to earn interest and an investment in superannuation. This is because with the private investment there are less funds to invest due to the higher tax paid prior to being available for investment. Receipts in the form of wages are clearly assessable as ordinary
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income, and therefore the benefit of any income earned via wages is the after tax value of the wage. In contrast, contributions to a superannuation fund are treated differently for income tax purposes both in terms of deductibility and the assessability in the hands of the superannuation fund. Employer contributions to an employee’s complying superannuation fund (see [18.30]) are tax deductible (s 290-60 of ITAA 1997) meaning that the employer’s tax situation is not altered by whether they pay a wage to an employee or lower their wage and contribute the balance to the employee’s superannuation fund. This is known as a salary sacrifice (see [6.60]). For the employee, however, there is a considerable tax advantage as the amount diverted to their superannuation fund is taxed at 15% (known as the contributions tax) rather than their marginal tax rate. This is because a genuine salary sacrifice is not assessable income of the employee but is taxed as a superannuation contribution at a rate of 15%.
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As of 1 July 2017, all eligible taxpayers have been able to make tax-deductible contributions to their own superannuation funds (s 290-150 of ITAA 1997). Prior to 1 July 2017, only self-employed taxpayers were entitled to a tax deduction for contributions to their superannuation funds. To separate the different treatment of certain contributions, the legislation specifies two types of contributions that can be made to a superannuation account: • concessional contributions; and • non-concessional contributions. In addition to these two types of contributions, the government has also introduced a system of co-contributions, whereby the government also contributes to the superannuation funds of low-income taxpayers.
Concessional contributions [18.70] Concessional contributions are effectively those that are included in the assessable income of the superannuation fund (s 291-25 of ITAA 1997). Concessional contributions can be made by any of the following methods: 1. Employer contributions. Superannuation contribution made by an employer into the employee’s superannuation account (ss 292-25 and 295-160 of ITAA 1997). These contributions will be tax deductible to the employer (ss 290-60 and 290-80 of ITAA 1997). A concessional contribution may arise from any of the following three types of payments: a .
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The Superannuation Guarantee Contribution (SGC) that employers must pay to an employee’s superannuation account (SGC must also be paid on contracts primarily for labour that are charged on an
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626 [18.70] PRINCIPLES OF TAXATION LAW 2020 hourly rate). Currently, an employer is required to contribute 9.5% of the employee’s salary provided the annual salary for employees over 18 years exceeds $450 per month (employees under 18 years must work at least 30 hours per week to be eligible). For example, if an employee has an annual salary of $80,000, the employer must contribute $7,600 ($80,000 × 9.5%) into the employee’s superannuation account. It is proposed that the SGC rise in future years to 12%. This increase is legislated to occur in a staggered manner starting 1 July 2021. TABLE 18.1 Proposed SGC increases Year
Rate
Current rate
9.50%
1/7/2021
10.00%
1/7/2022
10.50%
1/7/2023
11.00%
1/7/2024
11.50%
1/7/2025
12.00%
b. Employer contributions in excess of the SGC. Employer contributions resulting from an industrial agreement whereby an employer is obliged to contribute more than the SGC into the employee’s superannuation fund.
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c.
Salary sacrifice. Any amount that an employee agrees with their employer to reduce their wage and divert these funds into their superannuation account. For example, a taxpayer with a salary of $90,000 could request their employer to reduce their salary to $80,000 and pay the extra $10,000 into the employee’s super annuation account.
2. Taxpayer contributions into their own fund. Since 1 July 2017, all eligible taxpayers (under the age of 75, s 290-165 of ITAA 1997) have been able to make tax-deductible contributions to their own superannuation funds, provided they nominate the contribution to be a concessional tax-deductible contribution and notify the super fund of this (s 290-170 of ITAA 1997). Although contributions made by such taxpayers are tax deductible (s 290-150), they cannot generate an overall tax loss (s 26-55). Prior to 1 July 2017, only self-employed taxpayers could do this into their superannuation accounts, provided they nominated the contribution to be a concessional contribution (ss 291-25 and 295-190 of ITAA 1997). A self-employed person was defined as one who receives employer superannuation on less than 10% of assessable income (s 290-160). In effect, there is no contributions tax payable by the employer or eligible taxpayer on concessional contributions made to complying superannuation
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funds. However, when contributions are received by a superannuation fund, these contributions are assessable income of the fund and taxed accordingly. Normally, the rate of tax payable by the superannuation fund on concessional contributions received is lower than the tax rate that would have been paid by the employer or eligible taxpayer had they earned the money as their own assessable income (see [18.50]).
Concessional contribution caps [18.80] To reduce the potential exploitation of the tax concessions available on concessional contributions, the legislation imposes a cap on the annual contribution that will benefit from the lower tax rates. Since 1 July 2017, most individuals have a maximum concessional contribution cap of $25,000 a year (s 291-20 of ITAA 1997) (beforehand the cap was larger).
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If more than the maximum concessional contribution is made in a year, the taxpayer will have the excess added as assessable income to their personal tax return and therefore will be taxed on this excess at their marginal tax rate. Interest is also added to the additional tax to account for the delay in payment. The taxpayer can if they wish to elect to release up to 85% of their excess concessional contribution (amount above the cap) from their superannuation account to pay this additional tax. Although there is additional tax if the cap is exceeded, the concessional contribution is still tax deductible for the employer or the eligible taxpayer. Since 1 July 2018, to the extent, this cap is unused by an individual, they are able to rollover the unused portion for up to five years as long as their superannuation balance is less than $500,000 at the close of the previous tax year (s 291-20(3)–291-20(7) of ITAA 1997). This means that the first year that the carried forward unused concessional contributions can be utilised is the 2019–2020 tax year. For example, if an eligible employee has total concessional contributions to their superannuation fund of $10,000 per year for the 2018– 2019 and 2019–2020 tax years, then they have accumulated $30,000 (2 × ($25,000 − $10,000)) of unused concessional contributions. As a result, in the 2020–2021 tax year, they could contribute $55,000 ($30,000 + $25,000) of concessional contributions to their superannuation fund without exceeding the cap, as long as their total balance as at 30 June 2020 was less than $500,000.
Non-concessional contributions [18.90] Non-concessional contributions are effectively contributions that are not assessable income of the superannuation fund (s 292-90 of ITAA 1997). These contributions mainly consist of: 1. excess concessional contributions (contributions above the conces sional contribution cap);
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628 [18.100] PRINCIPLES OF TAXATION LAW 2020 2. amounts paid by the employee or self-employed person where they have not nominated the contribution to be a concessional contribution and have notified the super fund of this (s 290-170). For example, contributions made out of their income, capital or savings; and 3. contributions that a taxpayer makes into their spouse’s superannuation account. For example, a self-employed taxpayer makes a $10,000 concessional con tribution from their after-tax income into their superannuation fund and does not nominate this to be a concessional contribution. This contribution to their own superannuation fund is not tax deductible and is not assessable income of the superannuation fund. In other words, non-concessional contributions are not subject to additional tax when they are contributed to the superannuation fund because they are paid out of after-tax money (ie, income that has already been taxed in the hands of the taxpayer).
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Non-concessional contribution caps [18.100] Since 1 July 2017, a taxpayer’s non-concessional contributions have been capped at $100,000 per year (s 292-85) (previously the cap was larger). However, the legislation allows this to be brought forward over a three-year period for those under 65 without breaching this cap. Specifically, if a taxpayer that is under 65 contributes more than $100,000 a year, this will trigger this three- year rule, and the non-concessional contributions for the following two years will be respectively reduced. For instance, a non-concessional contribution of $300,000 (assuming no previous non-concessional contributions) could be made in the current tax year, and as long as no non-concessional contributions are made in the next two financial years, there will be no breach of this cap. If such a taxpayer had made a non-concessional contribution of $250,000 in the current financial year, then they could make a total of ($300,000 − $250,000) $50,000 of contributions in the following two years. The legislation allows amounts that breach the non-concessional contributions cap to be withdrawn from the superannuation fund (s 292-90). Any amounts that breach the cap but are not withdrawn are taxed at 47% including Medicare levy. Also, since 1 July 2017, those with a superannuation total balance of $1.6 million or more are unable to make any further non- concessional contributions (s 292- 85(2)(b), s 294- 35). Further, those with superannuation balances approaching $1.6 million are curtailed regarding their use of the three years “bring forward” rules that might otherwise allow them to contribute $300,000 in non-concessional contributions. Specifically, if their balance at the end of the previous tax year is: • between $1.5 million to under $1.6 million, then the taxpayer cannot utilise the bring- forward provisions, so they can only contribute at most $100,000 (s 292-85(3) of ITAA 1997); and
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• between $1.4 million to under $1.5 million, then they can use the bring- forward provisions for two years, which as a result means that they can at most contribute $200,000 in the first year (s 292-85(5) of ITAA 1997).
Example 18.2: Comparison of tax benefits of concessional and non- concessional contributions Alex (age 52) receives a salary of $110,000. If he wants to put extra money into his superannuation fund, he can take two approaches: First approach: Alex contributes $6,100 into the superannuation account out of his after-tax salary and does not declare this to be a concessional contribution (he might do this because he may have already used up their concessional contribution cap). As this is a non-concessional contribution, the superannuation fund pays no tax on this. As a result, the net increase in his superannuation balance would be $6,100.
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This contribution will have cost Alex $10,000 in gross earnings because he is on the 39% (including Medicare levy) marginal tax rate, which means that for the last $10,000 he earned, he will receive $6,100 after-tax. Second approach: Alex contributes $10,000 into his superannuation account out of his after-tax salary and declares this to be a concessional contribution to the super fund. This means that he receives a tax deduction of $10,000. Since this amount is deducted from his taxable income, this means that in effect he does not pay personal income tax on this $10,000 (his tax return would include a $3,900 refund which would reverse tax withheld on the $10,000 during the year). As this amount is contributed to his superannuation account and taxed at 15%, its balance would increase by $8,500 ($10,000 − ($10,000 × 15%)). Third approach: Alex asks his employer to reduce his salary by $10,000 (gross) and put this $10,000 into Alex’s superannuation account. This is the salary sacrifice approach. Salary sacrifice is a concessional contribution and so will be taxed at 15% by the superannuation fund, which means Alex will have a net increase of $8,500 in his superannuation account. In this case, Alex’s net salary will drop by $6,100 ($10,000 less tax of $3,900). In both instances, Alex has directly/indirectly “given up” $10,000 of his gross salary, but in the second and third approaches he has ended up with more money in his superannuation account.
Co-contribution scheme [18.110] In 2003, the government introduced a system of co-contributions whereby the government also contributes to the superannuation funds
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630 [18.120] PRINCIPLES OF TAXATION LAW 2020 of low-income taxpayers. The aim of this scheme is to boost the super annuation savings of taxpayers that do not have adequate earning capacity to save sufficient funds to support their retirement. A means test applies to eligibility (see below), so that these government funds are only directed to low- income earners. For taxpayers earning less than the maximum total income, the government will contribute an additional $0.50 for every $1 of eligible contributions up to a maximum of $500 per year. Co-contributions are shaded out where the taxpayer’s total income exceeds the maximum. The following conditions apply for eligibility for the co-contribution: • The taxpayer makes non-concessional contribution to their complying superannuation fund. • At least 10% of income is from eligible employment or business. • Earn total income for 2019–2020 of less than $53,564. The maximum co-contribution of $500 is reduced by 3.333 cents for every dollar the total income exceeds $38,564. Total income is the sum of assessable income, reportable fringe benefits (see [7.440]) and reportable employer superannuation contributions (salary sacrificed superannuation). • Under 71 years of age as at the 30 June of the current tax year. Co-contributions are effectively treated as a non-concessional contributions because they do not form part of the superannuation fund’s assessable income. As a result, any benefit paid out of the fund from these contributions will be tax free (see [18.180]).
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Low-income superannuation tax offset [18.120] Taxpayers who earn up to $37,000 a year are eligible for an offset that in essence refunds the contributions tax paid from their superannuation funds. The offset will be paid into the taxpayer’s superannuation account, and will be equivalent to 15% of their concessional contributions, up to a maximum amount of $500 per year. Example 18.3: Low-income superannuation tax offset Jane earns a salary of $30,000, and her employer pays her superannuation fund the compulsory 9.5% contributions, which is $2,850 ($30,000 × 9.5%). Her fund pays 15% contributions tax on this of $427.50 ($2,850 × 15%). The government would give Jane’s superannuation fund $427.50, meaning that in effect, Jane’s account would have had the contributions tax refunded.
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Age limits for superannuation contributions [18.125] Workers who are between 65 and 74 that wish to make concessional or non- concessional contributions to their superannuation fund on top of mandatory employer contributions need to pass a work test. Mandatory employer contributions will usually be the 9.5% legislated contributions, but will also include any amount the employer has to contribute under an industrial agreement. To pass the work test, a taxpayer needs to be gainfully employed for at least 40 paid hours in a period of no more than 30 consecutive days in a financial year: subreg 7.01(3) of the Superannuation Industry (Supervision) Regulations 1994 (Cth). Gainfully employed includes employment, self-employed, business, trade or profession. For instance, a 68 years old who works for 40 hours in a three-week period has passed the work test. Consequently, for that financial year, they are entitled to have concessional and non-concessional contributions deposited (on top of mandatory employer contributions) into their superannuation account. However, as from 1 July 2019, a person can be exempt from the “work test” for a one-off financial year if they fulfilled all of the following requirements (reg 7.04 of the Superannuation Industry (Supervision) Regulations 1994): • They satisfied the work test in the previous financial year. • Their superannuation balance at end of previous year was less than $300,000. • They have not used this “once off” exception previously. Workers who are 75 or over are entitled to have the compulsory 9.5% employer contributions deposited into their superannuation accounts. Furthermore, if the relevant employer needs to contribute more than this under an industrial agreement, then workers that are 75 or over will receive such an entitlement into their superannuation accounts. However, such workers cannot make concessional or non-concessional contributions on top of these amounts: reg 7.04 of the Superannuation Industry (Supervision) Regulations 1994. For instance, if an employee works in an industry where the Enterprise Agreement (a type of industrial agreement) specifies they are to receive 17% superannuation contributions, then the employee is entitled to this even if they are 75 or over. On the other hand, if an employee who is 75 or older works for an employer who is only obliged to pay 9.5% superannuation contributions, such an employee cannot salary sacrifice into superannuation or deposit savings into their superannuation account.
Stage 2: Taxation of superannuation funds [18.130] Previously in this chapter, the attributes of complying, non- complying, taxed and untaxed superannuation funds were outlined (see [18.30]). These classifications are now important in understanding how, if at all, these funds are subject to income tax. Whereas a superannuation fund is either complying or non-complying, it is also possible for a complying fund
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632 [18.140] PRINCIPLES OF TAXATION LAW 2020 to also be a taxed or untaxed fund. Untaxed funds are uncommon and are generally only available to very senior public officers, such as Federal Court judges. Therefore, most taxpayers are dealing with complying funds that are taxed funds (subject to income tax). Complying superannuation funds operate as trusts and are subject to the normal provisions of the income tax assessment acts with certain modifications. These modifications include: • the trustee of the fund is liable to tax on the income of the fund rather than the beneficiaries; • concessional contributions received are included in the assessable income of the fund; • a concessional tax rate of 15% applies to the taxable income of the fund; • capital gains are taxed at 10% and all assets, regardless of acquisition date, are subject to capital gains tax (CGT); and • income earned on investments that have been set aside to fund pension entitlements (income streams) for members is tax free.
Taxation of contributions received by the fund
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[18.140] Taxed superannuation funds pay tax at the rate of 15% on earnings and concessional contributions. However, capital gains that are eligible for the discount under Div 115 of ITAA 1997 are discounted by 33.33% resulting in a tax rate of 10% (15% − (1/3 of 15%)). Income earned from assets of the superannuation fund that are used to provide an income stream to retirees is tax free. Individuals earning an annual income of more than $250,000 (including concessional contributions and other benefits) will have their superannuation contributions effectively taxed at 30% rather than 15%. The legislation accomplishes this through Div 293 of ITAA 1997 by stating that such concessional contributions are subject to tax in the taxpayer’s hands at the rate of 15%. As concessional contributions are subject to tax in the hands of the superannuation fund at 15%, this means that the total tax burden is 30%. It should be noted that where the taxpayer is pushed over the $250,000 by the amount of the concessional contributions, the effective 30% tax rate will only apply to the excess over $250,000. Individuals are personally liable to pay this additional 15%, but in some cases, they can ask for it to be released from certain superannuation accounts. Since 1 July 2017, those with a balance of $1.6 million or more in their superannuation accounts at the beginning of a tax year are unable to make any further non-concessional contributions (s 292-85(2)(b), s 294-35). Untaxed funds, as their name suggests, do not pay tax on their earnings. However, as discussed later, when a taxpayer withdraws money from “untaxed funds”, there is additional tax payable than when money is withdrawn from “taxed funds”.
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Example 18.4: Tax benefits of salary sacrifice or making own concessional contributions (see also Example 18.1) Cindy is on a salary of $200,000, which means that her marginal tax rate is 47% (including Medicare levy). She agrees with her employer to salary sacrifice $5,000 into her superannuation account. Cindy now no longer has to pay 47% tax on the $5,000 that has been salary sacrificed. Instead, the superannuation fund will pay tax on it at 15%. Whereas if the $5,000 was received by Cindy as a salary, she would have retained $2,650 after- tax ($5,000 less 47% tax). In comparison, salary sacrificing the $10,000 to her superannuation fund means that the fund will retain $4,250 after-tax ($5,000 less the 15% tax paid by the superannuation fund) to invest rather than Cindy having $2,650 to invest. The same outcome would be achieved by Cindy making a concessional tax-deductible contribution into her superannuation fund. By contributing $5,000 and declaring it to be a concessional contribution, Cindy would get a tax deduction for $5,000. The effect of this is that rather than the $5,000 being taxed at her marginal tax rate of 47% and her only ending up with $2,650, it would be taxed at the 15% concessional contribution rate and her super fund’s balance would end up with $4,250 ($5,000 − ($5,000 × 15%)) added to it.
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Taxation of superannuation fund’s earnings [18.150] The investment phase of the superannuation cycle is where the funds contributed by the members are invested by the fund to earn income to benefit its members. As a general rule, the earnings of a taxed complying superannuation fund are subject to the taxation legislation in a similar manner to other taxpayers. However, an important exception exists when the member’s funds are supporting a superannuation income stream. Funds held in a superannuation account may be in either an “accumulation phase” or supporting a superannuation income stream (see [18.200]). The accumulation phase occurs while the member is not entitled to withdraw funds from their account or has not instructed the fund to pay out benefits. The funding of a superannuation income stream occurs when the members’ funds are segregated from the accumulation account and invested for the sole purpose of meeting the funds liability to pay a superannuation income stream (pension) to members. As of 1 July 2017, there is a maximum of $1.6 million that taxpayers can have supporting a superannuation income stream, meaning that effectively only up to $1.6 million can benefit from tax- free earnings. Any amount above $1.6 million will remain in the accumulation account, and the income will be taxed at 15%. The legislation for this is in Div 294 of ITAA 1997 and deems all taxpayers that have an account in “income
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634 [18.150] PRINCIPLES OF TAXATION LAW 2020 stream mode” to have a “transfer balance account” which must not exceed $1.6 million. This account works on a system of credits (increases) and debits (decreases). Any amounts that constituted an existing superannuation income stream prior to 1 July 2017, or superannuation income streams created post 1 July 2017 credit the transfer balance account. Earnings of the income stream account do not increase the balance of the transfer balance account. Debits to the transfer balance accounts include making a lump sum withdrawal from the account, as well as commuting the income stream back to its accumulations phase. However, non-lump sum withdrawals (such as the minimum age-based withdrawals) do not reduce the transfer balance account. Example 18.5: Transfer balance account
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A taxpayer is 67 and has $3 million in their accumulations account. They create one account-based pension of $1 million, and another of $400,000 which means they have $1.6 million left in their accumulations account. Their transfer balance account balance would now be $1.4 million. If they transfer one of their account-based pensions, the one with the $1 million balance, back into the accumulations phase, the transfer balance account would be reduced to $400,000. During the accumulation phase, income earned on the members’ accounts (eg, interest, dividends and capital gains) by complying superannuation funds is taxed at the concessional rate of 15% (Div 295 of ITAA 1997) under the normal provisions of the legislation. There is also an additional 1/3 reduction of assessable capital gains that are eligible for the Div 115 of ITAA 1997 discount. For example, interest and dividends will be assessable income, and the normal entitlements to dividend imputation and deductions are available. In contrast, income earned from funds that are supporting a superannuation income stream are exempt income and therefore tax free. Untaxed funds (see [18.40]) also do not pay tax on their earnings, but this influences the tax payable when members withdraw funds from their account (see [18.190]).
Example 18.6: Taxation of earnings of superannuation fund Jill has $100,000 in her superannuation fund, and her fund is in the accumulations phase. The fund has distributed Jill’s $100,000 into various investments and makes a gain of $15,000 for the current financial year. This gain consists of $10,000 interest and $5,000 in capital gains from the sale of assets that had been held for more than 12 months.
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Tax on the $10,000 interest is $1,500 (15% × $10,000) and tax on the $5,000 capital gain will be $500 (($5,000 − (1/3 × $5,000)) × 15%). Although the fund pays this tax, it will be taken out of Jill’s account. This will give Jill a closing balance before fees of $113,000 ($100,000 + $15,000 − $1,500 − $500).
Example 18.7: Taxation of earnings of superannuation fund Ian (age 66) has retired with $300,000 in his superannuation fund, and his fund is paying him a superannuation income stream (pension) of $50,000 per year. To provide funds for the pension payments, Ian’s superannuation fund has transferred the $300,000 to various qualifying investments which return a gain of $40,000 for the current financial year. This $40,000 is tax free to the superannuation fund as it is derived from earnings that have been segregated into supporting a superannuation income stream. As a result, the full $40,000 will be credited to Ian’s account leaving him a closing balance of $290,000 ($300,000 − $50,000 + $40,000).
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Stage 3: Taxation of superannuation benefits paid to members [18.160] When a taxpayer wants to retire, they will need the money in their superannuation accounts. Taxpayers over the preservation age are entitled to withdraw their money in the form of an income stream, lump sum, or a combination of the two.
Preservation age and access to superannuation [18.170] In general, most of the money in superannuation accounts is preserved, which means that taxpayer cannot access this money until they reach their preservation age. Preservation age is important in applying the tax rules for superannuation and for those born before 1 July 1960, and considering retirement, the preservation age is 55. However, for younger people, it is important to realise that this preservation age is being gradually increased to 60. This will delay the age at which the tax concessions on pay-outs from superannuation funds can be accessed. The preservation ages for taxpayers (as specified by reg 6.01 of the
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636 [18.180] PRINCIPLES OF TAXATION LAW 2020 Superannuation Industry ((Supervision) Regulations 1994 (Cth)) are as listed in Table 18.2: TABLE 18.2 Preservation age based on date of birth Date of birth
Preservation age
Before 1/7/60
55
1/7/60–30/6/61
56
1/7/61–30/6/62
57
1/7/62–30/6/63
58
1/7/63–30/6/64
59
After 30/6/64
60
For those under 60 that have reached their preservation age, they are entitled to access their superannuation when: • an arrangement in which they are gainfully employed has come to an end; and • the trustee of the superannuation fund is reasonably satisfied that the person no longer intends to be gainfully employed. On the other hand, those that have reached their preservation age and are at least 60 are entitled to access their superannuation merely when an arrangement in which they are gainfully employed has come to an end. Those that are at least 65 can access their superannuation without fulfilling any other conditions (even if they have not ceased any of their employment).
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In general, when taxpayers can access their superannuation, they can do so in the form of a lump sum and/or an income stream.
Taxation of benefits paid as a lump sum Taxed funds [18.180] Benefits paid as a lump sum when the taxpayer is at least 60: If the fund is a taxed fund, the benefit will be tax free in the hands of the member upon withdrawal. Benefits paid as a lump sum when the taxpayer is at least preservation age but less than 60: If the fund is a taxed fund, the benefit will be taxed as follows: 1. Taxable component: These are amounts that are from concessional contributions and returns made by the superannuation funds on concessional and non-concessional contributions. The first $210,000 will be tax free, and anything over $210,000 will be taxed at 17%
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2. Tax-free component: These are amounts that are from non-concessional contributions. These are tax free upon withdrawal. Benefits paid as a lump sum when the taxpayer is less than preservation age: If the fund is a taxed fund, the benefit will be taxed as follows: 1. Taxable components: Will be taxed at up to 22% including Medicare Levy. 2. Tax-free component: These are tax free upon withdrawal. TABLE 18.3 Taxation of members’ benefits paid from a taxed superannuation fund Taxpayer is at least 60
Taxpayer is less than 60 but greater than preservation age
Taxpayer is less than preservation age
Taxable component
Tax free
First $210,000 is tax free, anything in excess taxed at 17% (including Medicare levy)
Taxed at up to 22% (including Medicare levy)
Tax-free component
Tax free
Tax free
Tax free
Untaxed funds
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[18.190] Benefits paid as a lump sum when the taxpayer is at least 60: If the fund is an untaxed fund, the benefit will be taxed as follows: 1. Taxable components: These are amounts that are from concessional contributions and returns made by the superannuation funds on the concessional and non-concessional components. The first $1,515,000 will be taxed at up to 17% including Medicare levy, anything over this will be taxed at 47% including Medicare levy. 2. Tax-free component. These are amounts that are from non-concessional contributions. These are tax free upon withdrawal. Benefits paid as a lump sum when the taxpayer is at least preservation age but less than 60: If the fund is an untaxed fund, the benefit will be taxed as follows: 1. Taxable components: The first $210,000 will be taxed at up to 17% including Medicare Levy. Every dollar over $210,000 but under $1,515,000 will be taxed at 32% including Medicare Levy. Every dollar over $1,515,000 is taxed at 47% including Medicare Levy. 2. Tax-free component: These are tax free upon withdrawal. Benefits paid as a lump sum when the taxpayer is less than preservation: If the fund is an untaxed fund, the benefit will be taxed as follows: 1. Taxable components: The first $1,515,000 will be taxed at 32% including Medicare Levy, anything over this will be taxed at 47% including Medicare Levy. 2. Tax-free component: These are tax free upon withdrawal.
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638 [18.200] PRINCIPLES OF TAXATION LAW 2020 Taxation of members’ benefits paid from a untaxed super TABLE 18.4 annuation fund Taxpayer is at least 60
Taxpayer is at less than 60 but greater than preservation age
Taxpayer is less than preservation age
Taxable component
First $1,515,000 taxed at up to 17% (including Medicare levy), anything over this taxed at 47% (including Medicare levy).
First $210,000 is taxed at up to 17% (including Medicare levy), anything over $210,000 up to $1,515,000 taxed at 32% (including Medicare levy), every dollar over $1,515,000 taxed at 47% (including Medicare levy).
First $1,515,000 taxed at up to 32% (including Medicare levy), every dollar in excess of this taxed at 47% (including Medicare levy).
Tax-free component
Tax free
Tax free
Tax free
Taxation of benefits paid as an income stream
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Types of income streams [18.200] When a taxpayer, wishing to access their superannuation, has reached their preservation age and fulfils the relevant conditions for accessing their superannuation (see [18.170]), they may choose to take part or all of the money in the form of an income stream. Under the relevant legislation, a superannuation income stream can take one of three forms: i) Account-based pension (s 307-70 of ITAA 1997, reg 995-1.01 of the Income Tax Assessment Regulations 1997 (Cth) and subreg 1.06(1) of the Superannuation Industry (Supervision) Regulations 1994): An account-based pension is a pool of funds that is invested by the superannuation fund, from which the taxpayer is allowed to withdraw however much they wish. However, the law specifies minimum age- based withdrawal limits. This means that the taxpayer must withdraw each year a minimum amount from their account-based pension. This minimum is a percentage of their balance and increases with age. The current age- based percentage is as follows (subreg 1.06(9A) of the Superannuation Industry (Supervision) Regulations 1994):
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TABLE 18.5 Account-based pension: Minimum annual withdrawal Age
Annual payment as a % of account balance
55–64
4%
65–74
5%
75–79
6%
80–84
7%
85–89
9%
90–94
11%
95+
14%
Example 18.8: Account-based pension
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Fiona is 66 and has a superannuation balance of $1 million in her accumulations account. On 1 July, Fiona transferred all of this money into an account-based pension. For the first year, Fiona would have to withdraw at least $50,000 because for a 66 year old, there is a 5% minimum withdrawal. Fiona could withdraw more than the minimum if she wishes.
ii) Innovative Income Stream (s 307-70 of ITAA 1997, reg 995-1.01 of the Income Tax Assessment Regulations 1997 and subreg 1.06A(1) of the Superannuation Industry (Supervision) Regulations 1994). These have been a type of superannuation income stream since 1 July 2017 and are yet to be widely available. For an income stream to constitute an innovative income stream, four requirements need to be fulfilled: 1. The superannuation member must have satisfied a condition of release, such as reaching their preservation age and retiring. 2. The income stream payments must continue throughout the life of the member once commenced (unless the income stream is cancelled). 3. Once the payments have commenced, they cannot be unreasonably deferred. 4. The income stream can only, at most, allow commutation back to capital sum on a “straight line” basis from its commencement till the expected life expectancy of the member. For example, a member that commenced an innovative income stream when they are 65 with $200,000 of their accumulation funds, and their expected life expectancy is 85. At age 75, the member decides to commute the income stream back into a capital amount that they can withdraw as a lump-sum. Since this is half way between commencement and life expectancy, the income stream instrument rules must allow
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640 [18.210] PRINCIPLES OF TAXATION LAW 2020 no more than $100,000 (50%) of the amount to be refunded. If it allowed no capital commutation, then this requirement would be fulfilled, as the requirement is a maximum. Note that the income stream can allow for 100% of the capital to be given as a death benefit (upon the death of the superannuation member) if the death occurs up to half-way between its commencement and the expected life expectancy of the member. iii) Annuity (s 307-70 of ITAA 1997, reg 995-1.01 of the Income Tax Assessment Regulations 1997 and subreg 1.05(1) of the Superannuation Industry (Supervision) Regulations 1994): An annuity is an arrangement by which a taxpayer uses part or all of their lump sum to purchase a regular income stream. In general, this income stream is either a fixed amount per period or it is indexed to some factor such as inflation. An annuity can be for a set amount of time (commonly called a term annuity) or for the taxpayer’s life (called a life annuity, which might in some instances also include a continuing payment for the taxpayer’s spouse).
Example 18.9: Annuity
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Sharon has reached her preservation age and has $600,000 in her superannuation account. She decides to take half of this as a lump sum and to convert half of it to an annuity. She purchases a 10-year annuity which gives her monthly payments equivalent to $35,000 per year indexed to inflation. At the end of the 10 years, she is not entitled to the return of any of her lump sum that she used to purchase this annuity.
Taxation of income streams [18.210] Taxation of income streams depends on whether the income stream is from a superannuation fund that is taxed or untaxed as well as the age of the taxpayer. Tables 18.6 and 18.7 show the relevant tax rates. TABLE 18.6 Taxed fund: Taxation of income streams Taxpayer is at least 60
Taxpayer is less than 60 but greater than preservation age
Taxpayer is less than preservation age
Taxable component
Tax free (s 301-10 of ITAA 1997)
Taxed at marginal tax rate less a 15% rebate (s 301-25 of ITAA 1997)
Taxed at marginal tax rate
Tax-free component
Tax free (ss 301-15 and 301-30 of ITAA 1997)
Tax free (ss 301-15 and 301-30 of ITAA 1997)
Tax free (ss 301-15 and 301-30 of ITAA 1997)
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TABLE 18.7 Un-taxed fund: Taxation of income streams Taxpayer is at least 60
Taxpayer is less than 60 but greater than preservation age
Taxpayer is less than preservation age
Taxable component
Taxed at marginal tax rates less a 10% rebate (s 301-100 of ITAA 1997)
Taxed at marginal tax rates (s 301-110 of ITAA 1997)
Taxed at marginal tax rates (s 301-120 of ITAA 1997)
Tax-free component
Tax free (ss 301-15 and 301-30 of ITAA 1997)
Tax free (ss 301-15 and 301-30 of ITAA 1997)
Tax free (ss 301-15 and 301-30 of ITAA 1997)
Example 18.10: Taxation of income stream Ellen is 56 year old and converted $300,000 of her accumulations superannuation account into an account-based pension. As Ellen never made any non-concessional contributions into her account, all of this amount is considered a taxable rather than tax-free component. During the first year, she withdraws $65,000 from her account. This would be taxed at her marginal tax rates less a 15% rebate.
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Transition to retirement accounts [18.215] In general, taxpayers that have reached preservation age but are under 65 can only access their superannuation if they have fulfilled certain conditions regarding ceasing employment (see [18.170]). However, those that have reached preservation age but have not fulfilled such conditions are allowed to put any of their superannuation balance into a “transition to retirement account”. Such an account has the characteristics of an account- based pension (see [18.200]) including the applicable age-based minimum withdrawal limits. However, it differs in one particular respect, in that the maximum amount that can be withdrawn in any year is 10% of the account balance (normal account-based pensions have no maximum limits). Prior to 1 July 2017, the taxation treatment was also the same as that of an account-based pension, in that the earnings are tax free (see [18.150]) and withdrawals were taxed in accordance with Table 18.6. However, since1 July 2017, earnings of Transition to Retirement Accounts are no longer tax free but are taxed the same as accumulations accounts (at a rate of 15% for most earnings, and 10% for capital gains regarding earnings that are from assets owned for at least 12 months).
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642 [18.220] PRINCIPLES OF TAXATION LAW 2020
Death benefits [18.220] When a member of a superannuation fund passes away, the person/s who receives the deceased’s superannuation benefits are said to have received a death benefit. In this case, there are two issues that need to be considered:
i) Who is entitled to receive a death benefit; and
ii) How the recipient of the death benefit is taxed on their receipt?
Entitlement to receive a death benefit
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[18.225] When a superannuation fund member passes away, the trustee has to decide who is to receive deceased’s benefits. In other words, the trustee decides who is to get the death benefit. Legally, the trustee is only allowed to give superannuation money to the following parties (reg 6.22 of the Superannuation Industry (Supervision) Regulations 1994): i) A dependant: s 10 of the Superannuation Industry (Supervision) Act 1993; or ii) The “Legal Personal Representative”: A Legal Personal Representative is the party responsible for administering the estate of the deceased, whether there is a will or not. This means that someone entitled under the deceased’s will or intestacy laws (if there is no will) will inherit the superannuation money. However, if after making reasonable inquiries, the trustee is unable to locate anyone that comes under these two categories, they can distribute the funds to other parties. If someone wishes to not leave the distribution of their superannuation money to the discretion of the trustee, then they should create a Binding Death Benefit Nomination (BDBN). Nearly all superannuation funds allow members to do this. If done properly, the trustee must distribute the money upon the member’s death in accordance with such BDBN (s 59(1A) of the Superannuation Industry (Supervision) Act 1993). The form of the BDBN must comply with the legislation, which means it must be in writing, signed and dated by the member as well as two disinterested adults, and cannot be effective for more than three years (reg 6.17A of the Superannuation Industry (Supervision) Regulations 1994). Example 18.11: Binding death benefit nomination Nicole wishes her superannuation money upon her death to go to her husband Alex. Consequently, she should either:
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i) complete a BDBN which names her husband as the nominated recipient of the superannuation money (this option is available because Alex is her dependant under the legislation); or ii) complete a BDBN which states that her superannuation money is to be distributed in accordance with her will (by stating that it is to be left to her Legal Personal Representative). In her will, she should state that her superannuation money is to be distributed to her husband Alex.
Example 18.12: Binding death benefit nomination Kevin does not have a family and wishes to leave his superannuation money to his best friend Jack. As Jack is not a dependant, he cannot directly nominate Jack via a BDBN. However, he can state that the superannuation money is to be left to his Legal Personal Representative to distribute in accordance with his will and ensure that his will states that the superannuation money is to be left to Jack.
An important issue to be considered is who is a dependant under the relevant legislation? This is relevant because:
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• a BDBN can only directly name dependants. If the member wishes the money to go to a non-dependant, they must do so through their Legal Personal Representative, in other words, through their will; or • if the member has not filled out a BDBN, then the trustee of the superannuation fund must distribute the money to a dependant or to the Legal Personal Representative. Under s 10 of the Superannuation Industry (Supervision) Act 1993, a “dependant” includes: • A Spouse. This includes de facto relationships, whether same or opposite sex. • The member’s child. This includes an adopted child and a stepchild. • Someone in an “interdependency relationship” with the superannuation member. As the definition is not an exhaustive definition, it also incorporates the case law meaning of dependant, which includes someone financially dependent upon the deceased.
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644 [18.230] PRINCIPLES OF TAXATION LAW 2020 As one of the types of “dependant” is someone in an interdependency relationship with the member it is also necessary to define the phrase “interdependency relationship”. “Interdependency relationship” is defined (s 10A of the Superannuation Industry (Supervision) Act 1993) as two persons if: (a) they have a close personal relationship; and (b) they live together; and (c) one or each of them provides the other with financial support; and (d) one or each of them provides the other with domestic support and personal care.
Example 18.13: Interdependency relationship Connie lives with her elderly mother. Connie pays the rent and household bills (and so provides financial support to her mother). Her mother takes care of the cooking, cleaning and laundry (and so provides domestic support). Her mother is likely to be regarded as being in an interdependency relationship with Connie, so will be a “dependant” for the purposes of the superannuation legislation.
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Taxation of a death benefit [18.230] The taxation of a “death benefit” depends on whether the recipient is a “death benefit dependant” or not. It is important to note that the definition of “death benefit dependant” is not identical to the definition of a “dependant”. A death benefit dependant is defined as someone who is one of the following (s 302-195 of ITAA 1997): i) The deceased’s spouse or former spouse. Spouse includes de facto relationships, whether they be same or opposite sex. ii) The deceased’s child, but only if they were under 18. iii) Someone with whom the deceased has an interdependency relationship with. This term has the same meaning as it does for dependant in s 302-200 of ITAA 1997. iv) Someone who is dependent of the deceased just before he or she died. This depends on the case law meaning of “dependant” which generally means someone who is financially dependent on that person.
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TABLE 18.8 Taxation of death benefits Taxpayer is a death benefit dependant
Taxpayer is not a death benefit dependant
Taxable component
Tax free (s 302-60 of ITAA 1997)
Capped at 15% (plus 2% Medicare levy if applicable) if from a taxed fund and at 30% (plus 2% Medicare levy if applicable) if from an untaxed fund (s 302-145 of ITAA 1997).
Tax-free component
Tax free (s 302-60 of ITAA 1997)
Tax free (s 302-145 of ITAA 1997).
Case study 18.1: In the AAT decision of Confidential and Deputy Commissioner of Taxation (2000) 43 ATR 1273, a son worked in a full-time job during the week but on the weekend also worked for free at his parents’ business (a delicatessen). The business would have been unable to survive without his free labour. After the son passed away, there was an issue involving previous legislation, whether the parents were dependants of the son under the case law meaning. The AAT decided that the parents were not dependants of the son. This was because the business was not the main income source for the parents as the father also had a job as a cabinet maker.
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Example 18.14: Taxation of death benefits Mary is 60 and writes a BDBN that half her superannuation is to be left to her husband, and half to her 30-year-old son. As both her husband and son are dependants under s 10 of the Superannuation Industry (Supervision) Act 1993, Mary is allowed to have a BDBN specifying they are to be the recipients. Upon Mary’s death, her husband’s receipt would be tax free in his hands. This is because he is a “death benefit dependant” under s 302-195 of ITAA 1997 as he is her spouse. On the other hand, her son being an adult child would not be a “death benefit dependant” under s 302-195 of ITAA 1997. This means that the “tax-free component” of the benefit (which is mainly from non-concessional contributions made by Mary) would not be subject to tax in his hands. However, the “taxable component” (which is mainly from concessional contributions and the earnings of the fund) is taxable in his hands. Assuming Mary’s fund was a taxed fund, this will be capped at a rate of 17%.
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646 [18.240] PRINCIPLES OF TAXATION LAW 2020
Questions [18.240] 18.1 Barbara is aged 53, and under the Superannuation Guarantee Charge, her employer pays $20,000 to her superannuation fund. In addition, she has entered into an effective salary sacrifice arrangement with her employer to sacrifice 20% of her salary into superannuation. This results in an additional contribution of $45,000 for the year. Barbara’s marginal tax rate is 47c/$ (including Medicare levy). Determine the total tax levied on the contributions to Barbara’s superannuation fund and the tax effect on Barbara’s employer. 18.2 Antonio is a member of an employer-sponsored superannuation plan. Under the terms of the plan, Antonio is required to contribute 5% of his salary ($5,000) to the fund each year, and the employer contributes $9,500 as part of the Superannuation Guarantee Charge. However, in the current year, Antonio also contributes $540,000 from an inheritance. Determine the total tax levied on the contributions to Antonio’s superannuation fund and the tax effect on his employer and himself. 18.3 Jenny receives a superannuation lump sum of $500,000 at age 60. Her superannuation lump sum includes a tax-free component of $300,000 and a taxable component in the fund of $200,000. Assume that the fund is a taxed fund. What tax if any is Jenny liable for?
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18.4 Jack retired and is 58 years of age when he receives a superannuation lump sum of $580,000 which comprised a tax- free component of $100,000 and the remainder was from a taxable component of the fund. Assume that the fund is a taxed fund. What tax if any is Jack liable for? 18.5 Liam retired on 1 July of the current tax year at the age of 53 because he was made permanently disable from a work-related accident. He received a payment on termination of $900,000 from his superannuation fund. $200,000 was a tax-free component in the fund and the remained was from the taxable component. Assume that the fund is a taxed fund. What tax if any is Liam liable for? 18.6 William is aged 58 and is self-employed. He is in good health, and he has asked you for advice on whether he should take his superannuation as a lump sum at the end of the current tax year or whether he should wait unit he is 60. Assume that the fund is a taxed fund.
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Over the years, William has contributed to a superannuation fund for self-employed business people, and the most recent statement from his taxed superannuation fund states the following entitlements: • Concessional contributions $420,000;
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• Non-concessional contributions $250,000; • Previous growth (interest and capital gain) $180,000. Before the end of the current year, William plans to contribute another $10,000 and the superannuation fund has reported an income of $20,000 before tax. Required: Advise William on the following: i) The effect of his contribution on his personal tax. ii) The tax if any to be paid by the superannuation fund on the income on William’s investments. iii) The tax impact of taking the total value of the superannuation benefits at the end of the current tax year. iv) The tax impact of taking the total value of the superannuation benefits after he turns 60. 18.7 Donna is 59 and fully retired. She has $2 million in her accumulation account. She converts $1.5 million of this to an account-based pension at the beginning of the tax year, which due to excellent earnings, grows to $1.7 million in value. She makes the minimum age-based withdrawals from this of $60,000 for the year. What would be the balance of Donna’s transfer balance account? 18.8 Don is 61 and still working full-time. He currently has a salary of $100,000, and receives $9,500 in mandatory superannuation contributions. Is there any way he could use the Transition to Retirement Provisions to reduce his tax without reducing his take-home pay?
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19 Partners and partnerships
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Key points.................................................................................................... [19.00] Introduction................................................................................................ [19.10] What constitutes a partnership?............................................................... [19.20]
Taxation law definition..................................................................................... [19.30] Compliance obligations of a partnership........................................................ [19.40] Taxation of partnerships............................................................................ [19.50] Net income of a partnership............................................................................ [19.60] Partnership losses............................................................................................ [19.70] Treatment of special partnership items.......................................................... [19.80] Partners’ salaries...................................................................................... [19.90] Interest payments between a partnership and its partners................. [19.100] Superannuation for partners................................................................. [19.110] Dividends received by the partnership................................................. [19.120] Capital gains tax..................................................................................... [19.130] Uncontrolled partnership income......................................................... [19.140] Alienation of share of partnership income........................................... [19.150] Variation or dissolution of partnership.................................................. [19.160] Work in progress............................................................................................ [19.170] Trading stock and depreciating assets.......................................................... [19.180] Limited partnerships................................................................................ [19.190] Questions................................................................................................... [19.200]
Key points [19.00] • The tax definition of “partnership” is wider than the general law definition and includes joint ownership of assets without the need for a business venture.
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650 [19.10] PRINCIPLES OF TAXATION LAW 2020 • Partnerships are in general taxed under the attribution or look through model under which a partnership is not a taxpayer; instead, the partners are assessed on the net income of the partnership. • The attribution model dictates that: (i) the nature of income derived by a partnership is preserved when assessed in the hands of the partners; and (ii) losses made in a partnership flow through to the partners. • “Salaries” paid to partners are not deductible to the partnership as the partners cannot employ themselves. Superannuation payments for partners are not deductible to the partnership. • Interest on initial capital contributed to the partnership is not deductible to the partnership. • Capital gains and losses on assets held in a partnership are taken to be made by the partners individually. • The death, retirement of an existing partner or introduction of a new partner are in general treated as the termination of the partnership for taxation purposes and require the preparation of a tax return up until the date of the variation of the partnership. • Payment for work in progress made to a retiring partner is treated as assessable income of the partner and is deductible for the paying partners. • Limited partnerships are in general taxed as companies.
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Introduction [19.10] Partnerships are not separate legal entities, and the partners retain personal liability even though they operate their business through a partnership. In Australia, the largest proportion of partnerships is in the agriculture, forestry and fishing industry. A partnership can exist for taxation purposes with companies or even trusts as the partners. The general taxation rules of partnerships are stipulated in Div 5 of Pt III of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). In general, partnerships are taxed under the attribution or look through model, under which partnerships are not taxpayers. Instead, the partners are assessed on the net income of the partnerships. The main tax advantages of conducting business through partnerships are twofold. First, losses incurred by a partnership are shared by the partners immediately and can be used to offset the partners’ other assessable income. In contrast, losses incurred by a company or a trust are in general trapped at the entity level. Second, the character of income derived by a partnership is preserved when assessed in the hands of the partners. For example, exempt income derived by a partnership remains as exempt income in the hands of the partners. This is in general not the case for companies.
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Figure 19.1: Overview of key issues
What constitutes+ a partnership?
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[19.20] Basically, a partnership is a contractual relationship between two or more people who wish to conduct a business in common with a view to profit. In general, partners in a partnership are liable jointly for the debts and obligations of the partnership. The partnership agreement stipulates the partners’ rights and duties, and interest in partnership property. The agreement can be in writing or merely an oral arrangement. A partnership can exist without a written agreement (Re Lance; Ex parte Nilant (1996) 34 ATR 573), and a partnership may be found not to exist even though there is a written agreement to that effect: Case 95 (1968) 14 CTBR (NS) 553. Partnership law is found in State statutory law and the general law, and all States have similar legislation relating to partnerships. For example, in Victoria, the Partnership Act 1958 (Vic) provides, among other things, the legal basis for the creation of a partnership, the rules that govern the liability of the partners and the procedure for the dissolution of a partnership. Section 5 of the Partnership Act 1958 provides a definition of “partnership” and requires the following elements to be present: 1. two or more people enter into a contract; 2. to carry on a business in common; 3. with a view to make a profit. This definition requires sufficient activity to constitute a business, an acceptance of the liability of each partner for the debts of the partnership, a joint and severable liability for the actions of the partners and a sharing of net returns. Persons wishing to avoid the inference of partnership generally
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652 [19.30] PRINCIPLES OF TAXATION LAW 2020 exclude joint and severable liability of the partners and provide for the sharing of gross returns which are netted at individual level. Although it is unnecessary to have a written contract, it is extremely advisable to do so. In TR 94/8, the Commissioner lists the factors in deciding whether a partnership exists between two or more persons:
• • • • • • • • •
mutual assent and intentions of the parties; joint ownership of business assets; registration of business name; joint business account and the power to operate it; extent to which the parties are involved in the conduct of the business; extent of capital contributions; entitlement to a share of net profits; business records; and trading in joint names and public recognition of the partnership.
The Australian Taxation Office (ATO) states that the above list of factors is not exhaustive, and the weight given to each factor will depend on the individual circumstances. Although no single factor is decisive, an entitlement to a share of net profits is considered essential.
Taxation law definition
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[19.30] Section 995-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) defines a partnership as: (a) an association of persons (other than a company or a limited partnership) carrying on business as partners or in receipt of ordinary income or statutory income jointly; or (b) a limited partnership. The tax law definition is wider than that of the general law. While the first limb in paragraph (a) of the definition is similar to the Partnership Acts in various states and territories, the second limb covers passive investment income from, for example, jointly owned investment properties and joint bank accounts even though the parties involved do not conduct a business. TR 93/32 considers the position of co-ownership of an investment property and contends that it satisfies the second limb of the tax definition of “partnership”. It will not satisfy the general law definition of a partnership and the first limb definition under s 6(1) of ITAA 1936 because the partners are not carrying on a business. Therefore, an agreement as to the sharing of the profit or loss other than in accordance with the percentage of ownership by the individual partners will have no effect for income tax purposes because no partnership
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exists outside the second limb of the tax definition. This position is based on the decision by Beaumont J in FCT v McDonald (1987) 18 ATR 957, where his Honour found that the parties were co-owners and not partners under the first limb of s 6(1) of ITAA 1936. Case study 19.1: Partnership v co-ownership FCT v McDonald (1987) 18 ATR 957 concerns a partnership between a husband and wife, Mr and Mrs McDonald, who jointly owned a number of investment properties. Mr McDonald claimed a tax deduction in the sum of $1,941 as a loss on the partners’ property investments. Mr and Mrs McDonald owned a number of properties as joint tenants but the husband and wife agreed to share the net profit of the partnership on the basis of the wife receiving 75% and the husband 25% and any loss being borne solely by the husband. The Commissioner allowed only 50% of the loss as a deduction. The Federal Court found that no general law partnership existed as Mrs McDonald was merely a passive investor and had no commercial expertise to contribute to the business. Mr McDonald could only claim half of the loss as a tax deduction against his own personal income. In the words of Beaumont J (at 967): “In my opinion, no partnership under the general law subsisted between the respondent and his wife. Their relationship was one of co-ownership, and even if they were deemed to be partners by reason of subsection 6(1) of the Act [ITAA 1936], this circumstance is immaterial for our purposes”.
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In order to satisfy the general law definition of a partnership, the partners must be engaged in the conduct of a business, not just joint ownership of property as joint tenants. As a result of FCT v McDonald, the ATO released Ruling TR 94/8 to provide a set of guidelines to determine whether a partnership exists for a husband and wife according to general law concepts and, in particular, what is required in terms of carrying on a business. If these guidelines are not satisfied, a partnership only exists under the second limb of the taxation law definition, and the partners share profits and losses equally. In practice, in these cases, the ATO does not require the husband and wife to file a partnership return, and allows them to include the income and deductions in their individual tax returns. Limited partnerships are discussed in [19.190].
Compliance obligations of a partnership [19.40] A partnership does not pay tax, but must lodge a tax return: s 91 of the ITAA 1936. A partnership has its own tax file number (TFN), and the
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654 [19.50] PRINCIPLES OF TAXATION LAW 2020 schedule at the end of the return sets out the amount of net income or loss attributed to each partner. The schedule also shows the breakup of each item of income, such as exempt income or NANEI. With the partnership return, the ATO can then match the data with the partners’ own tax returns. As a partnership is carrying on a business, it must: • obtain a TFN for the partnership, even though it is not a separate legal entity; • obtain an Australian Business Number (ABN); • register for goods and services tax (GST) if required; and • find out if it needs to obtain a registered business name from the State or Territory Government small business office, especially if the individual partners are not using their own names in the business.
Taxation of partnerships [19.50] As stated above, a partnership does not pay tax, and any partnership income or loss is included in the tax returns of the individual partners. Figure 19.2 provides a guide to determine a partner’s share of partnership income or loss.
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Figure 19.2: Determining a partner’s share of partnership income or loss
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Net income of a partnership [19.60] Section 90 of ITAA 1936 defines “net income” of a partnership as: [T]he assessable income of the partnership, calculated as if the partnership were a taxpayer who was a resident, less all allowable deductions except deductions allowable under section 290-150 or Division 36 of the Income Tax Assessment Act 1997.
It is important to note that the net income of a partnership does not include net capital gains. Capital gains are included in the assessable income of the partners: see [19.130] for more detail. Though assets of a partnership are legally owned by the partners, the computation of the net income of a partnership takes into account transactions with respect to certain assets. For instance, sales and purchases of trading stock are treated as income and deductions at the partnership level. The difference between the opening and closing stock values is also taken into account in the partnership accounts. Similarly, capital allowance on plant and equipment pursuant to Div 40 and capital works deductions pursuant to Div 43 are also claimed as deductions at the partnership level.
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The assessable income of a partner in a partnership includes a share of the net income of the partnership, as s 92 of the ITAA 1936 stipulates that the assessable income of a partner in a partnership shall include: (1) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was a resident; and (2) so much of the individual interest of the partner in the net income of the partnership of the year of income as is attributable to a period when the partner was not a resident and is also attributable to sources in Australia.
Case study 19.2: Calculation of net income Fred and Bill conduct a partnership providing IT consulting, sharing profits and losses equally. In this income year, the partnership derived fees of $180,000 (excluding GST) and incurred expenses of $40,000. The net income of the partnership is $180,000 –$40,000 = $140,000. Fred and Bill have to include in their tax returns assessable income from the partnership of $70,000 each.
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656 [19.70] PRINCIPLES OF TAXATION LAW 2020
Partnership losses [19.70] Section 90 of ITAA 1936 defines “partnership loss” as: the excess (if any) of the allowable deductions, other than deductions allowable under section 290-150 or Div 36 of the ITAA 1997, over the assessable income of the partnership calculated as if the partnership were a taxpayer who was a resident.
Partnership losses are shared by the partners who can deduct the losses in their own tax returns pursuant to ss 90 and 92(2) of ITAA 1936. Section 92(2) of the ITAA 1936 states that: [I]f a partnership loss is incurred by a partnership in a year of income, there shall be allowable as a deduction to a partner in the partnership: (a) so much of the individual interest of the partner in the partnership loss as is attributable to a period when the partner was a resident; and (b) so much of the individual interest of the partner in the partnership loss as is attributable to a period when the partner was not a resident and is also attributable to sources in Australia.
Exempt income derived by a partnership is similarly attributed to the partners and thus may affect the amounts of loss deductions available to the partners (see [3.170] for detail): s 92(3) of ITAA 1936.
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Case study 19.3: Calculation of partnership loss Same facts as in Case Study [19.2], except that the partnership incurred expenses of $200,000. The net loss of the partnership is calculated as $200,000 –$180,000 = ($20,000). Fred and Bill can deduct a loss from the partnership of $10,000 each in their own individual tax returns.
Treatment of special partnership items [19.80] Certain transactions with respect to partnerships are subject to specific taxation treatments, including: • partners’ “salaries”; • interest payments between a partnership and its partners; • superannuation deduction for partners; • dividends received by a partnership; • capital gains and losses made on partnership assets;
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• uncontrolled partnership income; and • alienation of share of partnership income. These items are discussed in the following paragraphs.
Partners’ salaries [19.90] As a partnership is not a separate legal entity, partners cannot be employed by themselves. It is sometimes the case that, as a means of recognising the extra value of a partner to the partnership, one partner is paid an extra amount of money over and above the share of partnership profits. This may be described as a “salary”. However, a partner’s salary is not regarded as an expense to the partnership and thus not deductible for income tax purposes. Instead, it is treated as part of the allocation of profits and losses of a partnership to the partners. The ATO position on the issue of partners’ salaries is explained in TR 2005/7. The following two case studies illustrate the operation of the rules.
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Case study 19.4: “Salary” paid to a partner Andy and Ben are partners in a partnership, sharing profits and losses equally. Andy has special skills which are rewarded by the partnership in the form of a “salary” of $40,000. In this income year, profit of the partnership after deduction of the salary is $100,000. As the salary is not deductible for income tax purposes, the net income of the partnership is $100,000 + $40,000 = $140,000. Out of this amount, Andy shared (1) $40,000 which is received as “salary”; and (2) 50% of what remains, namely 50% of $100,000, or $50,000. Therefore, Andy has to include a total of $90,000 as assessable income in his tax return. Ben shared $50,000 out of the $140,000 net income of the partnership.
Case study 19.5: Partnership makes loss after deducting partner “salary” Same facts as Case Study [19.4], except that the partnership incurred a net loss of $30,000 after deducting the “salary” to Andy. Again, the salary is added back, resulting in a net income of the partnership of $10,000. According to TR 2005/7, Andy is treated as having the sole entitlement to the whole of the net income, as he is entitled to receive the “salary” before any allocation of the partnership’s profits or losses. He has to include the $10,000 as assessable income in his tax return.
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658 [19.100] PRINCIPLES OF TAXATION LAW 2020
Ben did not share any of the net income of the partnership in this income year. The non-deductibility of salaries paid to partners in a partnership was confirmed in Re Scott v FCT (2002) 50 ATR 1235. Case study 19.6: Partners’ salaries not deductible
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Re Scott v FCT (2002) 50 ATR 1235 concerns a partnership between a husband and wife, Mr and Mrs Scott, and their four sons. The partnership conducted a business involved in preparing tax returns, with Mrs Scott as the registered tax agent. Mr Scott was employed in the business, as well as their son, Andrew. The other three sons, while partners, were engaged in other professional activities not associated with the partnership. As a result of Mr Scott and Andrew being paid tax-deductible “salaries”, the partnership incurred a loss which was distributed to the other partners who then claimed the loss as a tax deduction against their other income. The Commissioner disallowed the payment of the “salaries” as a deduction. The AAT held that under the general law a partnership is not a separate legal entity and, as such, the partners cannot employ themselves and pay themselves a salary. The taxpayers relied in part on Ruling IT 2218, which allowed partnerships to take into account the contribution that a particular partner may make to the partnership by receiving an additional payment, a notional “salary”, but at no time did the ruling state that the “salary” was deductible to the partnership. As a result of this case, the ATO withdrew the ruling.
Interest payments between a partnership and its partners [19.100] Similar to the treatment of salaries paid by a partnership to its partners, interest paid to a partner on capital contributed to a partnership is not regarded as an expense to the partnership and thus not deductible. Instead, it is treated as part of the allocation of profits of the partnership to the partner. For the same rationale, interest credited to a partner’s current account is not deductible to the partnership, while interest debited to that account is not taxable to the partnership: FCT v Beville (1953) 10 ATD 170. Different tax implications apply to interest on a loan made by a partner to a partnership. As the loan is distinct from the capital introduced to the partnership, interest expenses on the loan are deductible to the partnership: Leonard v FCT (1919) 26 CLR 175.
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Interest expenses on external borrowings by a partnership as working capital are deductible to the partnership. This is so even if the loan is used to repay capital contributions of partners, provided the borrowings are used to refinance funds employed in the partnership business: FCT v Roberts and Smith (1992) 23 ATR 957; and Ruling TR 95/25. Case study 19.7: Interest expenses and the refinancing principle
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In FCT v Roberts and Smith (1992) 23 ATR 957, a partnership of lawyers claimed interest at the partnership level on a loan of $125,000 pursuant to s 51(1) of Income Tax Assessment Act 1936 (now s 8-1 of Income Tax Assessment Act 1997). The partnership used the money to pay each existing partner the sum of $25,000, representing a repayment of capital to each of the five partners. The Commissioner disallowed the expense as a deduction. Smith was an original partner and Roberts became a new partner some three years later. In the words of Hill J at 507:
The making of the regular interest payments was part of the cost to the new partner of becoming a partner. It in no way differed in substance from interest that would need to be paid had the incoming partner borrowed from an external financier to finance the purchase from the other partners of the partnership share. Nor in substance did it differ from a case where the incoming partner was financed into the partnership by the other partners and was required to pay interest to them. Nor would the case have been different if the arrangement had been to indemnify the other partners in respect of a proportionate share of the principal and to assume the liability for interest attaching to that share. In each of these cases the interest liability incurred has the necessary connection with the assessable income of the new partner to be thereafter derived under s 92 of the Act. It is relevant and incidental to that end.
As a result of FCT v Roberts and Smith, the ATO released Ruling TR 95/25, which sets out a series of guidelines to determine whether a partnership can deduct interest expense on funds borrowed to repay the initial capital contributions by the partners.
Superannuation for partners [19.110] Concessional superannuation contributions for partners are not deductible to the partnership because partners cannot employ themselves and therefore cannot make employer superannuation contributions. Partners are regarded as self-employed and, as a result of the simplified superannuation rules, they can make concessional contributions (see Chapter 18 for details).
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660 [19.120] PRINCIPLES OF TAXATION LAW 2020 The individual partners then claim the superannuation expenses as deductions in their own tax returns. In contrast, concessional superannuation contributions for employees, including the superannuation guarantee surcharge, are deductible to the partnership.
Dividends received by the partnership [19.120] Pursuant to s 207- 35 of ITAA 1997, if a partnership receives a dividend with an imputation credit attached, the amount of the dividend plus the imputation credit must be included in the assessable income of the partnership. When the dividend income is distributed to the partners as part of the share of the net income of the partnership, it retains its character in the hands of the partners. The individual partners can then claim as a tax offset in their individual tax returns the amount of the imputation credit attached to the dividend. Unlike a trust, even if a partnership has made a loss, the partners can still share the franking credit attached to the dividend (see [21.250] for detail).
Capital gains tax
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[19.130] Section 106-5 states that “any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets, is made by the partners individually”. In other words, a capital gain on a partnership asset is not included in the partnership’s assessable income. Instead, it is included in the partners’ own tax returns. Each partner’s capital gain or loss is determined by reference to the partnership agreement or partnership law if there is no agreement. Each partner has separate cost base and reduced cost base for the partner’s interest in the asset. It follows that upon the retirement of a partner from a partnership, the remaining partners are treated as acquiring a share of the departing partner’s interest in the partnership assets. Similarly, when a new partner is admitted to a partnership, the existing partners are regarded as disposing a part of their interest in the partnership assets. The following two case studies illustrate how the CGT rules apply to partnerships and their partners. Case study 19.8: CGT implications of a new partner Gary and George formed a partnership as equal partners and each contributed $30,000. The partnership bought land for $60,000 ten years ago, which increased in value to $600,000. Matt was introduced into the
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partnership as an equal partner and acquired one-third share in the land by paying Gary and George $100,000 each. For CGT purposes, Gary and George have each disposed of one-third of their interest in the land to Matt. Each has a cost base for that interest of $10,000 and capital proceeds of $100,000, resulting in a capital gain of $90,000 each before discount. Matt’s cost base of his interest in the land is $200,000. Source: Adapted from s 106-5(4) of ITAA 1997.
Case study 19.9: Disposal of partnership assets
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An investor and her spouse, Jacqui and Evan, created a partnership five years ago, sharing profits and losses equally. Jacqui contributed an investment property with a value of $300,000 to the partnership. Evan contributed cash of $300,000. The investment property was sold in the current income year for $400,000. Each partner has a cost base of $150,000 (ie, 50% of $300,000) in the property. Capital proceeds for each partner is $200,000 (ie, 50% of $400,000). Therefore, each partner made a capital gain of $50,000 before discount on the disposal of the property. If a partner had a carry-forward capital loss, that partner can offset the capital gain by the amount of the capital loss.
Uncontrolled partnership income [19.140] In the absence of specific anti- avoidance provision, it would be relatively easy for a high-income earner to shift income to another person with lower marginal tax rate by forming a partnership between the two persons. For example, a husband who is carrying on a business may form a partnership with his wife who is a housewife with no income, while the husband maintains total control over the partnership business and income. Section 94 of the ITAA 1936 is the specific anti-avoidance provision designed to deal with this kind of income- splitting arrangements. In particular, if a partner of a partnership has no real and effective control of his/her share of the net income of the partnership, that amount is regarded as “uncontrolled partnership income”. The provision imposes a penalty tax rate on the uncontrolled partnership income in the hands of the partner. The penalty tax rate is generally the top marginal tax rate less the average rate of tax of the partner. In other words, the uncontrolled partnership income is effectively
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662 [19.150] PRINCIPLES OF TAXATION LAW 2020 taxed at the top marginal tax rate. The specific anti-avoidance provision does not apply to a partner that is a company, a trustee or a minor.
Alienation of share of partnership income [19.150] As an income-splitting strategy, a partner may assign his share of partnership income to another person with a lower marginal tax rate: FCT v Everett (1980) 143 CLR 440. As a result of this case, this kind of assignment of interest in a partnership was known as an Everett assignment. However, since the introduction of the CGT provisions in 1985, these assignments in most cases may no longer provide any substantial tax benefit unless the relevant interest is a pre-CGT asset. Therefore, they are not discussed in detail here.
Variation or dissolution of partnership
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[19.160] It is a good practice to draft a partnership agreement whereby on admission of a new partner or the death or retirement of a partner the partnership business will continue. Otherwise the old partnership ceases to operate and a new partnership would need to be started. This would result in an accounting of the partnership profit or loss at the date of death, retirement or admission of a new partner and the lodgement of a tax return. If this happened during the financial year, a further tax return is required at the end of the financial year. This situation creates problems with the value of the work in progress, bad debts, trading stock and depreciating assets that were owned by the partners and partnership at the date of the death, retirement or admission of a new partner. For large professional partnerships, the Commissioner allows the partnership to lodge a single tax return at the end of the financial year that shows the allocation of profit or loss among the existing partners, new partners and retiring partners. For the CGT implications on partnership assets when a partner retires or a new partner is admitted, see [19.130].
Work in progress [19.170] When a partner retires from the partnership, the outgoing partner may sell the work in progress to the remaining partners or a new partner. The payment is income according to ordinary principles: Crommelin v FCT (1998) 39 ATR 377 and is now statutory income pursuant to s 15-50 of ITAA 1997. At general law, the partners purchasing the work in progress could not obtain a deduction because the outlay was on capital account. However, symmetric
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treatment is now achieved under the tax law by allowing a specific deduction for the purchase of work in progress: s 25-95 of ITAA 1997.
Trading stock and depreciating assets [19.180] When there is a change in the composition of a partnership, specific provisions apply to both trading stock and depreciating assets of the partnership. In broad terms, the trading stock is deemed to have been notionally disposed of at market value outside the ordinary course of business: s 70-100 of ITAA 1997. For depreciating assets of the partnership, s 40-340 of ITAA 1997 provides a roll-over relief so that no tax liability arises on a change in the partnership.
Limited partnerships [19.190] Limited partnerships are defined in s 995-1 of the ITAA 1997 to mean, among other things: an association of persons (other than a company) carrying on businesses as partners … where the liability of at least one of those persons is limited.
They are in general taxed as companies: Div 5A of Pt III of ITAA 1936.
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Questions [19.200] 19.1 Peter and Jill are in a partnership as retailers of electrical goods. The partnership records, exclusive of GST, for this income year disclose: Receipts ($): 300,000
Gross receipts from trading
Payments ($):
100,000
Purchases of trading stock
30,000
Partners’ salaries (each)
2,000
Interest on cash advance made to the partnership by Peter
60,000
Salaries for employees and rent paid
2,000
Legal expenses in recovering bad debts
Other details: • Peter and Jill share partnership profits equally; • Trading stock on hand 1 July: $10,000;
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664 [19.200] PRINCIPLES OF TAXATION LAW 2020 • Trading stock on hand 30 June: $20,000; • Peter’s personal records disclose: – Gambling winnings: $2,000; – Net salary as a part-time instructor (excluding PAYG tax instalments of $2,000): $5,000; – Subscription to professional journals: $500; – Peter is a member of a private health fund.
Calculate Peter’s taxable income for the income year explaining your treatment of each item in this question. 19.2 Alasdair is a retired solicitor. His wife Tracy is a retired school teacher. Both wish to remain active and they invest in a gift shop that is to be managed by their daughter Carol, who is aged 35. They form a partnership of three called “Carol’s Gift Shop”. Alasdair and Tracy contributed $40,000 each to fund the purchase of the shop. The partnership agreement provides: • Both Alasdair and Tracy are to receive interest at the rate of 10% pa on their capital contribution of $40,000. • Carol will receive a salary of $25,000 for the management of the shop, as well as superannuation contributions of $6,000. • A car will be leased by the business and provided to Carol. • All profits and losses are to be shared equally between the three partners. The accounts for this income year show the following:
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Income ($) Sales (excluding GST)
240,000
Expenses ($) Purchase of stock and related expenses
130,000
Interest on capital paid to Alasdair and Tracy
8,000
Salary to Carol
25,000
Superannuation to Carol
6,000
Lease payments on car (excluding GST)
7,000
Other deductible operating expenses (excluding GST)
14,000
The leased car was used 80% of the time for business and 20% of the time for private purposes. With reference to the facts above: 1. Calculate the net income of the partnership. Show the allocation of net income to each of the three partners. 2. Explain if the provision of the motor vehicle by the partnership to Carol imposes any fringe benefits tax liability on the partnership.
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19.3 Johnny and Leon are adult partners in a business selling sporting goods. The partnership records, excluding GST, for the current income year disclose the following: Receipts ($): 400,000
Sales of sporting goods (see Note 3)
10,000
Interest on bank deposits
21,000
Dividend franked to 60% received from an Australian resident company
10,000
Bad debts recovered
50,000
Exempt income
30,000
Capital gain from the disposal of shares acquired in 2009 and sold in June this income year (see Note 4)
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Payments ($): 10,000
Salary to Johnny
15,000
Salary to Leon
16,000
Fringe benefits tax
2,000
Interest on capital provided by Johnny
4,000
Interest on loan made by Johnny to the partnership
3,000
Johnny’s travelling expenses from home to work and return (see Note 5)
2,000
Legal fees for the renewal of lease of the office building
1,200
Legal expenses for preparation of a partnership agreement
700
Legal expenses for preparation of new lease of business premises
500
Debt collection expenses paid to a solicitor
500
Council rates on business premises
25,000
Staff salaries (see Note 6)
30,000
Purchase of sporting goods supplies
20,000
Rent on retail shop
30,000
Provision for doubtful debts (see Note 10)
10,000
Business lunches (see Note 11)
Notes 1.
Partnership profits and losses are shared between Johnny and Leon on an equal basis.
2.
The partnership is registered as a Small Business Entity (SBE).
3.
On 1 January this income year the partners discovered that an employee had stolen $3,000 cash in respect of money received from sales to customers.
4.
Johnny and Leon made a capital loss of $15,000 from the disposal of shares acquired in 2006 and sold in 2011.
5.
Johnny often takes work home as he finds it convenient to plan the next day’s work in his home study.
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666 [19.200] PRINCIPLES OF TAXATION LAW 2020 6.
Staff salaries include $10,000 paid to Johnny’s son Johnny Jr for washing the partners’ cars. The Commissioner considers $5,000 to be a reasonable commercial rate for washing the cars.
7.
Stock at beginning of the year was: $20,000.
8.
Stock at end of the year was: Cost $16,000: (a) Market selling value $18,000
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(b) Replacement $17,000 9.
Johnny and Leon did not make an election under s 328-285(2) of ITAA 1997.
10.
Johnny and Leon are owed $30,000 by a debtor who is bankrupt. They believe it is very unlikely that they will recover any money from the debtor, and do not take any action to recover the money.
11.
Johnny and Leon spent $10,000 on business lunches with overseas buyers at expensive restaurants.
12.
In the last income year, Johnny and Leon made a net partnership loss of $40,000.
13.
Johnny and Leon wish to minimise their tax liabilities for the income year.
Calculate the net income for the partnership for the income year. 19.4 Gary and Matt are partners in a partnership running a Thai restaurant. They share profits and losses equally under the partnership agreement. In addition, Gary receives salaries of $30,000 every year from the partnership for taking on the daily management role in the restaurant. In this income year, the partnership makes a loss of $45,000 after deducting the salaries paid to Gary. Explain the tax implications of Gary and Matt in this income year. 19.5 Peter and Paul are partners in a partnership. Their shares of the partnership profits and losses are 60% and 40% respectively. Peter is a resident and Paul is a non-resident. In this income year, the partnership derived the following income: • interest income from an Australian bank account: $30,000; • interest income from an overseas bank account: $18,000. Calculate the net income of the partnership and explain how that amount will be allocated and assessed in the hands of Peter and Paul.
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20 Trusts and beneficiaries
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Key points.................................................................................................... [20.00] Introduction................................................................................................ [20.10] What is a trust?........................................................................................... [20.20]
Fixed trusts....................................................................................................... [20.30] Discretionary trusts.......................................................................................... [20.40] Testamentary trusts......................................................................................... [20.50] Taxation of trusts....................................................................................... [20.60] Beneficiary presently entitled and not under a legal disability...................... [20.70] Income of the trust estate vs net income........................................................ [20.80] Proportionate and quantum views.......................................................... [20.90] Interim measures in response to Bamford case.................................. [20.100] Presently entitled............................................................................................ [20.110] Statutory present entitlement........................................................................ [20.120] Character of income preserved..................................................................... [20.130] Beneficiary presently entitled but under a legal disability............................ [20.140] No beneficiary is presently entitled............................................................... [20.150] Minor beneficiaries......................................................................................... [20.160] Non-resident beneficiaries............................................................................. [20.170] CGT events for trusts..................................................................................... [20.180] Questions................................................................................................... [20.190]
Key points [20.00] • Trusts are not separate legal entities. They can be classified as either a fixed trust or a discretionary trust. Each beneficiary of a fixed trust is entitled to a fixed proportion of the trust income. A common example of a fixed trust is a unit trust. In contract, the entitlement of a beneficiary of a discretionary trust is at the discretion of the trustee who determines the amount of distribution to each of the beneficiaries.
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668 [20.10] PRINCIPLES OF TAXATION LAW 2020 • If a beneficiary of a trust is presently entitled to a share of the trust income, his/ her assessable income includes that share of the net income of the trust. • In practice, net income of a trust calculated according to the tax law is often different from the trust income determined under the trust law. Case law suggests that the proportionate view is preferable to the quantum view in determining the amount of assessable income of the beneficiaries. • If a beneficiary is under a legal disability, the trustee pays income tax on behalf of the beneficiary. • The character of income of a trust in general is preserved upon distribution to beneficiaries. In particular, dividends and capital gains of a trust retain these characters in the hands of beneficiaries to whom they are entitled. • If no beneficiary is presently entitled to an amount of net income of a trust, the trustee is subject to tax on that amount at a penalty rate, namely the top marginal individual tax rate plus Medicare levy. • Trust distributions to minors in general are subject to the same penalty rate.
Introduction
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[20.10] A trust is not a separate legal entity. In broad terms, a trust refers to a relationship between a trustee and beneficiaries, under which the trustee is obliged to manage the trust assets and activities for the benefit of the beneficiaries. Trusts are commonly used in Australia not only for asset protection purposes, but also for carrying on businesses. Trusts typically account for approximately 3% of the number of taxpayers in Australia. Discretionary trusts are the most common type of trusts used in Australia. One of the main motivations for using a discretionary trust to hold assets or conduct a business is to shield the assets from claims against a taxpayer upon bankruptcy or for negligence and other legal liability. While the trustee is the legal owner of the assets of the trust, beneficiaries of a discretionary trust in general do not have any interest in the assets. The key legislative provisions relating to the taxation of trusts are stipulated in Div 6 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). While a trust itself does not have to pay tax, its trustee must lodge a tax return each year reporting the net income or loss of the trust. The current taxation regime of trusts in Australia is complex and can produce anomalous outcomes. The government announced in 2010 that it would rewrite the provisions and has proposed reform options to improve the regime. However, no progress has been made at the time of writing this book.
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Figure 20.1: Overview of key issues
What is a trust?
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[20.20] A “trust” is defined in HA Ford and WA Lee, Principles of the Law of Trusts (2nd ed, Lawbook Co, Sydney, 1990) at [101] as follows: A trust may be defined as an obligation enforceable in equity which rests on a person (the trustee) as owner of some specific property (the trust property) to deal with that property for the benefit of another person or persons (the beneficiaries) or for some object or purpose.
A “bare trust” can be established verbally by simply asking a person to hold property in his or her name as the trustee for another person when the true ownership of the property is concealed. An example of a bare trust is when a nominee owns shares on behalf of the true owner so that the ownership can be hidden from other parties. In practice, an express trust that is established formally with a trust deed is more common. An important and widely used form of a trust is a superannuation fund. Many financial investments are held in a trust, such as a managed investment fund or a property trust, where the investor owns units in the trust. Trusts can be categorised as either fixed trusts or discretionary trusts. In fixed trusts, the trustee is obligated to pay the income or capital of the trust in precise fixed proportions to specified beneficiaries. In contrast, the trustee of
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670 [20.30] PRINCIPLES OF TAXATION LAW 2020 a discretionary trust has the power and discretion to determine the amount of income and capital distributions to each of the beneficiaries. These two types of trusts are discussed in more detail below.
Fixed trusts [20.30] In fixed trusts, the entitlements of beneficiaries to income and corpus (capital) are predetermined, or fixed, by the terms of the trust deed. A typical example of a fixed trust is a unit trust. Many managed or collective investment schemes are structured as unit trusts and the values of the units are published in the financial part of the newspapers every week. They are a popular form of investment for superannuation funds. The case of Charles v FCT (1954) 90 CLR 598 is important because it provides an explanation of what it means to be a unit holder in a unit trust and this is compared with being a shareholder in a company. Dixon CJ, Kitto J and Taylor J provided the following distinction in their joint judgment (at 609):
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… for a unit held under this trust deed is fundamentally different from a share in a company. A share confers upon the holder no legal or equitable interest in the assets of the company; it is a separate piece of property; and if a portion of the company’s assets is distributed among the shareholders the question whether it comes to them as income or capital depends upon whether the corpus of the property (their share) remains intact despite the distribution. But a unit under the trust deed before us confers a proprietary interest in all of the property which for the time being is subject to the trust of the deed.
The beneficiaries of a unit trust are entitled to a fixed proportion of the net income or capital under the trust deed, and the trustee has no discretion to change the fixed entitlement. In particular, the share of net income and capital of a unit trust is determined by the number of units held by the beneficiary. The number of units held by each beneficiary typically corresponds to the contribution made to the trust by the beneficiary. Units in a unit trust are similar to shares in a company but without the statutory compliance requirements contained in the Corporations Act 2001 (Cth), as that Act has no bearing on trusts. However, if the unit trust is a public trading trust, then the offering of units to the public would constitute a financial product for the purposes of the Corporations Act 2001 (Cth). Figure 20.2 illustrates how a fixed trust may be structured. Certain unit trusts are taxed as companies, including corporate unit trusts and public trading trusts pursuant to, respectively, Divs 6B and 6C in Pt III of ITAA 1936. The government announced in 2010 that it would repeal Div 6B and modify Div 6C. Detailed discussion of these rules is beyond the scope of this book.
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Figure 20.2: Example –Andrews Unit Trust
Discretionary trusts
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[20.40] Under a discretionary trust, the trustee has an absolute discretion in allocating trust income or capital to a beneficiary each year. As the beneficiaries of a discretionary trust have no entitlement to trust property until the trustee determines otherwise, the trust provides asset protection in the case of beneficiaries becoming bankrupt. In addition, as CGT event E4 (see discussion in [20.170]) does not apply to discretionary trusts in practice, tax concessions at trustee level flow through to the individual beneficiaries. For example, where accounting profit exceeds net income of the trust, this excess can often be passed through to the individual beneficiaries in a discretionary trust. These are the main reasons why discretionary trusts are used extensively to operate small-to-medium businesses. In a typical family trust, the main beneficiary would appoint the trustee in its capacity as an “appointor”. The appointor is noted in the trust deed and has the power to remove the trustee or to appoint a new trustee if required. If the trustee is a company, then the directors of the company are responsible for the management of the trust fund and owe a duty to the company to conduct the affairs of the company in accordance with their statutory and common law duties as directors. The shareholders have the role of voting for the directors at the annual general meeting so that if the shareholders change, it is likely that the directors will change. The trust deed is often referred to as a “deed of settlement” and the “settlor” provides an initial amount of cash to the trustee to invest on behalf of the beneficiaries. It is important that the settlor is independent from the beneficiaries. In most cases, it is the family solicitor or accountant or a family friend that is chosen as the settlor. Figure 20.3 illustrates the way in which a discretionary trust is established.
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672 [20.40] PRINCIPLES OF TAXATION LAW 2020 Figure 20.3: Example –Lee family discretionary trust
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The issue of who should be the settlor is important if there are minor beneficiaries, as s 102 of ITAA 1936 may be applied by the Australian Taxation Office (ATO) to tax the trustee on the net income of a minor beneficiary. This issue is discussed in [20.160]. Once the settlor has established the trust by making the initial contribution of cash (usually $20) and executing the deed of settlement, the trustee is able to conduct the business of the trust. The deed of settlement has a vesting date, usually 80 years from the date of establishment. Eventually, the trust is wound up either on the vesting date or earlier by distributing all of the income and capital of the trust estate to the beneficiaries. The trustee is the legal owner of the trust property and has a range of statutory and common law obligations regarding how the trust fund is managed. The trust property is administered on behalf of the beneficiaries. In a family trust, the class of beneficiaries is identified in the deed of settlement, which allows for new family members to be included at a later time, such as grandchildren. As mentioned above, one of the advantages of discretionary trusts is the ability to split income between beneficiaries taking into consideration the tax profiles
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of the beneficiaries. For example, if a beneficiary has carried forward capital losses, the trustee may decide to distribute more capital gains to that beneficiary to minimise the tax liability of the capital gain. Of course, these arrangements are subject to the challenge of the Commissioner who may attempt to apply the general anti-avoidance provisions in Pt IVA of ITAA 1936 if he or she is of the opinion that the dominant purpose of entering into the arrangement is for the tax benefits (for a discussion of the general anti-avoidance provisions, see Chapter 23 on tax avoidance).
Testamentary trusts [20.50] A testamentary trust is a trust created under a will and can be either a fixed trust or a discretionary trust. The beneficiaries can be the widow or widower, and children or grandchildren. Testamentary trusts provide a vehicle for wealthy individuals who want to preserve their wealth. For example, if the offspring are not in a position to preserve the assets due to say a bad marriage, impending bankruptcy or a social problem such as drugs or gambling, the income and capital can be held at the trust level and eventually distributed to grandchildren.
Taxation of trusts
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[20.60] The taxation of trusts depends on, among other things, who is entitled to the trust income and whether or not they are under a legal disability. Figure 20.4 summarises how a trust is taxed. The first step is to calculate the net income or loss of a trust. Trust losses cannot be distributed to the beneficiary. Instead, subject to specific anti-loss trafficking provisions, they may be carried forward in the trust to offset against future income derived by the trust. If a trust has net income, the next step is to determine who should be the taxpayers for the amount. There are in general three possible scenarios under which the net income of a trust is subject to income tax in the hands of a beneficiary or the trustee: • the beneficiary is presently entitled to the trust income and is not under a legal disability; • the beneficiary is presently entitled to the trust income and is under a legal disability; and • no beneficiary is presently entitled to the trust income.
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674 [20.70] PRINCIPLES OF TAXATION LAW 2020
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Figure 20.4: Taxation of a trust
Each of these scenarios is analysed in the following paragraphs.
Beneficiary presently entitled and not under a legal disability [20.70] Section 97 of ITAA 1936 is a key provision in the taxation regime for trusts. It stipulates that: [W]here a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate … the assessable income of the beneficiary shall include … that share of the net income of the trust estate… (emphasis added)
The meanings of “the income of the trust estate”, “net income”, “presently entitled” and the word “share” in s 97 are critical for the taxation of trusts and are discussed in the following paragraphs.
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Income of the trust estate vs net income [20.80] The net income of a trust is defined in s 95(1) of ITAA 1936 as, among other things, the total assessable income of the trust estate calculated under the tax law as if the trustee were a resident, less allowable deductions. In other words, net income of a trust is broadly its taxable income calculated according to the tax law. In particular, capital gains made by a trust are typically included in its net income. In contrast, the “income of the trust estate” is not defined in the tax law. In the absence of specific definitions in the trust deed, the term may refer to the general concept of trust income under trust law, which typically excludes capital items. In this case, the income of a trust estate is likely to exclude capital gains. Case study 20.1: Concepts of trust income and net income
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A discretionary trust derived rental income of $100 and capital gain of $200 in the current income year. The trust adopts the general concept of income for trust law purposes. In this case, the net income of the trust is $300, while the trust income for trust law purposes is $100. The discrepancies between the net income of a trust under the tax law and the trust income under trust law have been problematic for many decades. For example, if a beneficiary of the trust in Case Study [20.1] is an income beneficiary (ie, a beneficiary that can only receive distribution of trust income but not capital from the trust), what is the amount of his/her assessable income under s 97? The answer depends on the meaning of the word “share” in the section and is discussed in the next section.
Proportionate and quantum views [20.90] There are two alternative approaches to interpret the word “share” in s 97 of ITAA 1936: the proportionate view and the quantum view. The best way to explain the difference between the two approaches is to use an example. Case study 20.2: Proportionate vs quantum views: income and capital beneficiaries Going back to the discretionary trust in Case Study [20.1], assume the trust has two beneficiaries, Gary and George. Gary is an income
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beneficiary who can only receive distribution of trust income. George is a capital beneficiary who can only receive capital distribution from the trust. Assume further that the trustee decides to distribute the trust income of $100 to Gary. In this case, Gary is presently entitled to $100, representing all the trust income according to the trust law. Literal reading of s 97 suggests that there are two alternative interpretations of the word “share”:
(1) Proportionate view: Under this view, the word “share” refers to the proportion or percentage. In other words, as Gary is presently entitled to 100% of the trust income, his assessable income has to include 100% of the net income, that is $300. This is so even though Gary cannot and will never receive the $200 capital gain.
(2) Quantum view: Under this view, the word “share” refers to the amount. In other words, as Gary is presently entitled to $100 out of the trust income, his assessable income has to include $100 out of the net income of the trust.
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Both interpretations are problematic. Under the proportionate view, Gary is taxed on the $200 capital gain that he will never receive. This case study shows that the proportionate view can tax the wrong taxpayer for the wrong amount. The quantum view, unfortunately, may not be appropriate either. Under that view, while Gary is taxed on the $100 out of the $300 net income, s 97 fails to identify who should be the taxpayer for the remaining $200. In that case, the trustee would be taxed on the $200 at the top marginal rate plus Medicare levy pursuant to s 99A of ITAA 1936 (see [20.150]). This tax outcome contradicts the reality that George as the capital beneficiary received the $200. He should be the taxpayer paying tax on the $200 at his marginal tax rate. In other words, the quantum view also taxes the wrong taxpayer for the wrong amount. The problems of the two conflicting views can also arise if a deduction originally claimed by a trust is disallowed by the ATO some years later, resulting in additional net income. The issue is who should pay tax on the additional net income, the beneficiaries or the trustee? Case study 20.3: Proportionate vs quantum views: adjustment of net income In Year 1, the ABC trust had a net income of $100 and distributed $20 to beneficiary A and $80 to beneficiary B. Each of the beneficiaries paid income tax on their distributions. In Year 2, the ATO disallowed a
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deduction for $30 so that the net income of the trust according to the tax law was adjusted to $130. Who should pay tax on the extra $30? If the proportionate view is accepted, each beneficiary is liable to pay tax on the additional amount in proportion to their original distribution: 20% to A, being $6, and 80% to B, being $24. If, on the other hand, the quantum view is adopted, the additional $30 would be assessed in the hands of the trustee at the top marginal tax rate. The reason for this is that, under the quantum approach, the specific dollar amount distributed to the beneficiaries is considered to be the correct share of the net income of the trust and no additional amounts can be distributed once the trustee has made its decision. The proportionate view is the prevailing view, as confirmed in the High Court case FCT v Bamford (2010) 240 CLR 481; [2010] HCA 10. Case study 20.4: Bamford case
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In Bamford v FCT, the trustee distributed the net income of the trust of $187,530 to the following beneficiaries: Child A
the first $643
Child B
the next $643
Company (corporate beneficiary)
the next $12,500
Church of Scientology
the next $106,000
Mr and Mrs Bamford equally
the next $68,000 ($34,000 each)
Church of Scientology
the balance
Total
$187,530
Mr and Mrs Bamford were employed by the Bamford Trust, and a superannuation contribution was made to a non-complying fund on their behalf. The contribution of $175,000 and interest of $16,701 on a loan to fund the contribution were claimed as deductions by the trust. The Commissioner disallowed the deductions and adjusted the net income of the trust to $379,232. Applying the proportionate view, the ATO assessed the beneficiaries on the following amounts: $ Child A
1,300
Child B
1,300
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Company
25,278
Church of Scientology
214,358
Mr Bamford
68,498
Mrs Bamford
68,498
Total
379,232
The case concerned the increased amounts of assessable income attributed to Mr and Mrs Bamford. The Bamfords argued that because a specific amount was distributed to each beneficiary in turn, and there was a residuary beneficiary, namely the Church of Scientology, the extra money should have been allocated to the church and not in proportion to all beneficiaries. In other words, they argued that a quantum approach should have been adopted instead of the proportional approach. The High Court confirmed that the proportional approach should be applied to assess the Bamfords.
Interim measures in response to Bamford case
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[20.100] Despite the long-standing consensus that the character of income is preserved through trusts (see [20.130]), the Bamford case created uncertainties with respect to the ability of trusts to stream capital gains and franked distributions to beneficiaries. In response to the uncertainties, the government enacted interim measures to specifically allow streaming of these two items: subdivs 115-C and 207-B of ITAA 1997. Detailed discussion of these provisions is outside the scope of this book.
Presently entitled [20.110] The concept of a beneficiary being presently entitled to the income of the trust is a key element to the taxation of trusts. In order for beneficiaries to be presently entitled to a share of the trust income, they must have a right to be paid that share by the trustee. The High Court provided the following explanation of what is meant by the term “presently entitled”. Case study 20.5: Meaning of “presently entitled” In Harmer v FCT (1991) 173 CLR 264, three solicitors agreed to hold a certain amount of money on trust until a dispute as to the rightful owner of the money had been resolved in court proceedings. The Commissioner assessed the solicitors on the interest earned on the money in dispute
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as there were no beneficiaries presently entitled to the income, and they were the trustees and liable to pay income tax pursuant to s 99A of ITAA 1936 at the penalty rate of 48.5% (now 46.5%). The applicant contended that they were not trustees or, if they were, there were taxpayers presently entitled pursuant to s 95A(2) and they should pay income tax at the individual rates and not the penalty rate. The High Court held that there were no beneficiaries that were presently entitled and, at best, their entitlement to the money was contingent on the outcome of the court case. The High Court stated (at 271) that a beneficiary has a present entitlement if:
• the beneficiary has an interest in the income which is both vested in interest and vested in possession; and
• the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.
The term “vested” in this context means that the beneficiary has a legal right to the money held in the trust. Beneficiaries can be presently entitled to trust income even if they have no knowledge of the distribution, as the Vegners case illustrates.
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Case study 20.6: Beneficiary has no knowledge of distribution In Vegners v FCT (1991) 21 ATR 1347, Ray Vegners Pty Ltd conducted a business of consulting engineers in its capacity as trustee of the Vegners Family Trust. The trust was a discretionary trust established by a deed of settlement dated 29 April 1980. The income and capital beneficiaries under the trust included Raymond Vegners and Helena Vegners. In 1982, Raymond Vegners and Helena Vegners, who had earlier separated, entered into a matrimonial agreement dated 2 July 1982, which provided that the wife receive payment from the trustee of the Vegners Family Trust by way of further property settlement, the lump sum of $39,128 by 134 equal calendar monthly instalments of $292 per month, the first of such instalments to be paid on 9 April 1981 and thereafter on the ninth day of each and every succeeding month. In 1982, the trustee resolved that out of the net income of the trust, $4,042 should be distributed to Mrs Helena Vegners for her own benefit. In 1983, a similar resolution was passed in respect of a distribution of $4,004 and
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in 1984, the sum was $3,504. During those years, payments totalling $3,504 were actually made by the trustee to Mrs Helena Vegners. Helena Vegners was assessed on the above amounts. They had not been included in her tax return as she had no knowledge that they were distributions from a trust. The Federal Court held (at 1349): The sole question is whether Mrs Vegners was personally entitled to trust income and assessable to tax under the provisions of s 97 and 101 of the Income Tax Assessment Act 1936 … The trial judge was correct in holding that the income which Mrs Vegners received and to which she was presently entitled was assessable as part of her income.
It was not necessary that Mrs Vegners knew that the money was a distribution from the trust before it was assessable.
Statutory present entitlement [20.120] A beneficiary under a discretionary trust is not presently entitled until the trustee exercises its discretion in the beneficiary’s favour. Section 101 of ITAA 1936 clarifies that once a trustee of a discretionary trust has resolved to exercise its discretion in favour of a beneficiary, that beneficiary is deemed to be presently entitled to the amount paid or applied to him or her.
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The concept of present entitlement is extended by s 95A(2), which stipulates that: … where a beneficiary has a vested and indefeasible interest in any of the income of a trust estate but is not presently entitled to that income, the beneficiary shall be deemed to be presently entitled to that income of the trust estate.
Character of income preserved [20.130] The character of an item of income is preserved when it is distributed to a beneficiary. For instance, if dividends received by a trust are distributed to a beneficiary, the amount remains as dividends in the hands of the beneficiary and the imputation credits can be attached to the distribution. In particular, the dividends are grossed up to determine the net income of the trust estate by the value of the imputation credit. When the dividend income is distributed to the beneficiaries, the beneficiary can claim the imputation credit attached to the dividend as an offset in his or her individual tax return. However, if the trust is in loss, the dividend income cannot be distributed and the tax offsets are lost. Similarly, a capital gain derived by the trust can be distributed to an individual beneficiary who may be eligible to claim a 50% discount on the capital gain. In particular, if a trust makes a capital gain on the realisation of a trust asset, the
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capital gain can be distributed to a specific beneficiary and the 50% discount for the individual may be claimed, provided among other things the trust has held the asset for more than 12 months. According to s 115-10 of ITAA 1997, the 50% discount applies to the trust and the trust would include a discounted capital gain in its net trust income calculation. When it distributes the capital gain to an individual beneficiary, the gain is grossed up to its non-discount amount and the individual (if eligible) then claims the 50% discount in his or her own tax return. The trustee needs to ensure that the capital gain is identified in the accounts of the trust and that the specific distribution is clearly identified in the distribution process.
Beneficiary presently entitled but under a legal disability [20.140] Where the beneficiary is presently entitled but under a legal disability, s 97 of ITAA 1936 does not apply to tax the beneficiary. Instead, the trustee will be required to pay income tax on behalf of the beneficiary at the rate of tax that the beneficiary would have paid: s 98 of ITAA 1936. Under general law, a person is under a legal disability if they are unable to give a valid discharge for a payment made to them. Common examples include minors, undischarged bankrupts and intellectually impaired persons.
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The amount of income tax is calculated as if the share of the net income was the only income of the beneficiary and no deductions are available. If the beneficiary derives other income, the total income is computed and the beneficiary is taxed on the total. The beneficiary is entitled to a deduction for the tax paid by the trustee: s 100(2) of ITAA 1936.
No beneficiary is presently entitled [20.150] In general, if all or part of the net income of a trust is not included in the assessable income of a beneficiary or the trustee under ss 97 or 98 of ITAA 1936, that amount is taxed in the hands of the trustee at the top marginal individual tax rate plus Medicare levy: s 99A of ITAA 1936. This penalty rate is designed to discourage accumulation of income in trusts in Australia. An exception applies to the penalty rate under s 99A. If a trust resulted from a will and the Commissioner is of the opinion that it is unreasonable to apply the penalty rates, the trustee will be taxed on that share of net income at the normal individual progressive tax rates: s 99 of ITAA 1936. This situation often arises in the case of a testamentary trust. To avoid the application of the penalty rate under s 99A, trust deeds of discretionary trusts generally contain a “default beneficiary” provision whereby if the trustee fails to distribute all trust income by the year end, the income will
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682 [20.160] PRINCIPLES OF TAXATION LAW 2020 be automatically distributed to, for example, a corporate beneficiary to cap the tax liability at 30% before midnight on 30 June.
Minor beneficiaries [20.160] The tax law has a specific anti- avoidance provision designed to deal with the splitting of income from a high-income earner (eg, a father) to his children under 18 through a trust: s 102 of ITAA 1936. However, the provision has proved to be totally ineffective in most cases, as it can be easily circumvented by having someone other than the father (eg, the grandfather of his children) establish the trust. The response of the government to this ineffective provision is the introduction of a new regime for income of minors, namely Div 6AA of ITAA 1936. Income of minors, including distributions from trusts, are in general taxed at the top marginal rate plus Medicare levy: Div 6AA of ITAA 1936. In particular, minors are eligible for a tax-free threshold of $416, which is progressively clawed back as shown below:
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TABLE 20.1 2018–2019 tax rates for Div 6AA income of resident minor beneficiaries Income amount ($)
Tax payable
0–416
Nil
417–1,307
66% of the excess over $416
1,308+
45% of the total Div 6AA income
Case study 20.7: Income of minor A trustee distributed $6,000 of trust income to a minor beneficiary aged 10 years. The beneficiary is treated as being presently entitled but under a legal disability. The trustee will pay tax on behalf of the beneficiary at the rates shown in Table 20.1. The tax payable is: $6 000 × 45% = $2 700 Certain minors are not subject to Div 6AA, including minors in full- time employment and disabled children: s 102AC(2) of ITAA 1936. Certain income items are also exempt from the penal rates, including employment income and income from deceased estates: s 102AE(2) of ITAA 1936.
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Non-resident beneficiaries [20.170] If a non-resident beneficiary is presently entitled to a share of the trust income and is not under legal disability, in broad terms, his or her share of the net income (excluding foreign-sourced income) is taxed in the hands of the trustee at the rates applicable to non-residents: ss 98(2A) and (3) of ITAA 1936.
CGT events for trusts [20.180] The tax law stipulates nine CGT events relating to trusts, including creation of a trust over a CGT asset (CGT event E1), transfer of a CGT asset to a trust (CGT event E2), beneficiary becoming entitled to a trust asset (CGT event E5), etc. The full list of CGT events concerning trusts can be found in Chapter 11. Detailed discussion of these events is beyond the scope of this book. However, CGT event E4 is worth some discussion in the context of the taxation of distributions to beneficiaries.
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CGT event E4 happens if in general (1) a beneficiary receives a payment (“non-assessable payment”) from the trustee with respect of his/her interest in the trust; and (2) the non-assessable payment is not regarded as assessable income in the hands of the beneficiary. The time of the event is defined, among other things, to be the time just before the end of the income year in which the trustee makes the non-assessable payment. The ATO is of the opinion that this CGT event is not applicable to discretionary trusts: TD2003/28. A typical example of CGT event E4 is the distribution of certain exempt income derived by a unit trust to its unit holders. In broad terms, the effect of CGT event E4 depends on the amount of the non- assessable payment relative to the cost base of the units held by the beneficiary. If the non-assessable payment is less than the cost base of the units, the cost base and reduced cost base of the units are reduced by the amount of the payment. Otherwise, the cost base and reduced cost base are reduced to zero, and the excess of the non-assessable payment over the cost base is the capital gain arising from the CGT event. Case study 20.8: CGT event E4 Gary bought one unit in a unit trust for $10,000 in 2010. During the current income year, the trustee made non-assessable payments of $6,000 per unit. Just before the end of the current income year, CGT event E4 occurs with the effect of reducing the cost base and reduced cost base of the unit from $10,000 to $4,000.
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If in the following income year, the trustee made another non-assessable payment of $6,000 per unit, CGT event E4 occurs again just before the year end. In this case, the cost base and reduced cost base of the unit are reduced to zero, and Gary made a capital gain of $2,000, which is eligible for CGT discount.
Questions [20.190] 20.1 Lawless Trust is a discretionary trust, with an Australian incorporated company as trustee. The trust derived the following income in this income year: • $600,000 profits from running a restaurant in Sydney; • $90,000 interest from an Australian bank account; and • $18,000 interest from a Hong Kong bank account. The trust has the following three beneficiaries who are entitled to receive both income and capital distributions from the trust: • Gary, 50- year- old Australian resident, a tax manager earning $200,000 salary in the year; • George, 40-year-old non-resident; and
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• Matt, 12-year-old Australian resident, with no other income. What are the tax implications of the three beneficiaries if the trustee distributes the above income equally to each of them? You are not required to compute the tax liabilities of the beneficiaries. 20.2 The Li Family Trust is a discretionary family trust with two adult resident beneficiaries, Emma and Peter. During this income year, the activities of the trust gave rise to the following: $ Loss from rental property Interest income from term deposits
(6,000) 4,000
Cash received from fully franked dividends
14,000
A capital gain from the sale of BHP shares that had been held for two years
10,000
The trustee of the trust resolved to distribute 100% of the trust income to Emma.
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Emma also has the following income: • Salary of $200,000 from which PAYG withholding tax instalments of $60,000 have been deducted. • Work-related expenses of $275. Emma has private hospital cover. Based on the facts above: 1 Calculate the taxable income and tax payable or refundable for Emma for the income year. 2 Would your answer differ if the Li Family Trust made a rental loss of $40,000? 20.3 Bruce Whelan established the “Whelan Family Trust” in 1990 with ABC Pty Ltd as the corporate trustee. Bruce and his wife May are the directors of the trustee company. The trust holds a variety of investments in property and cash. The trust was established to protect the investments as Bruce is always concerned that he could be sued for negligence. The trust records for this income year disclose the following: Receipts ($) 80,000 Rent from investment properties 6,000 Interest from a bank account
Payments ($) 2,000 Accounting expenses for tax return 10,000 Repairs to investment properties Copyright © 2019. Thomson Reuters. All rights reserved.
4,000 Interest on a loan for the investment property 1,000 Legal expenses incurred in defending a claim by a tenant
May does not work. Bruce is a senior tax manager and received a salary of $160,000 in this income year. He has three children: • a son, John, aged 21 years, a student at university who earned $12,000 for the year; • a daughter, Kim, aged 19, also a university student who earned only $2,000 for the year; and • a second daughter, Amy, aged 16 years, a full-time high school student with no other income. Bruce has his grandmother living with him, and she had no income for the year. All family members are beneficiaries of the trust. Bruce also established a corporate beneficiary, and this is available to receive trust distributions.
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686 [20.190] PRINCIPLES OF TAXATION LAW 2020 Calculate the net income of the Whelan Family Trust for this income year and advise Bruce as to how he can distribute the net income in the most tax-effective way. 20.4 Tom runs a small retail business selling men’s clothing in the suburb of Glen Waverley, Melbourne. The business is structured as a discretionary trust –the “Jones Family Trust” –with his company, Glen Waverley Clothing Pty Ltd, as the trustee. Tom and his wife, Mary, are the two directors of the trustee company. The trust has an ABN and TFN and is registered for GST. The trust had the following transactions in this income year: Receipts ($) 198,000 Retail sales 17,000 Rental income from an income-producing investment apartment 1,000 Interest on bank deposits
Payments ($) 15,000 Body corporate fees on income-producing property 66,000 Purchase of trading stock 5,000 Interest on money borrowed to purchase the income-producing investment apartment 5,000 Borrowing expenses relating to a new loan to acquire the investment apartment. The loan is for 10 years and began on 1 July 2012 1,100 Fees paid to a registered tax agent
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11,000 New equipment wholly used in business with an estimated life of 20 years 1,080 New equipment wholly used in business with an estimated life of three years 1,000 Travel to and from work
Additional information: (a) The trust has a carry forward tax loss of $10,000. (b) The trust is a small business entity (SBE) and prepares accounts on that basis. (c) Stock at beginning of the year was valued at $20,000. Stock at year end was:
Cost
$16,000
Market selling value
$19,000
Replacement $18,000 The trust does make an election under s 328-285(2) of ITAA 1997.
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(d) The opening depreciation pool balance for the general SBE pool was $30,000. (e) The trust purchased an investment apartment in a hotel complex brand new on 1 July this income year for a cost of $400,000. The quantity surveyor advised Tom that the construction cost of the apartment was $167,000. Calculate the net income of the trust for the income year. Note that the above figures include GST.
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20.5 A unit trust has two unit holders, John and Mary, both are residents of Australia. John holds 300 units which he acquired in 1983 for $300,000. Mary acquired her 100 units in 2001 for $400,000. In this income year, the unit trust derived $700,000 capital gain from disposing a pre-CGT asset and distributed the amount to the unit holders. Explain the tax implications of the unit trust, and the unit holders John and Mary.
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21
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Companies and shareholders Key points.................................................................................................... [21.00] Introduction................................................................................................ [21.10] Definition of company................................................................................ [21.20] Public officer............................................................................................... [21.30] Dividends..................................................................................................... [21.40] Taxation of dividends.......................................................................... [21.40] Meaning of “shareholders”.................................................................. [21.50] Meaning of “dividends”....................................................................... [21.60] Share capital account........................................................................... [21.70] Non-share dividends............................................................................ [21.80] Meaning of “paid”................................................................................ [21.90] Meaning of “profits”........................................................................... [21.100] Deemed dividends for private companies.............................................. [21.110] Introduction........................................................................................ [21.110] Private companies.............................................................................. [21.120] Deemed dividends............................................................................. [21.130] Deemed dividends for distributions by liquidator................................. [21.140] Imputation system.................................................................................... [21.150] Introduction........................................................................................ [21.150] Implications for companies............................................................... [21.160]
Franking a distribution........................................................................... [21.160] Franking credit attached to dividends................................................... [21.170] Franking account.................................................................................... [21.180] Franking deficit tax................................................................................. [21.190] Implications for shareholders............................................................ [21.200] Resident individual shareholders.......................................................... [21.210] Resident corporate shareholders.......................................................... [21.220] Excess franking offset: carried forward losses................................. [21.230] Excess franking offset: current year loss.......................................... [21.240] Resident partnerships and trusts as shareholders............................... [21.250] Non-resident shareholders.................................................................... [21.260]
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690 [21.00] PRINCIPLES OF TAXATION LAW 2020 Measures protecting the imputation system.................................... [21.270]
The benchmark rule............................................................................... [21.270] Qualified person..................................................................................... [21.280] 45-day holding period rule..................................................................... [21.290] Related payment rule......................................................................... [21.300] Company losses........................................................................................ [21.310] Introduction........................................................................................ [21.310] Carried forward realised losses......................................................... [21.320] Continuity of ownership test.................................................................. [21.330] Business continuity test......................................................................... [21.335] Same business test................................................................................ [21.340] Similar business test.............................................................................. [21.345] Unrealised losses............................................................................... [21.350] Multiplication of losses...................................................................... [21.360] Consolidation............................................................................................ [21.370] Introduction........................................................................................ [21.370] Policy objectives................................................................................ [21.380] Membership requirements................................................................ [21.390] Multiple entry consolidated groups.................................................. [21.400] Implications of electing to consolidate................................................... [21.410] The single entity rule.......................................................................... [21.410] The entry and exit history rules......................................................... [21.420] Liability to tax..................................................................................... [21.430] Pre-consolidation losses.................................................................... [21.440] The tax cost setting rules................................................................... [21.450] Questions................................................................................................... [21.460]
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Key points [21.00] • Companies are in general treated as separate taxpayers from their shareholders. A major exception is the consolidation regime under which a wholly owned resident corporate group can elect to be taxed as one single taxpayer. • Companies may be public or private. Public companies are generally those listed on the stock exchange. • Certain distributions by private companies may be deemed to be assessable dividends, including excessive salaries, payments, loans and forgiveness of loans to shareholders or associates. • Dividends paid out of profits of a company are in general assessable income to its shareholders. This is so even if the profits include exempt income at the company level. • Under imputation, a company may distribute a dividend with franking credits to its shareholders. Companies are required to maintain a franking account which records the amount of income tax paid by the company and other companies paying dividends to the company.
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• A resident shareholder receiving a franked dividend is subject to tax on a “gross up and tax offset” basis. The assessable income includes not only the amount of dividend but also the “gross up” amount representing the franking credit attached to the dividend. The shareholder’s tax liability is then reduced by the amount of tax offset equal to the gross up. • Excess tax offset for a resident individual shareholder is refundable. However, such amount is not refundable to resident corporate shareholders; instead, they are subject to specific rules dealing with the excess tax offset issue. • Unlike partnerships, companies cannot distribute losses which are trapped at the company level. The losses can be carried forward indefinitely to later years, provided the company satisfies either the continuity of ownership test (COT) or the business continuity test (BCT). • A wholly owned resident corporate group may elect to be taxed as one single taxpayer under the consolidation regime. The advantages of electing to consolidate includes the ability to offset taxable income and tax losses among group members and tax-free transfers of assets within a consolidated group. However, the consolidation regime in Australia is notoriously complex.
Introduction
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[21.10] The income tax law in general treats a company as a separate taxpayer from its shareholders. In particular, the tax law stipulates that income tax is “payable by each individual and company …” (emphasis added): s 4-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). The general principle of treating a company as a separate taxpayer from its shareholders implies that, when income flows through a company to its shareholders, income tax may be imposed at two levels: first at the company level upon its derivation of the income and then at the shareholder level upon receiving distribution from the company. Potentially, the same economic income may be subject to double taxation. Countries have introduced different regimes attempting to deal with this issue. Australia’s imputation system aims to eliminate this double taxation by providing a tax offset to the shareholder, representing the amount of income tax already paid on those profits at the company level. Pursuant to the neutrality principle, the total income tax paid on the income by the company and the shareholders should equal the amount of income tax payable if the shareholders receive the income directly without passing through the company. However, the imputation system fails to achieve this neutral effect in many circumstances, including tax-preferred income and non-resident shareholders. Companies in general are subject to income tax at a standard flat rate of 30%. However, companies that are small business entities are subject to a reduced rate of 27.5%. This small business company tax rate is scheduled to be reduced
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692 [21.20] PRINCIPLES OF TAXATION LAW 2020 progressively to 25% by 2021–2022. For clarity purposes, the applicable tax rate for companies in the discussion in this chapter is assumed to be 30%, unless specifically stated otherwise. Compared to the top marginal tax rate for individuals, the lower tax rate of companies offers tax arbitrage opportunities to defer income tax for high- income earners. Specific anti- avoidance provisions are designed to deem certain payments from private companies to their shareholders to be assessable dividends. Losses incurred by a company can be carried forward indefinitely to offset future taxable income of the company, subject to specific anti- avoidance provisions dealing with trafficking of losses. One major exception to the general rule of the separate entity treatment for companies is the consolidation regime, under which a consolidated group is treated as one single taxpayer for income tax purposes.
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Figure 21.1: Overview of key issues
Definition of company [21.20] Section 995-1 of the ITAA 1997 defines “company” as: (a) a body corporate; or (b) any other unincorporated association or body of persons; but does not include a partnership or a non-entity joint venture. Under the definition, a non-profit-making club is treated as a company under income tax law. The taxation treatment for companies is extended to other
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“corporate tax entities”, namely corporate limited partnerships, corporate unit trusts and public trading trusts: s 960-115 of the ITAA 1997. This chapter focuses on the taxation of incorporated companies limited by shares.
Public officer [21.30] Every company carrying on business or deriving property income in Australia must appoint a public officer: s 252 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). The public officer must be a resident and a natural person aged at least 18. Service of any document on the public officer is sufficient service upon the company for all the purposes of the income tax law. The public officer is answerable for all obligations imposed on the company by the income tax law. If the company defaults, the public officer shall be liable to the same penalties as the company.
Dividends Taxation of dividends
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[21.40] Section 44 of the ITAA 1936 stipulates that the assessable income of a resident shareholder in a company includes: (a) dividends paid to the shareholder by the company out of profits derived by it from any source; and (b) all non-share dividends paid to the shareholder by the company. The provision applies to both resident and non- resident companies. The section further provides that the scope of taxation on dividends paid to non- resident shareholders is basically limited to the amounts attributable to sources in Australia. However, dividends subject to withholding tax, and franked dividends that are exempt from withholding tax, are specifically deemed to be non-assessable non-exempt income: s 128D of the ITAA 1936. For more discussions on withholding tax, see Chapter 22. Issues arising from s 44 include:
(1) (2) (3) (4)
Who is a shareholder? See [21.50]. What are “dividends” and “non-share dividends”? See [21.60]–[21.80]. When is it paid? See [21.90]. What is the meaning of “profits”? See [21.100].
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694 [21.50] PRINCIPLES OF TAXATION LAW 2020
Meaning of “shareholders” [21.50] Section 6 of the ITAA 1936 defines “shareholder” to include “member or stockholder”. Entry on the company’s register of members is necessary to constitute membership of a company: Patcorp Investments Ltd v FCT (1976) 6 ATR 420. A person with beneficial ownership of shares, but without registration, generally would not be a shareholder. Since 1 July 2001, for the purpose of s 44 of the ITAA 1936, the meaning of “shareholder” has been extended by the debt/equity regime. In particular, holders of “equity interest” are treated in the same way as shareholders: s 43B(1)(b) of the ITAA 1936. The debt/ equity regime in general aims to classify interests in a company into either “equity interest” or “debt interest” according to their economic substance: s 974-10(1) of the ITAA 1997. For example, a financial arrangement may be a loan in legal form but may be classified as an “equity interest” under the debt/equity rules. One of the consequences is that payments made under the arrangement would not be deductible as interest expenses. Instead, in general, they would be treated as dividends.
Meaning of “dividends” [21.60] “Dividend” is defined in s 6(1) of the ITAA 1936 to include: (1) any distribution made by a company to its shareholders, whether in money or other property; and
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(2) any amount credited by a company to its shareholders as shareholders. The definition is potentially very broad, including any distribution of money or property to shareholders. One important exception in the definition is distribution representing return of capital. In particular, the definition of “dividend” excludes “moneys paid or credited by a company to a shareholder … where the amount … is debited against … the share capital account of the company”. Such amounts should not be taxable to shareholders as they are payments made by a company to return the capital contributed by the shareholders. The “debit against share capital account” exception may, in the absence of specific anti- avoidance provision, provide opportunities to avoid or defer income tax liability by designating a distribution to be a return of capital. However, there are capital gains tax (CGT) consequences. The non-assessable payment would reduce the cost base and reduced cost base of the shares. If such payment exceeds the cost base, the excess is taxed as capital gain under CGT event G1: s 104-135 of the ITAA 1997.
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Case study 21.1: Return of capital Mr Bond bought one share in Company A for $100 two years ago. The company made a distribution of $20 to Mr Bond from its share capital account this year. The $20 received by Mr Bond is not dividend, and thus not taxable under s 44 of the ITAA 1936. Instead, the distribution triggers CGT event G1. The cost base and reduced cost base of the share is reduced to $80. If Mr Bond now sells the share for $120, he will have a capital gain of $40 (ignoring CGT discount).
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Share capital account [21.70] “Share capital account” of a company is in general defined as “an account which the company keeps of its share capital”: s 975-300 of the ITAA 1997. In the absence of anti-avoidance provision, it would be possible for a company to convert otherwise taxable distribution of profits into non-taxable amount by capitalising profits into its share capital account. The tax law has a specific anti-avoidance provision to deal with this issue. A share capital account is tainted if it includes amounts transferred from other accounts of the company: s 197-50 of the ITAA 1997. A “tainted” share capital account is in general not regarded as a share capital account for the purposes of the tax law: Div 197 of the ITAA 1997. In other words, a shareholder’s distribution that is debited against a “tainted” share capital account would still fall under the definition of “dividend”. Furthermore, the distribution is also deemed to be paid out of profits derived by the company: s 44(1B) of the ITAA 1936 and s 975-300(3)(d) of the ITAA 1997. This is to ensure that such a distribution would be assessable income to the shareholder under s 44 of the ITAA 1936. There are two other implications of tainting a share capital account. First, a franking debit arises in the company’s franking account when an amount is transferred to its share capital account that results in tainting the account: s 197-45 of the ITAA 1997. Second, distributions coming out of a tainted share capital account are unfrankable distribution: ss 202-45(e) and 975-300(3)(ba) of the ITAA 1997. Another anti-avoidance provision to protect the integrity of the tax policy on return of capital is s 6(4) of the ITAA 1936. The section applies if, under an arrangement, a person subscribes shares in a company which credits the amount to its share capital account, and the company makes distributions to another person by debiting the share capital account. An example of such an arrangement is when a company issues new shares to new shareholders and uses the funds raised to make distributions to existing shareholders. If s 6(4)
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696 [21.80] PRINCIPLES OF TAXATION LAW 2020 applies, the “return of capital” exclusion in the definition of “dividend” would not apply and the distributions would still be regarded as dividends.
Non-share dividends [21.80] “Non-share dividends” are defined in broad terms as distributions made by a company to holders of its “non-share equity interest”: ss 974-115 and 974-120 of the ITAA 1997. “Non-share equity interest” in a company means basically an interest in a company that is not a share in the company per se but is classified as “equity interest” under the debt/equity rules: s 995-1 of the ITAA 1997. The definition of “non-share dividends” is subject to an exclusion similar to the “return of capital” exclusion under the definition of “dividends” discussed at [21.60]. In particular, a distribution made to a holder of a non-share equity interest in a company is not a “non-share dividend” to the extent that the company debits the distribution against its share capital account or non-share capital account: s 974-120(2) of the ITAA 1997.
Meaning of “paid”
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[21.90] The definition of “paid” in relation to dividends includes credited or distributed: s 6(1) of the ITAA 1936. The meaning of “paid” was considered in the High Court case of Brookton Co-operative Society Ltd v FCT (1981) 147 CLR 441, which held that a dividend was still paid if it is credited and the crediting could not be revoked.
Meaning of “profits” [21.100] Dividends (other than non-share dividends) would be assessable income of a shareholder provided, among other things, they are paid out of profits derived by the company: s 44(1) of the ITAA 1936. What is the meaning of “profits” in this context? In the High Court case FCT v Slater Holdings Pty Ltd (1984) 156 CLR 447, it was held that dividends paid out of exempt income of a company were paid out of profits and thus assessable under s 44 of the ITAA 1936. The important implication of this meaning of profits is that income passing through a company will lose its character and in general is taxed as dividends when distributed to the shareholders. The Corporations Act 2001 (Cth) was changed in 2010 in respect of the requirements for paying dividends. The original “profits test” –that is, dividends might only be paid out of company profits –was replaced with a more flexible requirement that allows a company to pay dividends if, among other things, the company’s assets exceed its liabilities before the dividend is declared: s 254T of the Corporations Act 2001
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(Cth). In response to the change of the company law, “a dividend paid out of an amount other than profits” is now deemed to be a dividend paid out of profits for income tax purposes: s 44(1A) of the ITAA 1936.
Deemed dividends for private companies Introduction [21.110] The difference between the corporate tax rate of 30% and the top individual marginal tax rate provides incentive for taxpayers to accumulate profits at the company level, instead of making distributions to shareholders. Various schemes have been devised to pass benefits to shareholders and, at the same time, avoid being regarded as dividends. Examples include loans to shareholders, excessive salaries paid to shareholders and transfer of property between a company and its shareholders at non-arm’s length prices.
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Case study 21.2: Avoidance opportunity for private companies Mr Solo, an Australian resident subject to the top marginal tax rate, owns all the shares in a company incorporated in Australia. The company derives $200,000 net investment income in the current income year. The company’s tax liability would be 30% of $200,000, that is, $60,000. This is less than the tax liability of Mr Solo if he receives the income directly. If the company distributes the income after tax of $140,000 to Mr Solo as dividends, the amount would be taxable to Mr Solo (under the imputation system discussed in [21.150]) at his marginal tax rate. Assuming no specific anti-avoidance provisions, Mr Solo would be able to avoid the tax if the payment made to him is disguised as say a loan to the company’s shareholder. The tax law contains specific anti-avoidance provisions to tackle this kind of scheme involving private companies. The general effect of the provisions is to deem such transactions to be assessable dividends. Such deemed dividends are unfrankable under the imputation system: s 202-45(g) of the ITAA 1997.
Private companies [21.120] “Private company” is defined as a company that “is not a public company”: s 103A(1) of the ITAA 1936. “Public company” is defined broadly to include a listed company and a subsidiary of a public company: s 103A(2) of the ITAA 1936. However, a listed company in general is not a public company
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698 [21.130] PRINCIPLES OF TAXATION LAW 2020 if control over the company is relatively concentrated. For instance, a company cannot be a public company if, among other things, not more than 20 persons hold at least 75% of the value of the share or voting power in the company: s 103A(3) of the ITAA 1936.
Deemed dividends [21.130] If a private company pays salaries or fees for services provided by its shareholder (or associate), and the amount exceeds a reasonable amount determined by the Commissioner, the excess in general would be deemed as a dividend paid by the company to a shareholder out of profits derived by the company: s 109(1) of the ITAA 1936. The company cannot claim the excess as a deduction. Division 7A was introduced in 1998 to overcome limitations of the now repealed s 108 of the ITAA 1936. For instance, s 108 required the Commissioner to form an opinion that a loan represents a distribution of profits. Division 7A, instead, would operate automatically provided the conditions stipulated in the relevant sections are satisfied. The scope of the Division is more comprehensive and applies to three kinds of amounts: (1) Payments to shareholders
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If a private company makes a payment to its shareholder (or associate), the payment is in general deemed to be a dividend: s 109C of the ITAA 1936. “Payment” is widely defined as a payment or credit to, on behalf of, or for the benefit of, the shareholder, and a transfer of property to the shareholder. The very wide scope of the section is limited by certain exclusions. For example, a payment to discharge arm’s length debt owed by the company to a shareholder is excluded from the deeming provision: s 109J of the ITAA 1936. Payment made to a corporate shareholder is also excluded, as the shareholder in this case would be subject to the same tax rate as the private company: s 109K of the ITAA 1936. (2) Loans to shareholders If a private company makes a loan to its shareholder (or associate) and the loan is not repaid by the “lodgement date” of the income year, the amount of outstanding loan in general is deemed to be a dividend: s 109D of the ITAA 1936. “Loan” is again widely defined to include an advance, a provision of credit or a transaction which in substance effects a loan. “Lodgement date” is defined to be the earlier of the due date or actual lodgement date of the company’s income tax return. Certain loans are excluded from the operation of s 109D. Examples include loans made to a corporate shareholder: s 109K of the ITAA 1936; loans made in the ordinary course of business of the private
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company on arm’s length terms: s 109M of the ITAA 1936; and loans made under written agreements which meet criteria for minimum interest rate and maximum term: s 109N of the ITAA 1936. (3) Forgiven debts to shareholders If a private company forgives a debt owed by a shareholder (or associate), the amount of forgiven debt is deemed as a dividend: s 109F(1) of the ITAA 1936. Again, the section defines “forgiven debts” widely. For instance, if a reasonable person concludes, based on all the circumstances, that the private company will not insist on repayment of the debt, the debt is taken to have been forgiven: s 109F(6) of the ITAA 1936. However, certain debts that are forgiven by a company are not taken to be a dividend, for example, debt owed by another company, debt forgiven due to the bankruptcy of a shareholder, and debt forgiven for a shareholder under financial hardship due to circumstances beyond its control: s 109G of the ITAA 1936. The total amount of deemed dividends under Div 7A is capped at a maximum of the “distributable surplus” of the company: s 109Y of the ITAA 1936. The policy objective is to limit the amount of deemed dividends to the amount of profits of the company. In broad terms, “distributable surplus” is defined as the company’s net assets, reduced by the amounts of paid-up capital and loans deemed as dividends under ss 108, 109D and 109E of the ITAA 1936.
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Amounts deemed as dividends under Div 7A are taken to be paid to the taxpayer as a shareholder of the private company out of the profits of the company: s 109Z of the ITAA 1936. The Division contains rules to avoid double taxation on shareholders if subsequent dividends are used to set off against amounts previously deemed as dividends under the Division: s 109ZC of the ITAA 1936. Case study 21.3: Deemed dividends for private companies Continuing with Case Study [21.2], if Div 7A applies and the company’s distributable surplus is $180,000, the whole amount of the “loan to shareholder” of $140,000 would be deemed to be assessable dividend and Mr Solo would have to pay tax on it at his marginal tax rate.
Deemed dividends for distributions by liquidator [21.140] For general law purposes, distributions made by a liquidator in the course of the winding up of a company do not constitute distributions of the company’s profits: Burrell’s Case [1924] 2 KB 52. The tax law overrides this
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700 [21.150] PRINCIPLES OF TAXATION LAW 2020 principle by deeming certain distributions by a liquidator to be dividends. In particular, distributions to shareholders by a liquidator are in general deemed to be dividends paid out of profits, to the extent that they represent income derived by the company before or during liquidation: s 47(1) of the ITAA 1936. Similar to the definition of “dividend” in s 6(1) of the ITAA 1936, a distribution by a liquidator that represents a return of capital is excluded from being a deemed dividend under s 47. Provided a liquidator properly keeps accounts for the company, it is possible for the liquidator to specify the source of a distribution. In other words, the liquidator can determine that a distribution is to be regarded as being out of particular profits or income, or a return of capital: Archer Bros Pty Ltd v FCT (1953) 90 CLR 140. This provides opportunities to reduce or defer income tax liability on the distribution. Liquidation distributions to shareholders would also be subject to CGT. When a share is redeemed or cancelled, CGT event C2 in general would apply: s 104-25 of the ITAA 1997. If capital proceeds received by the shareholder upon the cancellation are more than the cost base of the share, the shareholder makes a capital gain. The amount of the capital gain would be reduced by any amount that has already been captured as assessable income pursuant to s 47 of the ITAA 1936: s 118-20 of the ITAA 1997. If a liquidator makes an interim distribution that is not deemed a dividend and the company is not dissolved within 18 months of the payment, CGT event G1 may apply: s 104-135 of the ITAA 1997. In that case, the cost base and reduced cost base of the shares are reduced by the amount of distribution. Any excess of the distribution over the cost base in general would be a capital gain of the shareholder.
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Imputation system Introduction [21.150] Income tax law in general treats a company as a separate taxpayer from its shareholders. One important implication is the possible double taxation on the same economic income flowing through the company to its shareholders. If assessable income flows through a company to its shareholder, the income would be subject to income tax first at the company level and then again at the shareholder level upon the distribution of profits from the company. Case study 21.4: Double taxation issue Assume a company derives $100 assessable income and pays $30 income tax on the income. When it distributes the $70 to the shareholder as dividend, the shareholder would have to pay income tax on the dividend. If the shareholder does not receive any credit for the tax paid
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at the company level, and assuming the shareholder’s marginal tax rate is 47%, the tax liability at the shareholder’s level would be $70 × 47%, or about $33. The total income tax paid on the $100 income under this scenario would be $63. However, if the income is received directly by the shareholder without passing through the company, the income tax would have been only $100 × 47%, or $47. This outcome violates the efficiency principle, which requires that the income tax system should not, as far as possible, affect the business decisions of taxpayers. In other words, the income tax law ideally should achieve the same net tax result regardless of whether a taxpayer decides to carry on a business as a sole trader or through a company. However, the income tax system depicted in Case Study [21.4] (known as the classical system) is biased against using a company as an investment vehicle. The imputation system is one of the possible regimes addressing the “double taxation” issue. The fundamental feature of the system is to allow a shareholder to claim a tax relief for the amount of income tax paid by the company on the profits out of which the dividend is paid.
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Case study 21.5: Imputation system: basic operation Going back to Case Study [21.4], under an imputation system, upon receiving the $70 dividend, the shareholder would be required to calculate its income tax based on the gross amount of income received by the company (ie, $100). The income tax so calculated (ie, $47) would then be offset by the amount of income tax paid by the company (ie, $30), leaving a net income tax liability of $17 for the shareholder. The total income tax paid on the $100 income under this system would be $47, the same amount as if the income is received directly by the shareholder. Australia adopted the classical system from 1941 to 1987. The imputation system was introduced on 1 July 1987 with the primary objective to avoid the “double taxation” issue of the classical system. The current imputation system in Pt 3-6 of the ITAA 1997 is a result of the recommendations of the Ralph Report, aimed at simplifying the system. The imputation system in essence operates on a “gross up and offset” mechanism. In general, a shareholder is required to “gross up” its assessable income by the amount of franking credit attached to the dividend received from a company. Franking credits basically represent income tax paid by the company. The shareholder is then allowed to claim a tax offset equal to
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702 [21.160] PRINCIPLES OF TAXATION LAW 2020 that amount of franking credit: see [21.160]–[21.260] for more details of the system.
Implications for companies Franking a distribution [21.160] An entity can frank a distribution only if it satisfies the following conditions: (a) it is a resident “franking entity”; and (b) the distribution is a “frankable distribution”: s 202-5 of the ITAA 1997.
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“Franking entity” is in general defined as a “corporate tax entity”, excluding a company acting as a corporate trustee at the time of distribution: s 202-15 of the ITAA 1997. “Corporate tax entity” means a company or an entity that is taxed as a company under the income tax law (ie, corporate limited partnership, corporate unit trust or public trading trust): s 960-115 of the ITAA 1997. A franking entity has to be an Australian resident before it can frank a distribution: s 202-20 of the ITAA 1997. An exception to the residency requirement is a “NZ franking company”: Div 220 of the ITAA 1997. The Division is designed specifically to deal with the Trans-Tasman triangular tax issue but illustrates a more general and fundamental problem of the imputation system: bias against non-residents (see [21.260] for a discussion of the implications of the imputation system on non-residents). Under the Division, in broad terms, a New Zealand resident company can elect for the application of the Australian imputation system. It would then keep a franking account in respect of Australian income tax (including withholding tax) and frank distributions to Australian shareholders. Correspondingly, in general, New Zealand also allows Australian resident companies similar treatment under the New Zealand imputation system. For a company, “distribution” is defined as “a dividend, or something that is taken to be a dividend” under the income tax law: s 960-120(1) of the ITAA 1997. Not all distributions are frankable. “Frankable distribution” is defined in a negative sense as a “distribution … to the extent that it is not unfrankable …”: s 202-40 of the ITAA 1997. “Unfrankable distributions” are listed in s 202-45 of the ITAA 1997, including deemed dividends under Div 7A, Pt III of the ITAA 1936 and distribution in respect of a non-equity share.
Franking credit attached to dividends [21.170] If a company is a franking entity and makes a frankable distribution, it can attach a “franking credit” to the distribution: s 202-5 of the ITAA
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1997. The maximum amount of franking credit that can be attached to a distribution is determined by the following formula under s 202-60(2) of the ITAA 1997: Frankable distribution ×
corporate tax rate 1− corporate tax rate
The corporate tax rate in the formula in general is 30%, unless the company is a small business entity. In that case, the applicable corporate tax rate is the reduced corporate tax rate for small business companies. Basically, the maximum franking credit amount represents the amount of income tax that the company could have paid in respect of the distribution. For example, if a company which is subject to the standard corporate tax rate of 30% pays a distribution of $70, the maximum franking credit that can be attached to it would be: $70 ×
30% = $30 1− 30%
The $30 represents the maximum amount of income tax that the company could have paid on its profits (ie, $100), out of which it can distribute the $70.
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A company can decide whether or not to frank a distribution and, if so, how much franking credit to attach to the distribution (up to the amount of maximum franking credit). It must give its shareholder a distribution statement which states, among other things, the franking percentage for the distribution: ss 202-75 and 202-80 of the ITAA 1997. The accounting profit of a company would most likely be different from its taxable income. A company may also derive income that is not subject to income tax, for example, certain foreign sourced income. Therefore, a company may not always be able to fully frank its distributions.
Case study 21.6: Franking credit attached to a dividend Assume a company decides to pay a cash dividend of $70 and frank it to 80%. The franking credit attached to the dividend is: $70 ×
30% × 80% = $24 1− 30%
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704 [21.180] PRINCIPLES OF TAXATION LAW 2020
Franking account [21.180] In theory, a franking credit should represent income tax already paid by a company on profits from which a distribution is made. It is therefore important for a company to keep track of the amount of available franking credits to frank its distributions. Every corporate tax entity must keep a franking account: s 205-10 of the ITAA 1997. Before 1 July 2002, the account was kept on a taxed profits basis, which created problems whenever the corporate tax rate changed. The account is now kept on a tax paid basis. The current basis is not only simpler but also aligns better conceptually with the objectives of an imputation system. Credits in general arise in the franking account of a franking entity if the entity (s 205-15 of the ITAA 1997): (1) pays income tax or Pay As You Go (PAYG) instalments; (2) receives a franked distribution directly or indirectly through a partnership or trust; or (3) incurs a liability to pay franking deficit tax. Debits in general arise in the franking account of a resident franking entity if it (s 205-30 of the ITAA 1997): (1) franks a distribution; (2) receives an income tax refund; or
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(3) violates the benchmark rule due to under-franking (see [21.270] for details).
Franking deficit tax [21.190] The tax law allows corporate tax entities to frank distributions based on “anticipated” franking credits: s 205-45(1) of the ITAA 1997. If a company is allowed to do so indefinitely, the legislation would compromise the fundamental objective of the imputation system. In other words, the system would not be passing on the amount of income tax already paid by a company to its shareholders in the form of franking credit. What happens if a company over-franks its distributions and has a net debit balance in its franking account at the end of the income year? If a franking account is in deficit at the end of an income year, the franking entity is required to pay a franking deficit tax: s 205-45(2) of the ITAA 1997. The tax is equal to the amount of deficit in the franking account. As a credit arises in the franking account of the entity when it incurs the liability to pay franking deficit tax pursuant to s 205-15 of the ITAA 1997, the debit balance in the franking account is effectively cancelled out.
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The franking deficit tax is in general not a penalty, as the amount of the tax is available to the franking entity as a tax offset against its income liability: s 205-70(1) of the ITAA 1997. However, a penalty is imposed if the deficit is excessive. The deficit is regarded as excessive if it exceeds 10% of the total amount of franking credits arising in the income year: s 205-70(2) of the ITAA 1997. In that case, the amount of tax offset generated from the franking deficit tax is generally reduced by 30%.
Implications for shareholders [21.200] “Gross up and tax offset” is the basic mechanism of the imputation system on shareholders. In general, if a shareholder receives a franked distribution, it has to “gross up” its assessable income by the amount of franking credit attached to the distribution: s 207-20 of the ITAA 1997. In addition, the shareholder is entitled to a tax offset equal to the same amount of the “gross up”. Case study 21.7: Gross up and tax offset
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Assume a shareholder receives a $70 fully franked dividend. Under the imputation system, the shareholder’s assessable income includes not only the $70 dividend pursuant to s 44 of the ITAA 1936 but also the “gross up” of $30, which is the amount of franking credit attached to the dividend. In addition, the shareholder is entitled to a tax offset of $30 which can be used to offset against its income tax liability. The following sections deal with the tax implications of four types of shareholders under the imputation system: (1) Resident individuals: see [21.210]; (2) Resident companies: see [21.220]; (3) Resident partnerships and trusts: see [21.250]; and (4) Non-residents: see [21.260].
Resident individual shareholders [21.210] If an individual shareholder’s income tax liability is less than the amount of tax offset, should the excess tax offset be refunded to the shareholder? Theoretically, it should be so; otherwise, the imputation system would not achieve the tax policy objective of efficiency as discussed in [21.150].
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Case study 21.8: Refund of excess tax offset Assume that assessable income of $100 passes through a company to an individual shareholder with a marginal tax rate of 0%. The company pays $30 income tax on the income and distributes $70 as dividend to the shareholder. The shareholder would not be liable to any income tax. Therefore, the net income received by the shareholder is $70. This would be the end result if excess tax offset is not refundable to the shareholder. However, if the income is received directly by the shareholder without passing through the company, the net income received by the shareholder would have been $100. Pursuant to the policy objective of efficiency, the excess tax offset should be refunded to the shareholder. In that case, the shareholder would receive $70 dividend tax free and $30 tax refund. The total net income received by the shareholder would then be the same in both scenarios, namely $100.
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The imputation system in Australia did not allow refund of excess tax offsets to individual shareholders until 1 July 2000. Now, tax offsets available under Div 207 of the ITAA 1997 are in general refundable, except for certain entities including: (1) a corporate tax entity (except certain exempt institutions and life insurance companies); (2) a trustee who is liable to tax on a share of net income of a trust under s 98 or 99A of the ITAA 1936; and (3) a trustee of non- complying superannuation fund: s 67- 25 of the ITAA 1997.
Resident corporate shareholders [21.220] Upon receiving a franked dividend, a corporate shareholder is subject to the same “gross up and tax offset” mechanism as for an individual. In addition, a credit arises in its franking account: s 205-15 of the ITAA 1997. However, as explained in [21.210], it is not entitled to a refund of any excess tax offset. That may lead to a problem of “wasting losses/deductions”. The following example illustrates the problem. Case study 21.9: Excess tax offset for corporate shareholders Assume Company Z has a carried forward loss of $200 and receives a fully franked dividend of $70 and other assessable income of $100.
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Assessable income of Company Z is $200, which, in the absence of any specific provision to deal with the issue, would have been fully offset by the carried forward loss. Company Z would not have any tax liability but have an excess tax offset of $30 that is not refundable. This is not the proper tax outcome. A fully franked dividend should be effectively tax free in the hands of a corporate shareholder, as its tax rate of 30% is the same as that for the dividend payer. In other words, a fully franked dividend should not reduce the amount of tax loss that should be available to Company Z to offset against its other assessable income.
Since 1 July 2002, the tax law has specific provisions designed to deal with this issue. Different measures are adopted to deal with situations involving carried forward losses and losses generated in the current year, respectively.
Excess franking offset: carried forward losses
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[21.230] A corporate tax entity with a carried forward loss in general can choose the amount of the loss to be utilised in the current income year: s 36- 17 of the ITAA 1997. It may choose to utilise none of the loss or any amount up to a maximum above which would generate excess franking offset.
Case study 21.10: Excess tax offset and carried forward losses Referring back to Case Study [21.9], pursuant to s 36-17, the company may choose not to use any of the carried forward loss. In that case, the company would have a tax liability of $60. With the tax offset of $30 generated by the franking credit attached to the dividend, the net tax payable would be $30, representing the income tax payable on the other assessable income of $100. In other words, the fully franked dividend would flow through Company Z effectively tax free. Alternatively, the company may choose to use up to $100 of the carried forward loss this year. In that case, assessable income of Company Z net of the carried forward loss would be $100. Income tax thereon is $30, which would be fully offset by the franking tax offset. The company cannot choose to utilise more than $100 of the carried forward loss. Otherwise, excess tax offset would result.
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Excess franking offset: current year loss [21.240] If a corporate tax entity has an excess franking offset due to deductions in the current year, in general, the excess franking offset is converted into a tax loss at the prevailing corporate tax rate: s 36-55 of the ITAA 1997.
Case study 21.11: Excess tax offset and current year loss Assume a company receives a fully franked dividend of $70 and has a deduction of $200. Its assessable income is $70 (dividend) and $30 (gross up), or $100. After deducting the $200 expenses, it has a tax loss of $100. The excess franking offset is $30, which is converted into additional tax loss of $30/30%, or $100. The total tax loss that can be carried forward to future income years is therefore $200.
Resident partnerships and trusts as shareholders
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[21.250] Specific rules in subdiv 207-B of the ITAA 1997 are designed to trace franked distributions through partnerships or trusts that are not corporate tax entities. The objective is to ensure that partners, beneficiaries or trustees would receive their corresponding shares of the distributions and franking credits. In broad terms, when a partnership receives a franked distribution, it follows the general rule to gross up its assessable income by the amount of the franking credit attached to the distribution for the purpose of working out its net income or partnership loss: s 207-35 of the ITAA 1997. Each partner would share the net income or partnership loss according to the partnership agreement. A partner in general would also be entitled to a tax offset equal to the amount of its share of the franking credit: s 207-45 of the ITAA 1997. This is so even if the partner does not receive the full amount of its share of the distribution (eg, due to deductions at the partnership level): s 207-55 of the ITAA 1997. Case study 21.12: Franked distribution flowing through a partnership Assume a partnership has two resident individual partners sharing profits and losses equally, and the only assessable income it derives this income year is a $70 fully franked dividend. The net income of the partnership is $100, making up of $70 dividend and $30 gross up. Each partner will share $50 assessable income and $15 franking credit from the partnership. The $50 will be included in the computation of each partner’s taxable income, and the resulting tax liability will be reduced by the $15 tax offset.
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Distributions flowing through a trust would be subject to similar tax treatment. However, as any loss at the trust level cannot be attributed to the beneficiaries or the trustee, franking credit is lost if the trust is in a tax loss position.
Non-resident shareholders [21.260] When a franked distribution is made directly to a non- resident individual or corporate tax entity, the general rule of “gross up and tax offset” does not apply: s 207-70 of the ITAA 1997. In other words, a non-resident shareholder will not include any franking credit attached to the distribution in its assessable income and will not be entitled to a tax offset representing that franking credit. Furthermore, a dividend paid to a non-resident is generally non-assessable non-exempt income: s 128D of the ITAA 1936 (note that the term “foreign resident” is used in ITAA 1997 instead of “non-resident”: see [4.160]). Instead, the non-resident may be subject to withholding tax on the unfranked part of the dividend. See Chapter 22 for discussion of the withholding tax regime. For franked dividends that flow indirectly through partnerships and trusts to a non-resident, the recipient can deduct from its assessable income an amount equal to its share of franking credit attributable to the distribution: s 207-95 of the ITAA 1997. Effectively, the provision cancels out the non-resident’s share of the “gross up” amount included in its assessable income.
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Case study 21.13: Franked dividend flowing indirectly to non-resident shareholders Going back to Case Study [21.12], assume that one of the partners is a non-resident individual. In this case, out of the $50 share of net income of the partnership, the dividend portion of $35 is non-assessable non-exempt income pursuant to s 128D of the ITAA 1936. In addition, the non- resident partner is entitled to a specific deduction of $15, thus removing the gross up portion of his share of the partnership’s net income. The end result is that the non-resident partner has no net assessable income from the fully franked dividend. In addition, the fully franked dividend is exempt from withholding tax. In summary, a non-resident recipient of a franked distribution is effectively outside the scope of the imputation system. Its tax position may be less favourable than that of a resident shareholder. This is because the non-resident shareholder would not be able to claim any tax offset for the amount of income
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710 [21.270] PRINCIPLES OF TAXATION LAW 2020 tax paid at the company level. In effect, the non-resident shareholder is taxed under a classical system.
Case study 21.14: Imputation system and non-resident shareholders Assume a resident company receives $100 income and pays $30 tax on it. If it distributes $70 fully franked dividend to a non-resident individual shareholder, the dividend would be non-assessable non-exempt income to the shareholder under s 128D of the ITAA 1936. Assume further that the shareholder is subject to income tax in its home country, which has a tax system similar to Australia. In that case, the $70 dividend would be taxable to the shareholder at its marginal tax rate without any relief for the franking credit attached to the distribution. For instance, if the marginal tax rate for the shareholder is 47%, the home country tax payable on the dividend would be about $33. The total tax paid on the $100 income would therefore be $63, which is much higher than that for a resident shareholder (namely, $47). The structural bias of an imputation system against non-resident shareholders is one of the driving forces in many countries to search for alternative corporate/ shareholder taxation systems. In fact, most countries have already replaced their imputation systems with other forms of dividend taxation regimes.
Measures protecting the imputation system Copyright © 2019. Thomson Reuters. All rights reserved.
The benchmark rule [21.270] Not every shareholder can enjoy the benefit of a franking credit attached to a dividend. As discussed in [21.260], franking credits in general are of little value to non-resident shareholders. Companies may have the incentive to stream franked dividends to resident shareholders and unfranked dividends to non-resident shareholders. The Government believes that dividend streaming is unacceptable. Elaborate anti-streaming provisions have been introduced to tackle such arrangements. For instance, the benchmark rule was introduced on 1 July 2002 with a policy objective to “ensure that one member of a corporate tax entity is not preferred over another when the entity franks distributions”: s 203- 15 of the ITAA 1997. The rule requires that a corporate tax entity should frank all distributions in a “franking period” to the same franking percentage known as the “benchmark franking percentage”: s 203-25 of the ITAA 1997. “Benchmark franking percentage” is effectively the franking percentage of the first frankable distribution made by the entity in the franking period: s 203-30 of the ITAA
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1997. For a private company, “franking period” is the income year: s 203-45 of the ITAA 1997. For a public company, in general, an income year has two franking periods: the first six-month period and the following six-month period in the year: s 203-40 of the ITAA 1997. If an entity over-franks a distribution under the benchmark rule, it is liable to pay over-franking tax: s 203-50(1)(a) of the ITAA 1997. The tax is a penalty as it does not generate any credit in the entity’s franking account, or any tax offset for the entity. If an entity under-franks a distribution under the benchmark rule, a franking debit arises in its franking account: s 203-50(1)(b) of the ITAA 1997. This is again a penalty, as the franking debit cancels out otherwise available franking credits in the franking account. An entity may deviate from the benchmark rule if the Commissioner permits, but such permission may be given only in extraordinary circumstances: s 203-55 of the ITAA 1997.
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The benchmark rule requires the same franking percentage to be applied to all distributions made in a franking period. There are opportunities for entities to circumvent the rule by franking distributions to different franking percentages over different franking periods. For instance, a company may make a fully franked distribution to resident shareholders in one year and an unfranked distribution to non-resident shareholders in the next year. The income tax law has specific provisions to deal with this issue. In particular, if the benchmark franking percentages between franking periods differ significantly, the entity must notify the Commissioner in writing: s 204- 75 of the ITAA 1997. For two adjacent franking periods, benchmark franking percentages differ significantly if they differ by more than 20%. In that case, the Commissioner is empowered to request further information from the entity to determine whether the entity is streaming distributions: s 204-80 of the ITAA 1997.
Qualified person [21.280] Subdivision 207-F of the ITAA 1997 in general denies an entity from the “gross up and tax offset” rule if it manipulates the imputation system, including:
(1) (2) (3) (4)
the entity receiving the franked distribution is not a “qualified person”; streaming distribution under s 204-30 of the ITAA 1997; dividend stripping operations; and arrangements that trigger the operation of the general anti-avoidance provision on imputation benefits under s 177EA of the ITAA 1936.
The concept of “qualified person” is briefly discussed in the next two sections. Detailed discussions of the other anti-avoidance provisions are outside the scope of this book.
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45-day holding period rule [21.290] If a franked distribution is made to an entity that is not a “qualified person”, the franking credit attached to the distribution is not included in the assessable income of the entity, and the entity is not entitled to a corresponding tax offset: s 207-145(1)(a) of the ITAA 1997. The primary objective of the provision is to ensure that only the entity that effectively bears the risk of holding the shares and enjoys the benefit of the distribution is allowed to apply the “gross up and tax offset” rule.
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The definition of “qualified person” was stipulated in Div 1A,Pt IIIAA of the ITAA 1936 and is still applicable through the operation of s 207-145. In broad terms, a shareholder is a qualified person if, among other things, it holds the shares for a continuous period of at least 45 days during the “primary qualification period”: s 160APHO of the ITAA 1936. If the shares are preference shares as defined under s 160APHD of the ITAA 1936, the holding period is extended to 90 days. “Primary qualification period” is defined to be the period beginning on the day after the acquisition day of the shares and ending on the 45th day after the ex-dividend day: s 160APHD of the ITAA 1936. If the shares are preference shares, the period is extended to end on the 90th day after the ex-dividend day. In counting the number of days of the continuous holding period, days on which the taxpayer has materially diminished risks of loss or opportunities for gain in respect of the shares are excluded: s 160APHO(3) of the ITAA 1936. In other words, the taxpayer has to be “at risk” in relation to the shares. If the taxpayer is not in effect bearing the economic risks of holding the shares, those days would not be counted towards the holding period. A taxpayer is taken to have “materially diminished” risks of loss or opportunities for gain if its net position in relation to the shares has been less than 30% of those risks and opportunities: s 160APHM of the ITAA 1936. The “net position” is worked out based on a financial concept known as “delta”: s 160APHJ of the ITAA 1936. For example, a put option with a delta of −0.5 reduces the risks and opportunities in relation to the shares by 50%. Individual shareholders with relatively small shareholdings are exempt from the “qualified person” test. In particular, an individual shareholder is exempt if the amount of tax offset in question is not more than $5,000, and there is no related payment with respect to the dividends: s 160APHT of the ITAA 1936.
Related payment rule [21.300] If the shareholder has made, or will make, a “related payment” with respect to the dividend, the holding period test is tightened. In particular, in that case, the shareholder would have to satisfy the 45-day (or 90-day for preference shares) holding period test during the “secondary qualification period”, which
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is defined to be the period beginning on the 45th day before, and ending on the 45th day after, the ex-dividend day: s 160APHD of the ITAA 1936. A “related payment” in general refers to any arrangement under which the taxpayer in effect passes the benefit of the dividend to other persons: s 160APHN of the ITAA 1936. Examples include a payment made to another person, provision of services, transfer of properties and offset of debts.
Company losses Introduction
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[21.310] If deductions exceed a taxpayer’s total assessable income and net exempt income, the excess is the taxpayer’s tax loss for the income year: s 36-10 of the ITAA 1997. In general, the tax loss can be carried forward indefinitely to offset against future taxable income of the taxpayer. However, the separate legal entity principle for companies creates a problem with respect to the entitlement to enjoy the benefit of carried forward losses. For example, in Year 1, a company incurred a tax loss. In Year 2, all its shareholders changed and then it generated taxable income. Should the new shareholders (through the company) be entitled to enjoy the benefit of the tax loss from Year 1? The separate legal entity principle would suggest that the company, being a separate legal entity, is the taxpayer who incurred the tax loss and thus should be the one to utilise the tax loss. This would be so even if the company’s shareholders have changed after the loss year. This was the policy in Australia before 1944, and it led to significant “loss trafficking” activities. Companies with tax losses were actively traded. They were bought by taxpayers who would then utilise the tax losses to offset against their taxable income. Anti-avoidance provisions were introduced in 1944 to tackle these arrangements involving revenue losses. Over the years, the anti-loss trafficking provisions have become stricter and additional provisions were enacted to cover other categories of losses, for example, net capital losses after the introduction of the CGT regime, and unrealised losses in response to the recommendations of the Ralph Report.
Carried forward realised losses [21.320] A company in general cannot deduct a carried forward revenue loss unless it satisfies either the continuity of ownership test (COT) or the business continuity test (BCT): s 165-10 of the ITAA 1997. The tests also apply to a company that incurs a revenue loss in the current year: subdiv 165-B of the ITAA 1997. In broad terms, the company would have
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714 [21.330] PRINCIPLES OF TAXATION LAW 2020 to divide the income year into two periods: one before the majority change of ownership and one after that change. Notional taxable income or net loss is calculated separately for each period. Any notional net loss in one period cannot offset against notional taxable income in the other period. Similar rules apply to prior year net capital losses, current year net capital losses and bad debts: subdivs 165-CA, 165-CB and 165-C of the ITAA 1997.
Continuity of ownership test [21.330] To satisfy the COT, a company has to maintain the same majority owners during the “ownership test period”. The test period is defined to be the period from the start of the loss year to the end of the current income year: s 165-12(1) of the ITAA 1997. A company is regarded as maintaining the same majority owners if at all times during the ownership test period, the same persons hold: (1) more than 50% of the voting power in the company; (2) rights to more than 50% of the company’s dividends; and (3) rights to more than 50% of the company’s capital distributions: s 165- 12 of the ITAA 1997.
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Subdivision 165-D of the ITAA 1997 stipulates detailed rules on the COT. For instance, in counting the voting, dividend or capital rights, the focus is on persons who beneficially own shares that carry those rights in the company. If the company has one or more corporate shareholders, the counting focuses on non-corporate persons who have, or are reasonably assumed to have, control directly or indirectly over those rights in the company. In other words, in general, it is necessary to trace the rights to the ultimate individual owners of those rights. Case study 21.15: Continuity of ownership test A company is wholly owned by Mr Boxx and carries on a shoe retail business at a loss for the past couple of years. On 1 July, this income year, Mr Boxx transferred 80% of the shares in the company to his son George, who managed to turn around the company to a profitable position. The company fails COT on 1 July this income year. It cannot utilise the carried forward losses to offset against the current year’s taxable income unless it satisfies the same business test. The COT is protected by a number of anti-avoidance provisions, including: (1) “Same share same person” rule The COT in general would take into account only shares that are “exactly the same shares and are held by the same persons”: s 165-165
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of the ITAA 1997. This rule prevents the situation under which there is a majority change of share ownerships between existing shareholders, but the shareholders taken together remain the same group of persons. However, a company is deemed to have satisfied the same share same person rule if it can substantiate that less than 50% of the tax loss has been duplicated: s 165-12(7) of the ITAA 1997. This saving rule is particularly helpful in situations when a loss company issues new shares. (2) Change of control over voting power Even if a company satisfies the COT, it is deemed to have failed the test if, during the ownership test period, a person began to control directly or indirectly voting power in the company for the purpose of getting tax benefits for itself or someone else: s 165-15 of the ITAA 1997.
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In practice, it may be very difficult for listed companies to satisfy the COT, especially for those that are heavily traded in the stock exchange. The tax law provides certain concessional treatments for listed companies: Div 166 of the ITAA 1997. In broad terms, it is sufficient for these companies to satisfy the COT at certain designated points of time during the ownership test period. The designated points of time are (a) the start of the loss year; (b) the end of the current income year; (c) the end of each intervening year; and (d) the time of each “corporate change”: s 166-5 of the ITAA 1997. “Corporate change” is defined in s 166-175 of the ITAA 1997 to include: (1) a takeover bid for shares in the company; (2) any arrangement involving acquisition of more than 50% of the company’s shares; and (3) an issue of shares in the company that results in an increase of 20% or more in the issued share capital of the company or the number of shares on issue. Furthermore, all shareholdings of less than 10% in a listed company are treated as if they are held by a single shareholder: s 166-225 of the ITAA 1997. This reduces the compliance costs of listed companies with respect to the COT, as they would not have to trace the rights to the ultimate owners of these shares.
Business continuity test [21.335] If a company fails to satisfy the COT, it must satisfy the BCT before it can deduct a tax loss: s 165-13 of the ITAA 1997. The BCT is satisfied if the company satisfies either the same business test (SaBT) or the similar business test (SiBT): s 165-210 and 165-211 of the ITAA 1997. These two tests are explained in the following paragraphs.
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Same business test [21.340] A company satisfies the SaBT if in the current income year: (a) it carries on the same business as it carried on immediately before the test time; and (b) it does not derive any assessable income from a new kind of business or a new kind of transaction that it did not carry on or enter into before the test time: s 165-210 of the ITAA 1997. “Test time” is defined in general to be the time that the company fails the COT: s 165-13 of the ITAA 1997. However, if it is not practical to show that there is a period under which the company would satisfy the COT, the test time would in general be the start of the loss year. An anti-avoidance provision would deem a company as failing the SaBT if the company started a new kind of business or entered into a new kind of transaction before the test time and did so for the purpose of satisfying the SaBT: s 165-210(3) of the ITAA 1997. The meaning of “same” business is critically important. In Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97, it was held that the same business meant an identical business, not merely a similar business. However, in AGC (Advances) Ltd v FCT (1975) 132 CLR 175, the High Court adopted a more liberal interpretation and held that a company could still carry on the same business even if it had changed its name, address and clientele.
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Case study 21.16: Same business test Going back to Case Study [21.15], Mr Boxx’s company can utilise the carried forward losses only if it satisfies the SaBT. If the company continues to run the shoe retail business in the current year and the only change was to expand its business with an online shop having the same trade name, it would most likely satisfy the SaBT. However, if the company opened a new retail shop selling clothes, it would likely to have failed the SaBT. Tax Ruling TR 1999/9 explains the Australian Taxation Office’s (ATO) position on the interpretation and application of the SaBT. It contains some interesting examples suggesting that the ATO adopts a restrictive view on the meaning of “same business”.
Similar business test [21.345] SiBT was enacted in 2019 and applies retrospectively to income years starting on or after 1 July 2015: s 165-211 of the ITAA 1997. The policy
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objective of the test is to encourage innovation, and is expected to be easier to satisfy than SaBT. In broad terms, a company satisfies the SiBT if the business it carries on in the current income year is similar to the business it carried on immediately before the test time, which is typically the time when the company fails the COT. Whether the current business is similar to the former business is a question of facts. The law stipulates that besides other matters that may be taken into account in ascertaining whether the businesses are similar, the following four factors must be considered: s 165-211(2) of the ITAA 1997: (1) the extent to which assets used in the current business were also used in the former business; (2) the extent to which the activities and operations of the current business were also those of the former business; (3) the identity of the current business and that of the former business; and (4) the extent to which changes to its former business result from development or commercialization of assets, products, processes, services, etc of the former business. For the purpose of protecting the SiBT from abuse, a company does not satisfy the test if before the test time, it started to carry on a new business or entered into a new kind of transaction, and did so for the purpose of meeting the “similar” business requirement: s 1675-211(3) of the ITAA 1997.
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Unrealised losses [21.350] Companies might circumvent the COT by transferring shares in a company that had assets with unrealised losses. In that case, even though there was a majority change of ownership in the company, the two tests would not apply as there was no tax loss in the company at the time of the ownership change. The unrealised loss may then be realised by the company by disposing of the asset. Since 11 November 1999, the scope of the COT tests is extended to cover unrealised losses. The extension was implemented in response to the recommendations of the Ralph Report. The highly complex regime in subdiv 165-CC of the ITAA 1997 will apply if, in broad terms, a company fails the COT in an income year, and it has an “unrealised net loss” at that change- over time: s 165-115A(1) of the ITAA 1997. “Unrealised net loss” is worked out under either of the following methods: (1) “individual asset method”: under this method, unrealised net loss is calculated by adding up unrealised gain or loss of each CGT asset of the company; or (2) “global method”: this method was introduced as a compliance cost saving measure. Unrealised net loss is calculated by comparing a
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718 [21.360] PRINCIPLES OF TAXATION LAW 2020 global market valuation of all the CGT assets of the company against the total cost bases of those assets: s 165-115E of the ITAA 1997. The general effect of the regime is to disallow, up to the amount of the unrealised net loss, subsequent realisation of losses from those CGT assets that the company held at the change-over time: s 165-115B of the ITAA 1997. The disallowance does not apply if the company were able to satisfy the BCT. The major source of complexity arises from the market valuation requirements. The government has introduced a number of measures to reduce the compliance costs of taxpayers, including: (1) a company satisfying the maximum net asset value test under the small business relief regime (ie, net asset value not more than $6 million) is exempt from the subdivision: s 165-115A of the ITAA 1997; and (2) a CGT asset with acquisition cost less than $10,000 is exempt from the application of the regime (provided the company elects to use “individual asset method” to calculate unrealised net loss): s 165- 115A(1B) of the ITAA 1997.
Multiplication of losses
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[21.360] A loss incurred by a company may affect the value of shares in the company. If we assume that the value of shares would be reduced by the amount of loss incurred at the company level, there would be duplication of the loss at the shareholder’s level. The effect would multiply in a company chain. The same multiplication effect, of course, may occur for gains derived by a company. The Ralph Report recommended that anti- avoidance provisions should be introduced to tackle the issue of multiplication of losses (but not gains). The resulting legislation is the highly complex subdiv 165-CD of the ITAA 1997. The subdivision in general applies if: (1) an “alteration time” occurs in respect of a company: “alteration time” basically refers to the time when the company fails the COT: ss 165- 115L and 165-115M of the ITAA 1997; and (2) the company is a “loss company” at that time: a company is a loss company if, among other things, it has carried forward tax losses or current year tax loss in the income year, or “adjusted unrealised loss” at the alteration time: s 165-115R of the ITAA 1997. Similar to subdiv 165-CC, “adjusted unrealised loss” may be calculated under either the individual asset method or the global method: s 165-115U of the ITAA 1997. However, there is one important difference. Under
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the individual asset method in subdiv 165-CD, only unrealised losses (but not unrealised gains) are taken into account. This contrasts with the global method which takes into account both unrealised gains and losses. The general effect of subdiv 165-CD is to adjust the reduced cost bases of “relevant equity interest” in the company, except those held by individuals: ss 165-115ZA and 165-115X(5) of the ITAA 1997. The adjustment effectively reduces the corresponding reduced cost bases by the amount of total realised and unrealised losses of the loss company: s 165-115ZB of the ITAA 1997. Case study 21.17: Multiplication of losses
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Company P owns all the shares in Company S1 which in turn owns all the shares in S2. The cost bases and reduced cost bases of the shares in S1 and S2 are both $10 million. S1 has no other asset than the shares in S2, while the only asset of S2 is a piece of land (cost $10 million; market value $8 million). S1 sells all the shares in S2 to a third party for $8 million. S2 is a “loss company” for the purposes of subdiv 165-CD. The sale of S2 by S1 triggers the operation of the subdivision which adjusts the reduced cost bases of the shares in both S1 and S2 from $10 million to $8 million. As a result, S1 does not have any capital loss on the sale of S2. Furthermore, if P sells S1 in future for its market value of $8 million, it will not result in any capital loss. An entity has a “relevant equity interest” in a loss company if, among other things, it: (1) together with its associates, directly or indirectly, controls more than 50% voting power, or has more than 50% of dividend rights or capital distribution rights in the company: s 165-115Z of the ITAA 1997; and (2) alone has an interest that directly or indirectly controls at least 50% voting power, or has at least 10% dividend or capital distribution rights, in the company: s 165-115X(1) of the ITAA 1997. Similar adjustments apply to significant debt interest in the loss company: s 165-115Y of the ITAA 1997. Similar to subdiv 165-CC, the market valuation requirement under subdiv 165- CD imposes substantial compliance costs on taxpayers. Measures to reduce compliance costs are basically the same as those for subdiv 165-CC.
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720 [21.370] PRINCIPLES OF TAXATION LAW 2020
Consolidation Introduction [21.370] The tax consolidation regime was introduced in Australia on 1 July 2002. It represents a fundamental change to corporate taxation and is one of the most important tax reform items recommended by the Ralph Report. If a group elects to consolidate, in general, the whole group will be treated as a single entity under the income tax law. This is despite the fact that the parent company and its subsidiary companies are separate legal entities for general law purposes. The consolidation regime is highly complex and consists of over 600 pages of technically challenging legislation. The ATO has devoted substantial resources to implement the regime. In particular, it has published and continuously updates the Consolidation Reference Manual of over 1,300 pages.
Policy objectives
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[21.380] In theory, a group of entities may be allowed to consolidate if they are economically so integrated that they should be treated as a single entity for income tax purposes. Many tax consolidation regimes require an ownership level equal or close to 100% between group members. The policy objectives of Australia’s consolidation regime are stipulated in s 700-10 of the ITAA 1997: (a) to prevent double taxation of the same economic gain realised by a consolidated group; (b) to prevent duplication of the same economic loss realised by a consolidated group; and (c) to reduce compliance costs and improve business efficiency by removing complexities and promoting simplicity in the taxation of wholly owned groups. It is doubtful that, in view of the sheer volume of the legislation and related materials on the consolidation regime, the last objective is achieved.
Membership requirements [21.390] A resident company (known as the “head company”) with all its wholly owned resident subsidiaries may elect to form a consolidated group:
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s 703-10 of the ITAA 1997. Once the election is made, it is irrevocable: s 703-50 of the ITAA 1997. Also, the “all in” rule applies, meaning that once an election is made to consolidate, all eligible group members must join the consolidation. The head company in general must be a resident company subject to the normal corporate tax rate and cannot be a member of another consolidated group: s 703-15(2) Item 1 of the ITAA 1997. Certain corporate unit trusts and public trading trusts may also elect to be a head company: s 713-130 of the ITAA 1997.
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Subsidiary members of a consolidated group can be a company, partnership or trust and must be an Australian resident and a “wholly owned subsidiary” of the head company: s 703-15(1) Item 2 of the ITAA 1997. An entity is a “wholly owned subsidiary” of the head company if the head company beneficially owns all the membership interests in the subsidiary: s 703-30 of the ITAA 1997. “Membership interest” is defined based on the concept of “members” of an entity. “Members” of entities are defined in s 960-130 of the ITAA 1997 as follows: Entity
Member
Company
A member of the company or a stockholder in a company
Partnership
A partner in the partnership
Trust (except corporate unit trust or public unit trust)
A beneficiary, unit holder or object of the trust
Corporate unit trust or public unit trust
A unit holder of the trust
In other words, a member of a company is defined literally to be “a member of a company”. Without further guidance from the tax legislation, the term is taken to mean a “member” of a company under the Corporations Act 2001. For companies limited by shares, in general, “member” refers to a shareholder. This definition of “membership interests” that relies solely on shareholding is uncommon in other countries’ consolidation regimes. Arguably, it ignores more relevant factors in deciding whether a group should be eligible for tax consolidation, for example, voting power. The definition also lacks specific rules to deal with options or convertible securities. In determining whether a subsidiary is wholly owned by a head company, shareholdings in a company issued under certain employee share schemes are ignored, provided those shares account for not more than 1% of the ordinary shares in the company: s 703-35 of the ITAA 1997.
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722 [21.400] PRINCIPLES OF TAXATION LAW 2020
Case study 21.18: Corporate groups eligible to consolidate Consider the following corporate group: P
S1
S2
S3
S4
S5
All the six companies except S4 are resident of Australia. P owns all the shares directly in S1 to S4 (except 1% shares in S3 being owned by employees of the group under an employee share scheme) and indirectly in S5. P can elect to form a consolidated group with S1, S2, S3 and S5. S4 cannot join the consolidated group as it is a non-resident company.
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Multiple entry consolidated groups [21.400] In addition to the general consolidation rules catering for domestically owned groups, Australia provides a more flexible consolidation regime for groups owned by foreign parents, known as the Multiple Entry Consolidated Group (MEC group) regime. In broad terms, if more than one company (known as “tier-1 companies”) in Australia are direct wholly owned subsidiaries of a foreign company, any two or more of the tier-1 companies (and their wholly owned subsidiaries) may elect to form an MEC group: s 719-5 of the ITAA 1997. One of those tier-1 companies would be the “head company” of the group. Case study 21.19: Multiple entry consolidated group Consider the same corporate group in Case Study [21.17], except that P is a non-resident company. In this case, S1, S2 and S3 are tier-1 companies. They can decide which companies to form an MEC group. The possible combinations include:
(1) all three companies (together with S5) form an MEC group; (2) S1 (together with S5) forms an MEC group with either S2 or S3; and (3) S2 and S3 form an MEC group while S1 forms a separate consolidated group with S5.
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It is not clear why foreign-owned groups are allowed to cherry pick entities to consolidate. This contrasts the strict “all in” rule for domestically owned groups.
Implications of electing to consolidate The single entity rule
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[21.410] If a group elects to consolidate, in general, the whole group would be treated as a single entity for income tax purposes. In particular, all subsidiary members of the head company are taken to be “parts of the head company of the group, rather than separate entities” for the purposes of computing income tax liabilities and losses of the head company and the subsidiaries: s 701-1 of the ITAA 1997. This is known as the single entity rule (SER). In other words, subsidiaries are treated as divisions within the head company under the consolidation regime. An important implication is that assets of a consolidated subsidiary are deemed to be held directly by the head company, triggering a complex set of cost bases adjustment rules (see [21.440] for more detail). A consolidated group has to file only one single income tax return. Intra-group transactions in general will be ignored under the income tax law. Intuitively, the regime is quite attractive as, prima facie, it may imply lower compliance costs. However, it is doubtful whether that is achieved in practice. There is constant tension between the single entity concept under consolidation and the separate legal entity principle that applies in general in other parts of the income tax law (see, eg, the difficulty of applying the general anti-avoidance provisions to a consolidated group in Commissioner of Taxation v Macquarie Bank Ltd [2013] FCAFC 13). This constant pressure on the implementation of the consolidation regime often results in complex provisions, and specific overrides of the SER are not uncommon. The position of the ATO on the SER is stated in Ruling TR 2004/11.
The entry and exit history rules [21.420] Upon consolidation, all subsidiary members become “parts” of the head company. To ensure that the head company can inherit tax attributes of the subsidiaries under the SER, the entry history rule applies. Under that rule, “everything that happened in relation to [a subsidiary] before it became a subsidiary member is taken to have happened in relation to the head company”: s 701-5 of the ITAA 1997. If a subsidiary member leaves a consolidated group, the exit history rule applies to ensure that the subsidiary can inherit relevant tax attributes from the head
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724 [21.430] PRINCIPLES OF TAXATION LAW 2020 company: s 701-40 of the ITAA 1997. The rule applies to all assets and liabilities that the subsidiary takes with it when it leaves the group.
Liability to tax [21.430] Under the SER, a consolidated group is effectively treated as an “inflated” version of the head company. It follows that the head company has the primary obligation to pay the consolidated group’s tax liability. If the head company fails to meet all its income tax liabilities by the due date, the head company and each subsidiary of the group in general are jointly and severally liable for the liabilities: s 721-15 of the ITAA 1997. This is so even if the subsidiary has been a member of the group for just a part of the period to which the liability relates: s 721-10(1) of the ITAA 1997. Group members may avoid the joint and several liability if a valid tax sharing agreement is in place to cover that liability. To be effective, a tax sharing agreement has to satisfy requirements stipulated in s 721-25 of the ITAA 1997, including: (1) the amount of tax liability allocated to each subsidiary represents a reasonable allocation of the total amount of the group liability; and (2) the tax sharing agreement is not entered into as part of an arrangement with a purpose to prejudice the recovery of the group liability by the Commissioner.
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Pre-consolidation losses [21.440] The major advantage of consolidation is intra-group loss offset among group members during consolidation. A difficult policy issue arises in respect of losses that a subsidiary has incurred before joining a consolidated group. Should the pre-consolidation losses be allowed to transfer to the head company and, if so, should there be any restrictions on the rate of utilisation of the losses? Intuitively, assuming the subsidiary would have satisfied the loss recoupment tests (namely, the COT and BCT discussed at [21.330], [21.340]) if it has not joined the consolidated group, consistent application of the SER and the entry history rule would imply that the pre- consolidation losses should be deemed to have been incurred by the head company and should be available to offset against the head company’s future taxable income. In Australia, pre-consolidation losses of a subsidiary can be transferred to the head company if it would have satisfied modified COT and BCT tests at the joining time: s 707-120 of the ITAA 1997. However, in fear of substantial revenue impact upon the introduction of the consolidation regime, the government
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imposed additional restrictions on the rate at which a head company may utilise pre-consolidation losses brought into the group by a subsidiary member. The measure designed to achieve this purpose is known as the “available fraction” rule. In broad terms, the maximum amount of pre-consolidation losses of a subsidiary that can be utilised by a head company in an income year is limited to the following amount (s 707-310 of the ITAA 1997): Available fraction × head company’s taxable income for the year
The main principle underlying the design of “available fraction” is stipulated in s 707-305(3) of the ITAA 1997: [T]he amount of the loss that the [head company] can utilise is to reflect the amount of the loss that the [subsidiary] could have utilised for the income year if the [subsidiary] … had not become a member of a consolidated group.
However, “available fraction” for a subsidiary’s loss is basically defined in terms of the ratio of the market value of the subsidiary at the time of the loss transfer to the market value of the group at that time: s 707-320 of the ITAA 1997. It is doubtful if such a ratio –which is not adjusted regularly to reflect the prevailing market values of the subsidiary relative to the group –can properly achieve the stated principle.
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Case study 21.20: Available fraction for pre-consolidation losses P owns all the shares in S and elects to consolidate on 1 July. S has $10 million pre- consolidation losses and is transferred to P upon consolidation. The available fraction of this loss determined on the date of consolidation is 0.3. The taxable income of P and S for the income year is $3 million and $9 million, respectively. In this case, the consolidated taxable income of the group is $12 million. Though S generated $9 million taxable income, the amount of pre- consolidation losses that can be used by P in the income year is limited to $12 million × 0.3, or $3.6 million. The formula to compute the “available fraction” may create anomalous results, for example, the fraction may be more than one, zero or even negative. The tax law contains several arbitrary rules to deal with these situations: s 707-320 of the ITAA 1997. Another feature of the consolidation regime with respect to pre-consolidation losses is that if a subsidiary member leaves a group, it cannot take away the remaining losses from the group: s 707-410 of the ITAA 1997. The amount stays with the head company.
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726 [21.450] PRINCIPLES OF TAXATION LAW 2020
The tax cost setting rules [21.450] During consolidation, intra-group transfers of assets are ignored as all subsidiaries are treated as divisions of the head company. If a subsidiary subsequently leaves the group, the tax law has to determine the tax cost bases of both the membership interests in the subsidiary and the assets taken away by the subsidiary. For this purpose, Australia adopts the asset-based model, as recommended by the Ralph Report. The corresponding rules, known as the tax cost setting rules (TCS rules), are highly complex. When a subsidiary joins a consolidated group, the TCS rules apply with the general effect of allocating the head company’s acquisition costs of the membership interests in the subsidiary (adjusted for the accounting liabilities of the company and other items) to the underlying assets held by the subsidiary: s 701-10 of the ITAA 1997. Assets of the subsidiary (except retained cost bases assets) are assigned reset cost bases which replaced the original cost bases forever, even after the subsidiary subsequently leaves the group. It is possible for an asset to receive a “step-up” cost base under the TCS rules.
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The TCS rules also apply when a subsidiary leaves a group. The objective of the rules in this respect is to reconstitute the cost bases of the membership interests in the subsidiary by basically adding together the cost bases (including reset cost bases) of assets taken away by the subsidiary, reduced by the amount of its liabilities: s 701-15 of the ITAA 1997. Under the exit history rule, the subsidiary inherits the tax costs of assets from the head company. Case study 21.21: Tax cost setting rules [This case study is based on the example at [C2-2-110] of the ATO’s Consolidation Reference Manual, which detailed the complex calculation involved in arriving at the reset cost bases.] P acquired 40% shares in S in 2001 when S had a piece of land with both cost base and market value equal to $100. P acquired all the remaining shares in S in 2002 and elected to consolidate. At that time, both the cost base and market value of the land remain $100. Upon consolidation, the TCS calculation determines that the reset cost base of the land is $74. If the group now sells the land to a third party for its market value of $100, it will derive a capital gain of $26. This is so despite the market value of the land remaining to be the same as the original cost base.
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Questions [21.460] 21.1 A resident company pays a fully franked dividend of $700 to a resident shareholder. Advise the income tax implications of the shareholder if it is: (a) an individual subject to the top marginal tax rate; (b) an individual with marginal tax rate of 19%; (c) a company with other assessable income of $8,000 and a carried forward loss of $12,000; (d) a company with other assessable income of $9,000 and deductions of $16,000; and (e) a partnership with two resident individual partners sharing equally partnership profits or losses. 21.2 A resident company pays a dividend of $1,400 (franked to 60%) to a non- resident shareholder. Advise the Australian income tax implications of the shareholder if it is: (a) an individual living in the United States; (b) a US company holding 20% shares in the resident company; and (c) a US company holding all the shares in the resident company. 21.3 A resident company, owned by two resident individuals, has an opening credit balance of $7,000 in its franking account in this income year. It has the following transactions in the year:
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• on 18 July, it paid a PAYG instalment of $30,000; • on 29 August, it paid a $35,000 cash dividend franked to 80%; • on 3 September, it received a $28,000 cash dividend franked to 90%; • on 21 September, it paid a $7,000 cash dividend with franking credits of $1,800 attached; • on 5 October, salaries paid to one of its shareholders were deemed to be dividends under Div 7A of the ITAA 1936. The amount of deemed dividend was $21,000; • on 2 February, it received an income tax refund of $18,000 from the ATO; • on 10 March, it paid a $20,000 cash dividend franked to 95%; • it had a $90,000 PAYG instalment due on 21 April but did not pay it until 3 July in the following income year. Prepare the company’s franking account for this income year. 21.4 Yumyum Thai Pty Ltd is in the business of running a Thai restaurant, serving traditional Thai food. It has two shareholders, Gary and Matt.
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728 [21.460] PRINCIPLES OF TAXATION LAW 2020 Gary held 75% of the shares in company while Matt held 25%. After a decade of profitable operation, the company incurred tax losses of $200,000 in each of the last two income years. Gary sold two-thirds of his shares to Matt on 1 July in this income year. Gary now holds 25% of the shares in the company and Matt holds 75%. Gary incurred a capital loss of $300,000 in the share disposal. Immediately after the share transfer, Matt introduced a new menu in the restaurant. Instead of traditional Thai dishes, the new menu features largely French dishes with hint of Thai flavour. The name and decoration of the restaurant was also changed to reflect the new menu. The company also published a cookbook in October this income year featuring the signature dishes of the restaurant. The book was a bestseller, contributing a significant amount of revenue to the company. The company turned around in the income year and became profitable again.
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Advise whether the company can use the carry forward losses in this income year. 21.5 Green Planet Pty Ltd was incorporated to research and develop a new technology to produce biodegradable plastic from seaweed. After making losses for several years, a venture capital company purchased 60% of the shares in the company. The company then discovered that the “seaweed to plastic” technology can also be used to make an organic fertiliser. This new product contributed 40% of the turnover of the company, which turned around and made a profit in the current income year. Advise whether the company can use the carry forward losses in this income year. 21.6 P has three wholly owned subsidiaries S1, S2 and S3. All the four companies are incorporated in Australia. P holds directly all the shares in S1 and S2. Shares in S3 are held through S4, another wholly owned subsidiary of P incorporated in Bermuda. In this income year, P has a taxable income of $2 million. S1 has a tax loss of $10 million, in addition to its brought forward losses of $80 million. S2 has a taxable income of $60 million. S3 has a taxable income of $10 million. S4 has no income or loss. The group seeks your advice on its eligibility to consolidate for income tax purposes and the tax implications of such an election. Advise the group of the income tax implications with respect to consolidation, including: (a) Is this corporate group eligible to consolidate? (b) If so, will you recommend the group to consolidate and why? (c) If the election to consolidate is made, what are the tax implications for the group, including the cost bases of assets in the group and the accumulated losses in S1?
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(d) What will be the tax consequences if P sells all shares in S1 a year later for $20 million? 21.7 P, a company incorporated in Australia, is the head company of a tax consolidated group with a wholly owned subsidiary S1. P acquired all the shares in S2, a company incorporated in Australia, on 1 July this income year. S2 had $20 million unused tax losses which were transferred to P upon consolidation. The available fraction for this bundle of losses is 0.3. The following income and expenses were recorded for the respective companies in this income year: • P: dividend income of $2 million from S1. • S1: sales income of $80 million on sales to S2, with production costs of $65 million. • S2: sales income of $100 million on sales to third party customers. The company incurred purchase costs of $80 million for the goods from S1. It also incurred marketing expenses of $8 million.
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S2 made a capital gain of $15 million from a sale of a piece of land. The land was acquired in 2006. The gain was calculated on a company stand-alone basis, based on the original cost base of the land of $10 million. The reset cost base of the land was $12 million. Explain the Australian income tax implications of the above transactions, and calculate the income tax payable by P for this income year. 21.8 P is a non-resident company and owns all the shares in three Australian resident companies, A, B and C. B owns all the shares in D, another resident company. A owns 90% of the shares in E, a resident company. The other 10% is held directly by P. How many different consolidated groups may be formed under the Australian consolidation regime? How will your answer be different if P is a resident of Australia? Do you think the different treatments between domestic and overseas corporate groups are justified? 21.9 Gary, an Australian resident, is the sole shareholder of MC Pty Ltd, a company incorporated in Australia. In this income year, MC Pty Ltd made an interest-free loan of $80,000 to Gary. By the income year end, the company waived 30% of the loan. The balance of the loan remains outstanding by the company’s lodgement date. The company’s distributable surplus for the income year is $60,000. Advise the tax implications of the above transaction for Gary. How will your answer be different if the shareholder of MC Pty Ltd is a wholly owned subsidiary of another company incorporated in Australia?
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22 International taxation Key points.................................................................................................... [22.00] Introduction................................................................................................ [22.10] Australia’s jurisdiction to tax..................................................................... [22.30] Background.......................................................................................... [22.30]
Residence and source.............................................................................. [22.40]
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Taxation of foreign source income of residents....................................... [22.50] Background.......................................................................................... [22.50] Exemption from Australian taxation................................................... [22.70]
Limited exemption for foreign employment income............................. [22.80] Exemption for foreign dividends............................................................. [22.90] Foreign branch income.......................................................................... [22.100] Foreign tax offsets.............................................................................. [22.110] Calculating available foreign tax offset................................................. [22.140] Accruals taxation................................................................................ [22.160] CFC rules................................................................................................ [22.170] Foreign losses.................................................................................... [22.240] Taxation of foreign residents................................................................... [22.250] Background........................................................................................ [22.250] Assessment........................................................................................ [22.270] Withholding tax.................................................................................. [22.280] Dividend withholding tax....................................................................... [22.290] Interest withholding tax......................................................................... [22.300] Royalty withholding tax......................................................................... [22.310] Capital gains....................................................................................... [22.320] Other income...................................................................................... [22.340] Transfer pricing......................................................................................... [22.350] Country-by-country reporting................................................................. [22.375] Thin capitalisation.................................................................................... [22.380] When do the thin capitalisation rules apply?.................................... [22.400] Types of entities................................................................................. [22.410] How are the thin capitalisation rules applied?.................................. [22.420] Tax treaties............................................................................................... [22.440] Business profits.................................................................................. [22.460]
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732 [22.00] PRINCIPLES OF TAXATION LAW 2020 Passive income.................................................................................. [22.470] Real property...................................................................................... [22.480] Individuals.......................................................................................... [22.490] Tax information exchange agreements.................................................. [22.500] Risks of aggressive tax planning....................................................... [22.500] Current TIEAs............................................................................................ [22.510] Other tax agreements.............................................................................. [22.513] OECD/G20 BEPS Project.......................................................................... [22.517] OECD measures to address BEPS..................................................... [22.517] Australian measures to address BEPS.............................................. [22.518] Questions................................................................................................... [22.520]
Key points
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[22.00] • “International taxation” is a phrase used to describe the tax law that applies to transactions that occur across two or more countries. • The domestic laws of a country, in our case, Australia, provide for situations where an international tax issue arises. • A resident taxpayer with foreign source income may be entitled to an exemption from Australian taxation or a foreign tax offset for tax paid in a foreign jurisdiction. • An accruals regime, which taxes income not repatriated, may apply to controlled foreign companies and foreign accumulation funds, to tax the income in the current year. • A foreign resident with Australian source dividend, interest or royalty income may be subject to withholding tax. • A foreign resident who holds taxable Australian property may be subject to the capital gains tax (CGT) regime where there is a CGT event in relation to the asset. • The transfer pricing provisions, which operate as an anti-avoidance regime, require related party transactions to be undertaken at an arm’s length price. • The thin capitalisation regime may limit the interest deduction available to affected parties where an acceptable debt-to-equity ratio is not met. • Double tax agreements to which Australia is a party may override the provisions of the domestic legislation. • Tax information exchange agreements have been entered into by Australia as part of its efforts to combat international tax avoidance. • Currently, countries are most concerned about base erosion and profit shifting (BEPS) with the Organisation of Economic Cooperation and
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22: International taxation [22.20] 733
Development (OECD) and G20 taking the lead in the reform of the international tax rules. • Australia has specific legislation to deal with international tax avoidance, known as the Multinational Anti-Avoidance Law, as well as a diverted profits tax (DPT) of 40%.
Introduction [22.10] This chapter considers the domestic law principles that apply to taxpayers with international dealings. The first category of taxpayers with international dealings is Australian residents with foreign source income. Three broad principles apply to this category: 1. exemptions for certain limited categories of income; 2. an offset for foreign tax paid for other categories of income; and 3. the accruals regime, which applies to certain foreign source income not repatriated to the Australian resident taxpayer. The second category of taxpayers with international dealings is foreign residents with Australian source income. Three broad principles apply to this category: 1. Australian withholding tax on certain passive income; 2. CGT on taxable Australian property; and
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3. tax on any other income. [22.20] In addition to the basic principles which provide for domestic taxing rights, there are anti- avoidance regimes contained in Australia’s domestic law relating to international tax transactions. First, the transfer pricing regime requires related party transactions to be undertaken at an arm’s length price. This regime is aimed at preventing tax avoidance by profit shifting to a low-tax jurisdiction through transfers between different parts of the same multinational entity. Second, the thin capitalisation regime reduces the deduction allowed for debt. In certain circumstances, a highly geared entity will not be allowed a full deduction for debt incurred. Finally, the domestic provisions relating to international transactions may be overridden by any international tax treaties to which Australia is a party. While each individual treaty has provisions unique to it, there are common principles across most of Australia’s treaties. Figure 22.1 provides a guide to dealing with the tax consequences of an international transaction.
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734 [22.30] PRINCIPLES OF TAXATION LAW 2020 Figure 22.1: Overall guide Does the taxpayer have international dealings?
Yes
No
Consider the residency status of the taxpayer See [22.40]
The tax consequences are not governed by the principles in the chapter
Are there any international related party transactions? See [22.350]
Are there any foreign loan transactions? See [22.380]
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Is there a double tax agreement which affects the domestic principles? See [22.440]
Australia’s jurisdiction to tax Background [22.30] “International tax” describes the tax law that applies to transactions that occur across two or more countries. There is no such thing as an “international tax”. Rather, the domestic laws of a country, in our case, Australia, provide for situations where an international tax issue arises. In Chapter 4, we learnt that the foundations of the Australian tax regime are residency and source. As well as providing the basis upon which tax is imposed in Australia, they are both considered notions that are part of international tax policy. Broadly, an Australian resident is taxed on income from all sources, that is, on worldwide income: see [22.50], while a foreign resident is taxed on income
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22: International taxation [22.40] 735
sourced within Australia: see [22.250]. However, Australia’s international tax rules are not as simple as applying the residency and source concepts to determine tax liability. In addition to these basic principles, there are special rules that apply to the foreign source income of residents and the taxation of foreign residents on Australian source income. There are also the anti-avoidance rules of the transfer pricing regime and thin capitalisation regime, and, finally, there is the overriding effect on the domestic rules of the international treaties (known as double tax agreements) to which Australia is a party. Globally, there is a concern about BEPS by large multinational entities. The OECD, at the request of the G20, has undertaken a comprehensive review of BEPS with recommendations for reform coming out of its 15-point action plan.
Residence and source [22.40] Chapter 4 discusses the principles of residency and source, and students should revise Chapter 21 before studying the principles of international taxation in this chapter. Remember that the principles of residency and source provide the main criteria upon which a taxpayer is assessed under the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). Residency and source rules are made up of statutory provisions and common law principles. Briefly, the rules can be summarised as follows. Residence of an individual requires a consideration of four tests: • resident according to ordinary concepts; • domicile test; • 183-day test; and Copyright © 2019. Thomson Reuters. All rights reserved.
• superannuation test. Residence of a company requires a consideration of three tests: • place of incorporation test; • central management and control test; and • voting power controlled by Australian shareholders test. Source tends to be primarily a common law test, with the determination of source being a practical, hard matter of fact to be determined separately in each case. Source usually depends on the identification of the particular class of income, and common categories are income from personal exertion (whether salary, wages or independent services), passive income (such as dividends, interest, royalties and rent) and trading and business profits. Once the residency of a taxpayer is determined, the tax consequences of any income can be considered.
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736 [22.50] PRINCIPLES OF TAXATION LAW 2020
Taxation of foreign source income of residents Background [22.50] Australian residents are taxed on income from all sources, and, as such, there is the potential for double taxation where foreign source income earned by an Australian resident is also taxed by a foreign jurisdiction. Double taxation occurs because one country taxes income based on source, while another taxes income based on residency. To overcome the possibility of double taxation, Australia’s domestic tax regime contains provisions allowing for exemptions from tax for certain income and an offset for foreign tax paid on certain other types of income. In addition to the provisions which prevent double taxation, Australian residents with foreign investments also need to consider the application of the Australian accruals tax regime, which may include amounts in assessable income which would not otherwise be included. Finally, Australian residents with foreign losses need to consider the domestic tax consequences of those foreign losses. [22.60] The taxation of foreign source income of residents is divided into four parts: • exemption method of relief from double taxation; • foreign tax offsets; • accruals taxation; and
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• foreign losses. Figure 22.2 indicates the issues to consider where the taxpayer is a resident. Figure 22.2: Taxation of foreign source income of residents Taxpayer resident of Australia with foreign dealings
Does the taxpayer have foreign income subject to exemption? See [22.70]
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Does the taxpayer have foreign income subject to a foreign tax credit? See [22.80]
Is any income not repatriated and therefore subject to the accruals taxation regime? See [22.160]
Does the taxpayer have foreign losses? See [22.240]
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22: International taxation [22.90] 737
Exemption from Australian taxation [22.70] The exemption method of relief from double taxation originally exempted most foreign income from Australian tax. The basis for the exemption was that the income had already been taxed at a comparable rate in the country of source. However, this was often not the case, and there was considerable scope for taxpayers to source their income in what are known as tax havens. To counter this type of tax avoidance, the foreign tax credit regime (now the foreign tax offset regime) was introduced on 1 July 1987. However, certain limited exemptions were retained. This included certain overseas services income. With the introduction of the accruals regime, exemptions were also introduced for non-portfolio dividends from foreign companies and foreign branch income of Australian companies. There is also the new exemption for temporary residents discussed in Chapter 4.
Limited exemption for foreign employment income
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[22.80] Section 23AG of Income Tax Assessment Act 1936 (Cth) (ITAA 1936) allows an exemption for certain foreign services income. Section 23AG provides that an Australian resident individual who is engaged in earning certain foreign service income for a continuous period of not less than 91 days is exempt from tax on any foreign earnings derived from the foreign service. In 2009, Tax Laws Amendment (2009 Budget Measures No 1) Act 2009 (Cth) amended s 23AG to limit the exemption for foreign employment income to certain types of employment. From 1 July 2009, an exemption from income tax on foreign employment income is only available where foreign service is directly attributable to work as an aid or a charitable worker employed by a recognised non-government organisation, as a government aid worker or as a specified government employee (eg, defence and police force personnel deployed overseas). In limited situations, an exemption may still apply to independent contractors under s 23AF, which exempts foreign service income derived from projects approved by the Minister for Trade.
Exemption for foreign dividends [22.90] Where a dividend is paid by a foreign resident company to an Australian resident company and it satisfies the conditions in s 768- 5 of ITAA 1997, the dividend is non-assessable non-exempt income. To be non- assessable non-exempt income the foreign equity distribution needs to be made to an Australian resident company, the distribution must satisfy the
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738 [22.100] PRINCIPLES OF TAXATION LAW 2020 participation test and the Australian resident company must not receive the distribution in its capacity as trustee. The participation test is satisfied where direct and indirect participation interests total 10% or more.
Foreign branch income [22.100] Subject to certain exceptions, s 23AH of ITAA 1936 provides that foreign branch income and foreign branch capital gains derived by an Australian resident company through a foreign permanent establishment (branch) are non-assessable non-exempt income. In limited circumstances, foreign income derived through a branch may still be assessable.
Foreign tax offsets [22.110] Most foreign income derived by an Australian resident is taxed in Australia. However, under the foreign tax credit offset, a taxpayer is allowed an offset for the foreign tax paid up to the amount of Australian tax payable on that income.
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[22.120] From 1 July 2008, taxpayers are entitled to a non-refundable tax offset for foreign income tax paid on an amount included in assessable income. The potential Australian tax will be reduced by the amount of the foreign income tax already paid on those double-taxed amounts or reduced to zero where the foreign income tax paid exceeds the potential Australian tax payable. [22.130] The foreign tax offset provisions are contained in Div 770 of ITAA 1997. The object of the Division is to relieve double taxation where foreign tax has been paid on amounts included in a taxpayer’s assessable income and that income is also taxable in Australia. Relief from double taxation is provided via a non-refundable tax offset for foreign tax paid on assessable income. A taxpayer is entitled to a tax offset for foreign tax paid in the year in which the income is included in assessable income in Australia: s 770-10(1). An offset will be available for “foreign income tax”, which is defined as “tax that is imposed by a law other than Australian law and is a tax on income, tax on profits or gains, whether of an income or capital nature, or any other tax, being a tax that is subject to a tax treaty”: s 770-15(1).
Calculating available foreign tax offset [22.140] The amount of the tax offset available is based on the foreign income tax paid subject to a limit on the maximum amount of offset available. The maximum offset available is $1,000 or an amount determined by a comparison between actual tax liability and the tax liability determined, ignoring certain foreign income and related deductions. A taxpayer claiming a foreign income
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22: International taxation [22.150] 739
tax offset of more than $1,000 must work out his or her foreign income tax offset limit using a three-step process: • Step 1 –Work out the income tax payable for the relevant income year, including Medicare levy and Medicare levy surcharge, but disregarding any tax offsets, penalties or interest. • Step 2 –Work out the income tax payable, including Medicare levy and surcharge, but disregarding any offsets, penalties and interest, making the following assumptions: (a) assessable income does not include: – any amount included in assessable income on which foreign income tax has been paid that counts towards the foreign income tax offset; and – any other income or gains from a non-Australian source; and (b) the taxpayer is not entitled to the following (where such deductions are actually allowable):
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– debt deductions attributable to overseas permanent establishment; – any other deductions (other than debt deductions) that are reasonably related to any amount covered by the first point above; and – an amount of the foreign loss component of one or more tax losses deducted in the income year. • Step 3 –Take away the result of Step 2 from Step 1. If the result is greater than $1,000, this is the offset limit. [22.150] Example –Calculating foreign tax offset. The following example is adapted from the Australian Taxation Office (ATO’s) Guide to Foreign Income Tax Offset Rules 2019 (https://www.ato.gov.au/Forms/Guide-to-foreign- income- t ax- o ffset- r ules- 2 019/ ? anchor=Calculating_ a nd_ c laiming_ y our_ foreign_in#Calculating_your_offset_limit). The example shows the result for the 2019–2020 income year. An Australian-resident taxpayer has income and expenses and pays foreign income tax for the income year as follows: A$ Employment income from Australia
22,000
Employment income from the United States
6,000
Employment income from the United Kingdom
4,000
Rental income from the United Kingdom
1,000
Dividend income from the United Kingdom
600
Interest income from the United Kingdom
400
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740 [22.150] PRINCIPLES OF TAXATION LAW 2020 Total assessable income Expenses incurred in deriving employment income from Australia
34,000 2,000
Expenses incurred in deriving employment income from the United States
450
Expenses incurred in deriving rental income from the United Kingdom
250
Interest (debt deduction) incurred in deriving dividend income from the United Kingdom
70
Expenses (debt deduction) incurred in deriving interest income from the United Kingdom
30
Gift to deductible gift recipient
70
Total deductions
2,870
Taxable income
31,130
Foreign income tax paid Employment income from the United States
1,800
Employment income from the United Kingdom
1,200
Dividend income from the United Kingdom
60
Interest income from the United Kingdom
40
Rental income from the United Kingdom
300
Total foreign income tax paid
3,400
The taxpayer calculates the foreign income tax offset limit as follows: Step 1: Work out the tax payable on her taxable income
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Tax on $31,130: $3,079.30 (income tax = $2,456.70). Medicare levy: $31,130 × 2% = $622.60 (includes Medicare levy). Step 2: Work out the tax that would be payable if: (a) The assessable income does not include any amount in respect of which foreign income tax has been paid, provided that the tax counts towards the foreign income tax offset or other non-Australian source amounts, calculated as follows: A$ Employment income from the United States
6,000
Employment income from the United Kingdom
4,000
Rental income from the United Kingdom
1,000
Dividend income from the United Kingdom
600
Interest income from the United Kingdom
400
Total
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12,000
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22: International taxation [22.160] 741
Although the taxpayer has not paid foreign income tax on employment income of $4,000 from the United Kingdom, it is subtracted from assessable income at this step as it is from a non-Australian source. (b) Any expenses that relate to amounts included in assessable income on which foreign income tax has been paid, provided that tax counts towards the foreign income tax offset or other non-Australian amounts that are part of assessable income (excluding debt deductions). Expenses
A$
Expenses incurred in deriving employment income from the United States
450
Expenses incurred in deriving rental income from the United Kingdom
250
Total expenses
700
Note: That the debt deductions of $100 that relate to the United Kingdom dividend and interest income are not disregarded as the taxpayer does not have an overseas permanent establishment. Nor is the deduction of $70 for the gift to a deductible gift recipient disregarded, as it does not reasonably relate to the excluded assessable income amounts at step 2(a). Calculation A$ Assessable income (disregarding step 2(a) amount): Less deduction (disregarding step 2(b) amount):
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Taxable income under step 2 assumptions:
22,000 2,170 19,830
Tax on $19,830: $309.70 (income tax = $309.70. Medicare levy = not payable as below the low income threshold). Step 3: Take away the result of Step 2 from Step 1 $3,079.30 − $309.70 = $2,769.60 This is the taxpayer’s foreign income tax offset limit. Although she has paid foreign income tax of $3,400, her foreign income tax offset is limited to $2,769.60. Note: Where there is a difference between the foreign income tax that the taxpayer has paid and the offset limit, that amount cannot be carried forward to a future income year.
Accruals taxation [22.160] The accruals taxation regime aims to prevent the deferral of tax by Australian residents where income is not repatriated. The purpose of the
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742 [22.170] PRINCIPLES OF TAXATION LAW 2020 regime is to tax Australian residents on an accruals or current basis on any income or profits derived by some foreign entities where that income has not been taxed at a comparable rate in a foreign jurisdiction. The regime does not tax all deferred income; rather, it broadly aims to capture passive and highly mobile income. Traditionally, there have been three components to the accruals taxation regime: • the controlled foreign company (CFC) rules: see [22.170]; • the transferor trust measures; and • the foreign investment fund (FIF) measures. In May 2007, it was announced that the CFC, transferor trust and FIF measures would be reviewed with the aim of reducing the complexity of the current regime. Minor changes were made to the accruals regime on 24 September 2007. In particular, certain taxpayers operating within the FIF rules had the option of calculating attributable income using the CFC rules. These amendments took effect for the 2008–2009 income year. From 2010–2011, the FIF rules were repealed altogether. It was announced in the May 2013 Federal Budget that the remaining CFC reforms and foreign source attribution rules would be reconsidered after the OECD completes its examination of tax BEPS. To date, this has not occurred.
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CFC rules [22.170] The CFC regime, contained in Pt X (ss 316–468) of ITAA 1936, applies to Australian residents with a substantial interest in an Australian-CFC. Where the rules apply to a taxpayer, a share of certain income and gains is included in the taxpayer’s assessable income. To determine whether the CFC regime applies, the following process is followed. [22.180] Is the foreign company a CFC? A CFC is a non-resident company that satisfies one of three tests: the strict control test (where a group of five or fewer Australian “1% entities”, together with their associates, own or are entitled to acquire a control interest of at least 50% in the foreign company), the assumed control test (where a single Australian entity owns, or is entitled to acquire, an associate-inclusive control interest of at least 40% in the foreign company) and the de facto control test (where a group of five or fewer Australian entities, either alone or with associates, effectively controls the foreign company). [22.190] Is the taxpayer an attributable taxpayer? A taxpayer is an attributable taxpayer if he or she has an associate-inclusive control interest of 10% or more in a CFC, if the CFC is a CFC because of the application of
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22: International taxation [22.210] 743
the de facto control test, the taxpayer is an Australian 1% entity, and the taxpayer is part of a group of five or fewer Australian entities who, alone or with associates –regardless of whether the associates are Australian entities – controls the CFC. An attributable taxpayer is only attributed a certain share of the attributable income of the CFC. This is based on an attribution percentage, which is determined by reference to the taxpayer’s direct and indirect attribution interest in the CFC. [22.200] Is the CFC’s income generally exempt from accruals taxation? Generally, only amounts known as tainted income are subject to the CFC regime and only if the CFC is not mainly engaged in a genuine business. This is known as the active income test. Essentially, if the CFC’s portion of income that relates to potential tax deferral activities is less than 5%, the CFC will satisfy the active income test and will not be subject to the CFC regime. To pass the active income test, the CFC must:
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• • • • •
be a resident of a foreign country; have a permanent establishment in its country of residence; keep proper records; substantiate a claim that it meets the active income test; and have tainted income of less than 5%.
Tainted income consists of passive income (including dividends, tainted interest, rent and royalties), tainted sales income (income from the sale of goods where associated parties are involved in the transaction) and tainted services income (eg, where services are provided to a non-resident in connection with a business carried on in Australia). Controlled foreign companies located in countries that are considered to have tax systems closely comparable to Australia’s tax system are generally not subject to the CFC regime. Those countries considered comparable are referred to as listed countries. Presently, Canada, France, Germany, Japan, New Zealand, the United Kingdom and the United States are listed countries, and all other countries are unlisted countries. Controlled foreign companies located in listed countries will be exempt from accruals taxation unless it derives eligible designated concession income. Amounts generally included in eligible designated concession income are profits that are either not taxed at all or taxed at concessional rates in the foreign jurisdiction. [22.210] What is the attributable income to the taxpayer? If the CFC is not exempt from the CFC regime, it is necessary to determine the attributable
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744 [22.240] PRINCIPLES OF TAXATION LAW 2020 income of the CFC and the amount attributed to the taxpayer. The amount is calculated separately for each attributable taxpayer. Broadly, the attributable income of a CFC is its taxable income determined on the assumption that the CFC is a resident of Australia. The legislation specifically lists the amounts to be included in the calculation, with certain amounts (eg, active income of the CFC) being treated as notional exempt income.
Foreign losses [22.240] For income years 2008–2009 onwards, foreign losses are treated the same as domestic losses and can be offset against domestic income.
Taxation of foreign residents Background
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[22.250] An individual who does not come within the definition of “resident of Australia” is considered a foreign resident under the ITAA 1997 (the terminology used in the ITAA 1936 is “non-resident”). Therefore, a person who does not satisfy any of the four tests of residency is considered a foreign resident. Similarly, a company is a foreign resident where it does not satisfy any of the three tests of company residency. Foreign residents can also be partnerships, trusts or superannuation funds. The general principle under domestic tax law is that a foreign resident is taxed on income sourced in Australia. However, foreign resident status for an individual is also significant in relation to the assessment of tax, as the rate of tax applied varies from that applied to resident individuals. There are also specific rules which override the general principle. Foreign residents are potentially subject to special tax provisions on the following categories of income: • Unfranked dividends, interest and royalties paid by an Australian resident. In this case, the amounts are normally subject to withholding tax at specified rates. • Capital gains in respect of a CGT event that happens after 12 December 2006 in relation to a “taxable Australian property”. Prior to this date, a foreign resident was subject to Australian tax in relation to CGT events that happened to assets with a “necessary connection with Australia”. • Any other income derived from sources in Australia that is not exempt income.
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22: International taxation [22.280] 745
[22.260] The taxation of Australian source income of foreign residents is divided into four parts: • assessment; • withholding tax; • capital gains; and • other income. Figure 22.3 indicates the issues to consider where the taxpayer is a foreign resident. Figure 22.3: Taxation of foreign residents Taxpayer foreign resident with Australian dealings
Does the taxpayer have Australian source income subject to withholding tax? See [22.280]
Does the taxpayer have an Australian capital gain? See [22.320]
Does the taxpayer have other Australian income? See [22.340]
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Assessment [22.270] Foreign resident individuals are taxed at different rates to residents. Specifically, foreign residents do not receive the benefit of the tax- free threshold. Further, the first band of income (for the 2019–2020 income year: nil to $90,000) for a foreign resident is 32.5%. However, foreign residents are not subject to the Medicare levy of 2% of taxable income. Foreign resident companies are subject to tax at the same rate as Australian resident companies.
Withholding tax [22.280] Australia taxes foreign residents on income sourced in Australia. So, if interest, dividends or royalties are sourced in Australia, they should necessarily be taxed in Australia. As a practical matter though, it would be
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746 [22.290] PRINCIPLES OF TAXATION LAW 2020 difficult to ensure compliance where there are payments of passive income to foreign residents. Further, where there was compliance, the administrative burden would be significant, for both the taxpayer and the ATO. To overcome the problem of compliance with respect to certain categories of passive income, the withholding tax regime contained in Div 11A of Pt III of ITAA 1936 requires the payer of the dividends, interest or royalties to withhold tax. With obligation to pay the tax falling on the payer, the payment is a final tax and the foreign resident has no further liability to tax on any income derived which has been subject to withholding tax. The payer is obliged to withhold the tax and remit the withheld amount to the ATO. From 1 July 2016, a comprehensive withholding regime also applies to foreign residents who realise capital gains from transactions involving taxable Australian property. However, as described in [22.335], this is not a final tax and it operates differently to the traditional withholding tax regime. The rates of withholding tax prescribed by the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 (Cth) are as follows: • dividends: 30%; • interest: 10%; • royalties: 30%. The domestic rates are subject to the limits contained in the tax treaties discussed at [22.440].
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Dividend withholding tax [22.290] Dividends are generally assessable as statutory income under s 44(1) of ITAA 1936. However, dividends paid to a foreign resident are subject to withholding tax under s 128B of ITAA 1936 unless the dividends are specifically exempted. The primary exemption applies to those dividends which are fully franked. The exemption is provided on the basis that the dividends have already been taxed at the company rate, and, therefore, no further tax should be payable. We were introduced to the concept of the dividend imputation system in Chapter 21. Students should revise this concept. A fully franked dividend is one which has the company tax paid attaching to the dividend when distributed to the shareholder. For the purposes of foreign residents, the consequence is that the income tax has been taken out before the dividend is paid. Section 128D ensures that if a foreign resident receives a fully franked dividend, it is non- assessable non-exempt income and therefore is not subject to withholding tax. If a dividend is partly or completely unfranked, the payer is obliged to withhold tax before paying the foreign resident. However, if the dividends are paid by
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22: International taxation [22.310] 747
an Australian resident to an Australian permanent establishment of a foreign resident, the payment is exempt from withholding tax. The unfranked dividend does not need to be actually paid to the foreign resident to be subject to withholding tax. If the dividend is re-invested, accumulated or capitalised, it is deemed to be paid. For the purposes of the obligation to withhold tax, the time of the derivation of the dividends will be when the dividends are declared: see ABB Australia Pty Ltd v FCT (2007) 66 ATR 460. The rate of dividend withholding tax under the domestic provisions is 30%, but this is generally reduced to 15% under the tax treaties to which Australia is a party.
Interest withholding tax
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[22.300] Interest withholding tax is payable on amounts that are interest or in the nature of interest. This includes the common law concept of interest, as well as the statutory extension of the definition. For example, any amount that has been converted into a form that is in substitution for interest, a dividend paid in respect of non-equity shares or amounts paid under a hire purchase agreement will all be considered interest payments. Where an amount paid is interest as defined, it will be subject to withholding tax where the recipient is a foreign resident or it is paid to an Australian resident and incurred in a business carried on outside Australia through a permanent establishment. A payment is not subject to withholding tax if it is paid to a foreign resident and incurred in a business carried on through a permanent establishment in Australia. The tax must be withheld when the interest is paid or credited to the account of the foreign resident or dealt with on the foreign resident’s behalf. Any amount re-invested, accumulated or capitalised is deemed to be paid and subject to withholding tax. The rate of interest withholding tax under the domestic provisions is 10% and is not generally reduced under the tax treaties to which Australia is a party.
Royalty withholding tax [22.310] Where a payment for royalties is made to a foreign resident, the payment is subject to royalty withholding tax. A “royalty”, as defined in s 6(1) of ITAA 1936, includes the common law definition as well as, for example: • the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; • the use of, or the right to use, any industrial, commercial or scientific equipment;
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748 [22.320] PRINCIPLES OF TAXATION LAW 2020 • the supply of scientific, technical, industrial or commercial knowledge or information; • the reception of, or the right to receive, visual images or sounds, or both, transmitted to the public by satellite, or cable, optic fibre or similar technology; • the use in connection with television broadcasting or radio broadcasting, or the right to use in connection with television broadcasting or radio broadcasting, visual images or sounds, or both, transmitted by satellite, or cable, optic fibre or similar technology; and • the use of, or the right to use motion picture films, films or video tapes for use in connection with television, or tapes for use in connection with radio broadcasting. In Commissioner of Taxation v Seven Network Ltd [2016] FCAFC 70, the Full Federal Court held that payments for the broadcasting rights by Channel 7 to the International Olympic Committee were not royalties under the Australia – Switzerland Double Tax Treaty. An obligation to withhold tax arises where the payment is made by an Australian resident to a foreign resident, where the payment is not incurred by the resident in carrying on business through a foreign permanent establishment. The royalty does not need to be actually paid to the foreign resident, as long as it is dealt with on the foreign resident’s behalf.
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The rate of royalty withholding tax under the domestic provisions is 30%, but this is generally reduced to either 10% or 5% under the tax treaties to which Australia is a party.
Capital gains [22.320] From 12 December 2006, an asset held by a foreign resident can give rise to a CGT liability where a CGT event happens to taxable Australian property. [22.330] There are five categories of taxable Australian property of foreign residents: • taxable Australian real property; • an indirect interest in Australian real property; • business assets used in an Australian permanent establishment of a foreign resident; • options or rights to acquire assets in any of the above categories; and • assets where the capital gain or loss is deferred under an election when an entity ceases to be an Australian resident.
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22: International taxation [22.350] 749
A taxpayer who ceases to be an Australian resident may also have a CGT liability. Where the taxpayer is no longer an Australian resident, there is a deemed disposal at market value of any assets which are not taxable Australian property. A taxpayer who is an individual may elect to defer any CGT consequences when he or she ceases to be an Australian resident. Where there is an election, the assets are taken to be taxable Australian property until a CGT event happens or the individual becomes a resident again. As noted in Chapter 4, temporary residents are not entitled to the CGT discount. [22.335] From 1 July 2016, there is a non-final withholding tax applied to capital gains from transactions involving taxable Australian property which is subject to CGT. The tax was originally imposed at a rate of 10%, but, from 1 July 2017, this has increased to 12.5%. The obligation is on the purchaser to remit the tax to the ATO, and the seller can then claim a credit for the withholding payment upon lodgement of a tax return. For the 2016 year, only taxable Australian property with a market value of $2 million or more is subject to the withholding tax. That threshold has been lowered to $750,000 from 1 July 2017.
Other income
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[22.340] Where a foreign resident derives personal services income, that income may be assessed as having an Australian source: see Chapter 4 for the domestic source rules applicable to income from personal services. However, the domestic source rules will be overridden by any international treaties to which Australia is a party. The treaties are discussed at [22.440], and special rules apply where this is the case.
Transfer pricing [22.350] Parties to international dealings who are not dealing at arm’s length have the potential to avoid tax by manipulating the price at which the transactions occur. Taxpayers can avoid or reduce income tax payable by ensuring that the profits are located in a low-tax jurisdiction. The price manipulation may relate to the provision of goods or services. To prevent this behaviour, known as transfer price manipulation, the ITAA 1997 contains specific rules which require transactions between related parties to be undertaken at an arm’s length price. The original transfer pricing rules were contained in Div 13 of Pt III of the ITAA 1936. This Division applies where the taxpayer has entered into an international agreement with another party with whom they are not dealing at arm’s length, and the consideration paid or received was not an arm’s length consideration
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750 [22.360] PRINCIPLES OF TAXATION LAW 2020 and the Commissioner determines that the provisions should apply. From the 2013–2014 income year onwards, Div 13 has been replaced with new transfer pricing rules contained in subdivs 815-B–815-E of the ITAA 1997. These rules also replace the interim subdiv 815-A of the ITAA 1997. The purpose of the new rules is to update and provide consistency between the domestic provisions and the 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. At the time of writing, the Federal Government has indicated that it will update the transfer pricing regime to adopt the revised 2015 OECD Transfer Pricing Guidelines which are a result of the OECD’s BEPS program.
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Subdiv 815-B of the ITAA 1997 applies if an entity would otherwise get a tax advantage in Australia from cross-border conditions that are inconsistent with the internationally accepted arm’s length principle. The entity is treated for income tax and withholding tax purposes as if arm’s length conditions had operated. The consequence of subdiv 815-B of the ITAA 1997 is that if an entity gets a transfer pricing benefit from conditions that operate between the entity and another entity in connection with their commercial or financial relations, those conditions are taken not to operate, and instead, the arm’s length conditions are taken to operate. Subdiv 815-C of the ITAA 1997 applies the same principles in the context of permanent establishments, that is, the arm’s length principle will apply. Subdiv 815-D of the ITAA 1997 contains special rules for trusts and partnerships: see WR Carpenter Holdings Pty Ltd v FCT (2008) 69 ATR 29 and FCT v SNF (Australia) Pty Ltd (2011) 193 FCR 149. [22.360] The transfer pricing regime is centred on the arm’s length principle. While it is necessary to determine that there is an international agreement and the parties were not dealing at arm’s length, the basic prerequisite to the application of the transfer pricing regime is the requirement that the transactions did not occur at arm’s length. This may be because the goods or services were supplied at less or more than arm’s length consideration or for no consideration at all. The behaviour of independent parties is used as the benchmark for determining the arm’s length price. In Ruling TR 97/20, the Commissioner outlines the acceptable methodologies for determining the arm’s length price. The acceptable methodologies are divided into two groups: the three traditional methodologies and the two transactional profit methods. The methods are as follows: • Comparable uncontrolled price method –This method compares the price charged for goods or services transferred between related parties to the price charged for goods or services between unrelated parties in comparable circumstances.
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• Resale price method –This method determines an arm’s length price, where a good or service is purchased from a related party and then on-sold at a mark-up to an independent party. The price is determined by taking the price of goods or services supplied to the independent purchaser and deducting an appropriate mark- up to determine the arm’s length price of the original sale. • Cost plus method –This method determines an arm’s length price by taking the costs incurred by the supplier in a related party transaction and adding an appropriate mark-up to make an appropriate profit. • Profit split method –This method identifies the combined profit to be split for the associated enterprises from the non- arm’s length transactions and then splits those profits according to an economically valid basis compared to what would have been anticipated and reflected in an agreement made at arm’s length between independent parties. • Transactional net margin method –This method determines an arm’s length price based on comparisons at the net profit level between the taxpayer and independent parties dealing wholly independently in relation to a comparable transaction or dealings.
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In SNF (Australia) Pty Ltd v FC of T (2011) 193 FCR 149, the court held that in determining the arm’s length consideration, the focus must be on the transaction itself and the consideration paid, rather than on any subjective or special factors. This case suggested differences between the domestic law and DTAs, resulted in the interim Div 815 of the ITAA 1997 being introduced, the repeal of Div 13 of Pt III of the ITAA and the introduction of subdivs 815-B–815-D. Transfer pricing was also the central issue in Chevron Australia Holdings v FCT [2015] FCA 1092 which dealt with debt funding of an Australian investment by a foreign multinational entity. The central issue in Chevron was whether the interest rate on a loan from Chevron Texaco Funding Corporate, a wholly owned US-based subsidiary, to Chevron Australia Holdings Pty Ltd (CAHPL), the Australian parent company, exceeded the arm’s length interest rate. The facts revealed that Chevron loaned itself money via an internal transaction at a rate of 9% when it had borrowed the money from an external source at an interest rate of approximately 1.2%. The Federal Court found in favour of the ATO holding that the interest rate of the related party debt was not at arm’s length. Chevron appealed but ultimately lost its appeal to the Full Federal Court: Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation [2017] FCAFC 62. However, the reasoning of the Full Federal Court differed from the trial judge as greater emphasis was placed on the support that the taxpayer has as part of a worldwide group.
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752 [22.370] PRINCIPLES OF TAXATION LAW 2020 [22.370] To reduce the risk of audit by the ATO, taxpayers who enter into non- arm’s length international agreements should adequately document compliance with the arm’s length methodology. The International Dealing Schedule needs to be completed by taxpayers who enter into international dealings with related parties and lodged with their annual tax return. The International Dealing Schedule requires the taxpayer to disclose information about related party transactions, including: • the nature and amount of certain categories of transactions;
• • • •
details of interest-free loans; receipts or payments of non-monetary consideration; details of arm’s length methodologies used; the level of documentation held to support the selection and application of the most appropriate arm’s length methodologies; and • details of disposals of any interest in capital assets. It is often difficult for taxpayers to demonstrate compliance with the arm’s length pricing requirement, particularly where they are dealing in unusual or highly integrated products or services. Where this is the case, a taxpayer may wish to consider entering into an advance pricing arrangement whereby agreement is reached between the taxpayer and tax authority or authorities as to a suitable transfer methodology. The ATO believes that this type of arrangement offers such benefits as certainty, a solution where there may not have been one, a reduction in compliance costs and advance knowledge of the record-keeping requirements.
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Country-by-country reporting [22.375] The Tax Laws Amendment (Combating Tax Avoidance) Act 2015 added subdiv 815- E to the ITAA 97 which introduced country- by- country reporting. These changes require entities with annual global revenue of $1 billion or more to file three statements with the ATO. The measures take effect from 1 January 2016. Large multinationals operating in Australia will be required to provide this information, which will provide the Commissioner with relevant and reliable information to carry out transfer pricing risk assessments. An entity may be required to include in its statement one or more of: • a country-by-country report containing information on the location of the economic activity undertaken by the multinational group; • a master file, which provides a high-level description of the multinational group’s business operations; and • a local file, which describes the Australian entity’s operations and cross border-related party transactions.
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Australia has also signed the Multilateral Competent Authority Agreement for the automatic exchange of country-by-country reports.
Thin capitalisation [22.380] Thin capitalisation refers to the circumstances in which a taxpayer with cross-border investments has his or her deduction for interest limited according to an acceptable debt-to-equity ratio. The current thin capitalisation rules, contained in Div 820 of ITAA 1997, apply from 1 July 2001 and are subject to amendments from 1 July 2014. The former thin capitalisation rules, contained in Div 16F of Pt III of ITAA 1936, were replaced because they were not fully effective in preventing an excess of debt being allocated to the Australian operations of multinational entities. This was mainly because they only applied in limited circumstances, that is, to foreign-related party debt owed by an Australian entity in respect of inward- bound investment. The current provisions apply to an Australian entity’s total debt, rather than foreign- related party debt only, as well as both outbound and inbound investment. Amendments, effective from 1 July 2014, make the following key changes: • reducing the maximum statutory (safe harbour) debt limit from a debt- to-equity ratio of 3:1 to 1.5:1 for general entities and 20:1 to 15:1 for non-bank financial entities; • allowing the worldwide gearing ratio to be available to inbound investors and reducing the ratio from 120% to 100%;
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• increasing the safe harbour capital limit for authorised deposit-taking institutions (ADIs) from 4% to 6% of their risk weighted Australian assets; and • increasing the de minimis threshold from $250,000 to $2 million of debt deductions. [22.390] A thinly capitalised entity is one which has a high level of debt compared to its equity. Often, the thin capitalisation ratio is referred to determine whether an entity is highly geared. An entity which is funded by a high proportion of debt-to-equity, that is, a high debt-to-equity ratio, will be thinly capitalised. The purpose of the thin capitalisation rules is to limit the deduction allowed for a debt interest when an entity’s debt-to-equity ratio exceeds the specified statutory limits. Examples of debt interests are loans, bills of exchange and promissory notes. The thin capitalisation regime applies to both foreign-controlled Australian investments, that is, inward- investing entities, and to Australian entities investing overseas, as well as their associates. Taxpayers affected by the thin capitalisation provisions include not only companies but also trusts, partnerships and individuals. However, the rules do not apply to entities that
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754 [22.400] PRINCIPLES OF TAXATION LAW 2020 satisfy the de minimis rule where debt deductions are $250,000 or less in an income year. Further, the rules do not apply where the foreign assets of an entity represent 10% or less of their combined Australian or foreign assets. As a matter of practice, the thin capitalisation rules can be approached by a three-step process: 1. Do the thin capitalisation rules apply to the taxpayer? See [22.400]. 2. If the rules apply, what type of entity is the taxpayer under Div 820 of ITAA 1997? See [22.410]. 3. What are the specific thin capitalisation rules to be applied to that particular entity? See [22.420].
When do the thin capitalisation rules apply? [22.400] The thin capitalisation rules apply only in certain circumstances. The rules will not apply to: • an entity that does not incur debt deductions for the relevant tax year; • an entity that is not an inward-investing entity or an outward-investing entity; • a foreign entity that has no investment in Australia; • an entity whose debt deductions are $2 million or less for the relevant tax year; and
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• an outward-investing entity that is not foreign controlled and whose foreign assets are less than 10% of total assets. At this stage of the process, it is necessary to consider whether an entity is an outward-investing entity or an inward-investing entity. An outward-investing entity is an Australian entity that controls a foreign entity, carries on business through a foreign branch or is an associate of an entity that does either. An example is an Australian company with 51% share in a Canadian company. An inward-investing entity is an Australian entity controlled by a foreign entity or a foreign entity with an Australian branch or direct Australian investment. An example is a New Zealand company with a subsidiary in Australia. Associate entities will also be affected. An entity that is prima facie subject to the thin capitalisation rules must then be categorised.
Types of entities [22.410] The application of the thin capitalisation rules varies according to whether the entity is an inward-investing entity or an outward-investing entity, a general entity or a financial entity, or ADI. Entities will fall within one of the
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six possible categories, each containing specific thin capitalisation rules. The six categories are as follows:
• • • • • •
a general outward-investing entity; a financial outward-investing entity; a general inward-investing entity; a financial inward-investing entity; an inward-investing ADI; and an outward-investing ADI.
The concept of an inward-investing entity and outward-investing entity was discussed at [22.400]. Once it is determined which basic category the taxpayer falls into, it is necessary it consider whether it is a general, financial or ADI entity. A financial entity is an entity other than an ADI that is registered under the Financial Sector (Collection of Data) Act 2001 (Cth), a financial services licensee under the Corporations Act 2001 (Cth) that meets certain conditions or a securitisation vehicle. Finance companies and securities dealers are common examples of financial entities. Special thin capitalisation rules apply to ADIs under the Banking Act 1959 (Cth). Common examples of ADIs include Australian banks, as well as foreign banks that carry on business in Australia through a permanent establishment (branch). All other entities subject to the thin capitalisation rules are general entities.
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How are the thin capitalisation rules applied? [22.420] The maximum allowable debt is determined by reference to one of the three measures: • the safe harbour debt amount: three-fifths of the average value of the entity’s Australian assets (with some adjustments). This is commonly known as the safe harbour ratio of 1.5:1; • the arm’s length debt amount: the amount of debt that would have been borne by an independent entity carrying on the same operations in Australia (to calculate the arm’s length debt amount: see Ruling TR 2003/1); • the worldwide gearing debt amount: up to 100% of the gearing of an outward- investing entity’s Australian and foreign investments it controls. [22.430] The rules are applied as follows: • general outward- investing entities: maximum allowable debt is the greater of the safe harbour debt amount, arm’s length debt amount or worldwide gearing debt amount;
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756 [22.440] PRINCIPLES OF TAXATION LAW 2020 • financial outward-investing entities: maximum allowable debt is the greater of the safe harbour debt amount, arm’s length debt amount or worldwide gearing debt amount; • general inward- investing entities: maximum allowable debt is the greater of the safe harbour debt amount or arm’s length debt amount; • financial inward- investing entities: maximum allowable debt is the greater of the safe harbour debt amount or arm’s length debt amount; • inward-investing ADIs: minimum capital amount is the lesser of the safe harbour capital amount or arm’s length capital amount; and • outward-investing ADIs: minimum capital amount is the lesser of the safe harbour capital amount, arm’s length capital amount or worldwide capital amount.
Tax treaties
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[22.440] Currently, Australia has tax treaties, also known as tax conventions or double tax agreements (DTA), with over 40 different countries. The stated purpose of these treaties is the avoidance of double taxation and the prevention of fiscal evasion with respect to taxation. The treaties are also designed to foster co-operation between Australia and the treaty partner. While the stated purpose of the tax treaties is to avoid double taxation and prevent fiscal evasion, the practical effect of those treaties is to allocate the taxing rights between the parties to the treaty. This is generally done by limiting the source country’s right to tax (eg, placing a cap on the maximum tax it can levy) or, in certain circumstances (eg, where no permanent establishment exists), denying the source country’s right to tax at all. The treaties to which Australia is a party are part of the Australian taxation law. This is achieved by virtue of s 4(1) of the International Tax Agreements Act 1953 (Cth), which incorporates the Income Tax Assessment Acts and provides for the broad overriding effect of the treaties. Therefore, a taxpayer who is resident of a jurisdiction party to a treaty needs to consider any provisions of that treaty which may override the domestic law. Australia, currently, has tax treaties with the following countries. TABLE 22.1 Australian tax treaty partners Argentina
Ireland
Singapore
Austria
Italy
Slovakia
Belgium
Japan
South Africa
Canada
Kiribati
South Korea
Chile
Malaysia
Spain
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China
Malta
Sri Lanka
Czech Republic
Mexico
Sweden
Denmark
Netherlands
Switzerland
Fiji
New Zealand
Taipei
Finland
Norway
Thailand
France
Papua New Guinea
Turkey
Germany
Philippines
United Kingdom
Hungary
Poland
United States
India
Romania
Vietnam
Indonesia
Russian Federation
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[22.450] The primary function of the treaties is the elimination of international double taxation. Double taxation occurs when a taxpayer is subject to comparable tax on the same income in more than one country. This may occur because one country taxes the income based on residency, while another taxes the income based on source. The prevention of double taxation, as well as the elimination of international tax avoidance, is achieved by the application of broad rules which allocate the taxing right either exclusively to one of the countries or divide that right between the countries with provision for relief from double taxation. Where an exclusive right to tax is granted, that right generally goes to the country of residence. Where the right to tax is given to both the country of residence and the country of source, the country of residence is generally required to provide relief from double taxation by way of a credit or exemption. The treaties are all negotiated independently and, as such, contain different rules and terminology. However, there are commonalities between all of the agreements, particularly in relation to business profits (see [22.460]), passive income (see [22.470]), income from real property (see [22.480]) and the taxation of individuals: see [22.490]. As discussed in Chapter 4, treaties also contain provisions that deal with dual residency. In addition to the double tax conventions, Australia has entered into tax information exchange agreements (TIEAs) with various non-OECD countries. These TIEAs aim to eliminate harmful international tax avoidance and evasion practices by supporting the exchange information and improving the transparency of taxpayers’ financial arrangements and transactions.
Business profits [22.460] One of the principle allocation rules in the treaties is the business profits article. In the business profits article, which is contained in most of the Australian treaties, the profits of an enterprise in one country may be taxed
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758 [22.470] PRINCIPLES OF TAXATION LAW 2020 in the other country only if the enterprise carries on business in that other country through a permanent establishment and only to the extent that the profits are attributable to the permanent establishment. Broadly, a permanent establishment is a fixed place of business through which the taxpayer’s business of an enterprise is wholly or partly carried on. The most common example of a permanent establishment is a branch office. For the meaning of an “enterprise” within Art 7 of the double tax agreement: see Thiel v FCT (1990) 171 CLR 338, where the Full High Court held that short-term speculative gains derived by a foreign resident were profits of an enterprise.
Passive income [22.470] The categories of passive income dealt with in the treaties are dividends, interest and royalties. Each of these categories is subject to reduced withholding tax rates under the treaties. The current domestic dividend withholding tax rate is 30%; however, most treaties to which Australia is a party reduce this to 15%. The interest withholding tax rate is generally 10%, and the royalty withholding tax rate, normally 30%, is reduced to either 10% or 5% under most treaties. The exemption for franked dividends discussed at [22.290] will continue to apply even if there is a treaty.
Real property
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[22.480] The right to tax income from real property is generally allocated to the country in which the real property is located. Many of Australia’s tax treaties were signed prior to the introduction of CGT in Australia. However, in Ruling TR 2001/12, the Commissioner expresses the view that the treaties do not preclude the application of the domestic CGT provisions. The majority of Australia’s treaties contain a provision allowing the source country to tax non-residents on capital gains from the disposal of real property. Treaties also often extend the residence country’s taxing right to gains on shares in companies whose value is primarily attributable to real property within that jurisdiction. Often this will not be an issue because any capital gains will fall within the scope of the business profits article, and then, the question will be whether the taxpayer has a permanent establishment in Australia and the capital gains are connected with that permanent establishment: see Virgin Holdings SA v FCT (2008) 70 ATR 478; Undershaft (No 1) Ltd v FCT (2009) 74 ATR 888.
Individuals [22.490] There are several articles dealing with income earned by individuals.
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Income from employment, such as salary, wages or other similar remuneration, generally referred to as dependent services, is taxed in the country where the work is performed unless the taxpayer is present in that country for less than 183 days in a year and the remuneration is paid by a person not a resident of the country where the services are performed. Remuneration for the provision of independent services, other than the specific categories discussed below, is subject to tax in the taxpayer’s country of residence unless the taxpayer has a fixed base in the country where the services are performed. TR 2013/1 – “Employer” for the purposes of the short-term visit exception under Australia’s tax treaties explains the meaning of the term “employer” in the general exclusion provision provided under the Income from Employment Article, or its equivalent, of Australia’s tax treaties (“short-term visit exception”) and the approach to be taken in determining who the employer is for the purposes of the short-term visit exception.
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Australia’s treaties generally provide that annuities and pensions are only taxed in the taxpayer’s country of residence. Some treaties provide specific rules for professors and teachers, as well as students. Where such an article exists, professors and teachers normally resident of Australia teaching in another country for a period of less than two years are exempt from tax in that country. However, this article is not found in all treaties. In that case, the rules relating to dependent personal services will apply. Some treaties provide an exemption for international students in Australia where the income is sourced from outside Australia and is provided solely for the purpose of education or maintenance. Entertainers and sportspersons are generally subject to a specific article, which provides that income derived by a resident of one country as an entertainer (such as a theatre, motion picture, radio or television artiste) or a musician or as a sportsperson from that person’s personal activities in the other country may be taxed where the services are performed.
Tax information exchange agreements Risks of aggressive tax planning [22.500] TIEAs are intended to serve two purposes: complement DTAs, or be entered into with countries for which a DTA is not deemed appropriate, mainly because they have no, or low, taxes on income or profits. While TIEAs are much narrower in scope than DTAs, they are more detailed on the subject of information exchange. Australia has embraced TIEAs as a part of its efforts to combat offshore tax evasion and has entered into these agreements with jurisdictions known for their financial secrecy. The aim is to improve the transparency of ownership and accounting information and establish
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760 [22.510] PRINCIPLES OF TAXATION LAW 2020 an effective exchange of information on civil and criminal tax matters. The ATO states that the TIEA differs from a comprehensive DTA as it does not contain any provisions concerning the allocation of taxing rights over income. TIEAs also differ from the exchange of information article under the traditional international tax agreements in two ways: TIEAs are broader than international tax agreements as they cover all taxes administered by the Commissioner of Taxation and they cover criminal and civil tax matters, and they are narrower in that the information exchanged can only relate to a specific investigation occurring at the time –the information exchange article under the traditional international tax agreements allows for specific, spontaneous and Automatic Exchange of Information (AEOI).
Current TIEAs [22.510] The following table provides a current list of TIEA partners:
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Country Andorra
British Virgin Islands
Guatemala
Mauritius
St Vincent and the Grenadines
Anguilla
Brunei
Guernsey
Monaco
Turks and Caicos Islands
Antigua and Barbuda
The Cayman Islands
Isle of Man
Montserrat
Uruguay
Aruba
Cook Islands
Jersey
Netherlands Antilles
Vanuatu
The Bahamas
Costa Rica
Liberia
Samoa
Bahrain
Dominica
Liechtenstein
San Marino
Belize
Gibraltar
Macao
St Kitts and Nevis
Bermuda
Grenada
Marshall Islands
St Lucia
Other tax agreements [22.513] In 2011, Australia entered into the OECD Convention on Mutual Administrative Assistance in Tax Matters, which is a multilateral agreement designed to promote administrative cooperation in the assessment and collection of taxes with a view to combating tax avoidance and evasion. In 2014, Australia entered into an intergovernmental agreement with the United States to improve international tax compliance and to implement the US Foreign Account Tax Compliance Act (FATCA).
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In 2016, the Federal Government passed legislation to introduce the AEOI in a common reporting standard (CRS) which took effect on 1 July 2017. The OECD, at the invitation of G20 countries, developed this new single global standard for the AEOI between key authorities worldwide. This standard requires the annual AEOI relating to financial accounts obtained from financial institutions and exchanged in a common reporting format or standard. The OECD defines AEOI as the systematic and periodic transmission of “bulk” taxpayer information by the source country to the residence country concerning various categories of income. In addition, Australia signed the Mutual Competent Authority Agreement on 3 June 2015, which enables information to be exchanged between countries. The CRS is a single global standard for the collection, reporting and exchange of financial information on foreign tax residents. The regime requires banks and financial institutions to collect the information and report it to the ATO.
OECD/G20 BEPS Project OECD measures to address BEPS
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[22.517] The aim of the OECD/G20 BEPS project was to provide governments with solutions for closing the gaps in existing international rules that allow corporate profits to disappear or be artificially shifted to low/no tax environments, where little or no economic activity takes place. The final package of measures was released by the OECD in October 2015. Since then, we have seen the introduction of many of the recommendations at both a domestic and international level. Based on its 15-point action plan, the OECD made recommendations on the following:
• • • •
• •
•
•
Action 1: Addressing the Tax Challenges of the Digital Economy; Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements; Action 3: Designing Effective Controlled Foreign Company Rules; Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments; Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance; Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances; Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status; Actions 8–10: Aligning Transfer Pricing Outcomes with Value Creation;
• Action 11: Measuring and Monitoring BEPS; • Action 12: Mandatory Disclosure Rules;
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762 [22.518] PRINCIPLES OF TAXATION LAW 2020 • Action 13: Guidance on Transfer Pricing Documentation and Country- by-Country Reporting; • Action 14: Making Dispute Resolution Mechanisms More Effective; • Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties. Recommendations contained in these Actions can be implemented domestically and/or through Australia’s treaty network. To ensure countries are able to swiftly modify their bilateral treaties, the OECD designed a Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI). On 26 September 2018, Australia ratified the multilateral instrument (MLI). It entered into force for Australia on 1 January 2019.
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Australian measures to address BEPS [22.518] To date, Australia has implemented the recommendations coming out of Action 13, dealing with transfer pricing and country-by-country reporting. Australia has also taken unilateral action to amend Pt IVA of the ITAA 1936 (general anti-avoidance provisions) so that it extends to certain multinational entities. The measure, known as the Multinational Anti-Avoidance Law (MAAL), applies from 1 January 2016 where the foreign entity has annual global revenue of more than $1 billion (defined as a significant global entity). Treasury provides that the measure is intended to target situations in which: • a foreign multinational supplies goods or services to Australian customers and books that revenue offshore; • the activities of an Australian entity are integral to the Australian’s customer’s decision to purchase the goods or services; • the profits from Australian sales are subject to low or no global tax; and • one of the principal purposes of the arrangements is to obtain a tax benefit. Broadly, the MAAL applies where: • a foreign entity supplies goods or services to an Australian customer; • an Australian entity, that is an associate of or is commercially dependent on the foreign entity, undertakes activities directly in connection with the supply; • some or all of the income derived by the foreign entity is not attributable to an Australian permanent establishment; and • the principal purpose, or one of the principal purposes of the scheme, is to obtain an Australian tax benefit or to obtain both an Australian and foreign tax benefit.
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Administrative penalties have also doubled from 1 July 2015 where a significant global entity enters into tax avoidance and profit shifting schemes. From 1 July 2017, Australia has also introduced a DPT which imposes a tax of 40% on significant global entities where there is a scheme and: • a taxpayer (“the relevant taxpayer”) has obtained a tax benefit in connection with the scheme in an income year; • a foreign entity, that is an associate of the relevant taxpayer, entered into or carried out the scheme or is otherwise connected with the scheme; • the principal purpose, or one of the principal purposes of the scheme, is to obtain an Australian tax benefit or to obtain both an Australian and foreign tax benefit; and • none of the following exceptions apply: – the $25 million income test; – the sufficient foreign tax test; and – the sufficient economic substance test.
Questions [22.520]
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22.1 The following are the current year details of Angelo’s income, expenses and the foreign tax he paid. All of Angelo’s foreign income amounts have been converted to Australian dollars. Gross income
$
Employment income from Australia
44,000
Employment income from the United States
12,000
Employment income from the United Kingdom
8,000
Rental income from property in the United Kingdom
2,000
Dividend income from the United Kingdom
1,200
Interest income from the United Kingdom Total gross income
Expenses
800 68,000
$
Medical expenses
5,000
Expenses incurred in deriving employment income from Australia
4,000
Expenses incurred in deriving employment income from the United States
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900
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764 [22.520] PRINCIPLES OF TAXATION LAW 2020 Expenses incurred in deriving rental income from the United Kingdom
500
Gift to a deductible gift recipient
400
Interest (debt deductions) incurred in deriving dividend income
140
Expenses (debt deductions) incurred in deriving interest income Total expenses Foreign tax paid Employment income from the United States Dividend income from the United Kingdom
$ 3,600 120
Interest income from the United Kingdom
80
Rental income from the United Kingdom
600
Total foreign tax paid
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60 11,000
4,400
Determine Angelo’s foreign tax offset. 22.2 What do you see as the rationale for the use of the arm’s length price? Consider the acceptable methods for determining the arm’s length price. Do you believe they represent a “reasonable” transfer price between related parties? 22.3 Consider the Australian-Canadian Double Tax Agreement. Discuss the tax consequences of the following income amounts under that treaty: (a) business profits derived by a resident of one country from a “permanent establishment” in the other country; (b) dividends, interest and royalty income; (c) income from real property; (d) income from international operations of ships and aircraft; (e) income earned by an employee; (f) income earned by government officials; (g) income earned by public entertainers and athletes; and (h) students visiting the foreign country. 22.4 Kangaroo Wines Pty Ltd is a business which produces wines in Australia. Each bottle is produced at a cost of $5 which it sells unrelated foreign distributors at $10 each. It also sells nearly identical wine to Koala Wines Co, a controlled foreign subsidiary, which resells the wine to unrelated consumers at 20. (a) What transfer pricing method should be used and at what price? (b) What difference would it make if the only activity performed by Koala Wines Co is to resell the wine in a foreign market and it is determined that export distribution firms operating independently earn commissions of 20% on the purchase and sale of comparable products?
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(c) What difference would it make if Kangaroo wines Pty Ltd sells wine to Koala Wines Co without any brand name affixed? Koala Wines Co affixes its valuable brand name on the wine and sells the wine to customers in foreign markets. It is determined that the practice in industries similar to wine selling is to obtain a gross profit of 40% of the costs of production. 22.5 The Multilateral Instrument (MLI) entered into force for Australia on 1 January 2019. What are the consequences for Australia? How does the MLI modify the operation of Australia’s tax treaties? Provide examples of modifications.
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Part 6 Avoidance and Administration
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Parts 2–5 of this book focused on the substantive provisions of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) which enabled us to determine a taxpayer’s income tax liability. Throughout these parts, the issue of compliance was often alluded to but not dealt with in detail. Yet it is generally understood that there are certain obligations imposed on a taxpayer, to both undertake certain behaviour and not undertake other behaviour. For example, a taxpayer with assessable income is under a positive obligation to lodge an annual tax return and under a negative obligation not to partake in tax avoidance so defined. In Part 6, the specific compliance requirements of the income tax regime are examined. Chapter 23 considers the anti- avoidance regimes. It compares the concepts of tax evasion and tax avoidance with legitimate tax minimisation and considers the consequences of a taxpayer engaging in behaviour which fails to comply with either the ITAA 1997 or the ITAA 1936. As well as discussing specific anti- avoidance provisions, such as the requirement for arm’s length pricing between related parties, Chapter 23 provides a detailed analysis of Pt IVA of ITAA 1936. Part IVA contains the general anti- avoidance provisions which were introduced to strike down “blatant, artificial or contrived arrangements”. Chapter 23 also provides a comprehensive discussion of key anti- avoidance areas and the provisions dealing with personal services income. Once a taxpayer has calculated taxable income, determined according to the tax formula discussed in Parts 2–5, it is necessary to consider the assessment process as well as any other administrative requirements.
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768 PRINCIPLES OF TAXATION LAW 2020
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Thus, Chapter 24 considers the administrative regime which applies to all stakeholders. This includes not only the taxpayer but also tax agents and the Australian Taxation Office (ATO). The rights and obligations of these stakeholders are considered in the context of the assessment process, objections, reviews and appeals, and the role of the ATO.
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23
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Tax avoidance Key points................................................................................................... [23.00] Introduction............................................................................................... [23.10] Specific vs general anti-avoidance provisions........................................ [23.20] Common tax avoidance techniques......................................................... [23.30] Avoiding Australian-sourced income by non-residents.................... [23.40] Deferring income derivation or accelerating deductions.................. [23.50] Income splitting between family members....................................... [23.60] Converting income to capital.............................................................. [23.70] Choice of entity................................................................................... [23.80] Use of tax shelters............................................................................... [23.90] International tax avoidance.............................................................. [23.100] Tax rate arbitrage.................................................................................. [23.102] Hybrid entities....................................................................................... [23.104] Hybrid instruments............................................................................... [23.106] Specific anti-avoidance provisions........................................................ [23.110] Non-arm’s length prices between associated parties..................... [23.120] Transfer of right to income from property....................................... [23.130] Deemed dividends for private companies....................................... [23.140] Non-commercial losses.................................................................... [23.150] Personal services income................................................................. [23.160] What is personal services income?...................................................... [23.170] Deductions with respect to personal services income....................... [23.180] Personal services business..................................................................... [23.190] Results test........................................................................................ [23.200] Unrelated clients test........................................................................ [23.210] Employment test............................................................................... [23.220] Business premises test..................................................................... [23.230] Personal services business determination.......................................... [23.240] Specific anti-avoidance regimes for international transactions...... [23.250] General anti-avoidance provision –Part IVA........................................ [23.260] Introduction....................................................................................... [23.260] Key elements of Pt IVA..................................................................... [23.270] Scheme.................................................................................................. [23.280]
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770 [23.00] PRINCIPLES OF TAXATION LAW 2020 Tax benefit............................................................................................. [23.290] Dominant purpose................................................................................ [23.300]
High Court case on Pt IVA................................................................ [23.310] Application of Part IVA to specific transactions................................... [23.320] Leasing............................................................................................... [23.320] Agricultural schemes........................................................................ [23.330] CGT losses through wash sales....................................................... [23.340] Questions.................................................................................................. [23.350]
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Key points [23.00] • Tax evasion is illegal, involving fraud by telling lies to the ATO, deliberate concealment of material facts or entering into sham transactions. In contrast, tax avoidance is not illegal in the sense that a taxpayer attempts to use lawful means to reduce tax liability. • Legitimate tax planning consists of taking advantage of concessions and loopholes in the tax law. • The tax law has numerous specific anti-avoidance provisions which are designed to deal with particular tax avoidance arrangements. • Part IVA of the ITAA 1936 contains a general anti-avoidance regime designed to deal with tax avoidance arrangements that are not addressed by specific anti- avoidance provisions. It is not self- enforcing. The Commissioner must determine if a person has entered into a scheme for the sole or dominant purpose of enabling a taxpayer to obtain a tax benefit from the scheme. If so, the Commissioner is empowered to cancel the tax benefit. • There are eight criteria set out in s 177D(b) of the ITAA 1936 to ascertain the objective purpose of a person entering into the scheme. The subjective purpose is not relevant.
Introduction [23.10] Tax minimisation arrangements represent a spectrum ranging from legitimate tax planning through to blatant tax avoidance and, ultimately, tax evasion. Tax evasion involves the reduction or elimination of tax liability by illegal means, such as fraudulent concealment of transactions, supplying false information to the Australian Taxation Office (ATO), entering into sham transactions or the simple refusal to pay tax by companies operated through dummy directors as occurred in the bottom-of-the harbour schemes of the 1980s. In contrast, tax avoidance is not illegal. Nevertheless, the transaction may be prohibited by specific anti-avoidance provisions or the general anti-avoidance provision in Pt IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). Leaving aside tax evasion, there is difficulty distinguishing between acceptable
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general anti-avoidance provision. For example, a taxpayer has a legitimate commercial transaction which can be achieved by two different methods, one of which results in the paying of less tax. Should the taxpayer be obliged to adopt a course of action resulting in a greater tax liability? The High Court in Fletcher v FCT (1991) 173 CLR 1 stated that taxpayers were not in general obliged to structure transactions in such a way as to attract greater tax liability. Case study 23.1: Entitlement to minimise tax liability IRC v Duke of Westminster [1936] AC 1 is the general starting point of discussions on tax avoidance. In that case, the Duke employed a gardener for domestic purposes so that the salary was not deductible. The employment contract was discharged and the gardener was given an annuity which guaranteed the same payments as the employment contract, but imposed no obligation to work. The gardener continued to carry out the same work as when he was employed. Under the UK law as it then stood, the Duke was entitled to a deduction for this arrangement. The House of Lords held that there was no basis for construing the annuity as equivalent in substance to the earlier arrangement. Their Lordships affirmed the principle that every person is entitled to order his [or her] affairs so as to attract the least tax. Figure 23.1 lays out the key issues discussed in this chapter.
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Figure 23.1: Overview of key issues
Tax avoidance
Common tax avoidance techniques
Anti-avoidance previsions
Specific anti-avoidance provisions
Scheme
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General anti-avoidance provisions
Tax benefit
Sole or dominant purpose
Applying Part IVA to specific transactions
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772 [23.20] PRINCIPLES OF TAXATION LAW 2020
Specific vs general anti-avoidance provisions [23.20] The income tax law has numerous specific anti-avoidance provisions which are designed to deal with particular tax avoidance arrangements. For example, dividend made by a private company to its shareholder that is disguised as a loan to the shareholder is one of the targets of the specific anti- avoidance provisions in Div 7A of the ITAA 1936 (see [23.140]). In contrast, the general anti-avoidance provision in Pt IVA of the ITAA 1936 has no specific target. Instead, it is designed to tackle any tax avoidance scheme provided the Commissioner determines that the scheme should be subject to Pt IVA (see [23.260]). In general, if a tax avoidance transaction is subject to both a specific anti-avoidance provision and Pt IVA, the former has priority.
Common tax avoidance techniques [23.30] There are many techniques of tax avoidance. Nevertheless, certain themes recur, some of which are briefly discussed in the following paragraphs.
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Avoiding Australian-sourced income by non-residents [23.40] This occurs frequently in the mining industry where a project between an Australian resident and a non-resident is set up as a joint-venture that does not constitute a partnership and where agency is specifically excluded. The Australian party will perform activities within Australia and be liable to tax. The non-resident will perform activities outside Australia deriving foreign-sourced income which is not subject to Australian income tax. The government enacted s 6CA of the ITAA 1936 to ensure that in general it has the taxing right over income derived from natural resources of Australia. In particular, the section deems that in broad terms income derived by a non- resident from natural resources produced or recovered in Australia to be of an Australian source.
Deferring income derivation or accelerating deductions [23.50] Following Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314, prepayments of income for services are generally derived when the services
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are provided in later years. In this regard, the tax law principle is consistent with the accounting principles. In contrast, the meaning of “incurred” does not depend on the actual payment date. Many structures were designed to exploit this particular tax accounting rule (eg, from FCT v Australian Guarantee Corporation Ltd (1984) 15 ATR 982 to FCT v Citilink Melbourne Ltd (2006) 62 ATR 648). Most of these timing advantages are now eliminated under the Taxation of Financial Arrangements (TOFA) rules (see [9.70]). Specific anti-avoidance provisions were enacted to deal with prepayments which are designed to accelerate deduction: subdiv H of Div 3 of Pt III of the ITAA 1936 (see Chapter 16 for a discussion of the rules).
Income splitting between family members [23.60] Income splitting between family members is a typical example of tax arbitrage designed to take advantage of the different tax profiles of the family members. For example, in a discretionary trust, income may be distributed to children over 18 who are subject to low marginal tax rates, capital gains may be distributed to beneficiaries who have capital losses, and a corporate beneficiary may cap the overall tax rate to 30%.
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As tax rates have been progressively flattened over the last 20 years, this technique is less critical than it used to be. The top marginal tax rate at one stage was 66% and in the early 1980s was 60%, which applied to an income of $34,000 a year. The top marginal tax rate now is 46.5%, which still provides incentive to this technique.
Converting income to capital [23.70] Ever since the enactment of the Commonwealth income tax legislation in 1915, it has been conventional wisdom that it is better to have a capital receipt than an income receipt. This was especially true before CGT was introduced in 1985. Capital receipt may remain preferable for taxpayers with pre-CGT assets, and individuals who are eligible for the 50% discount (see Chapter 11 for a discussion of the CGT rules).
Choice of entity [23.80] Partnerships and trusts have the advantage that in general the character of income is preserved upon distribution to the partners and beneficiaries respectively. Any CGT concession at the partnership or discretionary trust level flows through to the individuals concerned. Furthermore, as discretionary
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774 [23.90] PRINCIPLES OF TAXATION LAW 2020 trusts are not subject to CGT event E4, they do not suffer from the clawback of tax preferences. In contrast, regardless of the character of income at the company level, distributions of profits to shareholders will in most cases be dividends and thus taxable to the shareholders. See the respective chapters on the taxation of entities for more discussion of the rules.
Use of tax shelters [23.90] Tax shelter is not a defined term in the tax law. In general, it refers to a legal method of minimizing a taxpayer’s tax liability and ranges from particular forms of investment that provide favourable tax treatment to particular activities or transactions that reduce taxable income. Examples include superannuation and main residence exemptions. They are specific concessions provided in the tax law and can be regarded as legitimate tax planning. For instance, taxpayers may salary sacrifice future income for which services have not already been provided into superannuation giving an effective tax rate of 15% (see Chapter 18 for discussion of the rules).
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International tax avoidance [23.100] Globalisation provides opportunities for multinational enterprises (MNEs) to engage in international tax avoidance. They can achieve tax arbitrage not only within the domestic tax provisions, but also between the differential tax treatments offered by different countries. Detailed discussion of these issues is beyond the scope of this book. The following paragraphs aim to provide three examples illustrating some of the basic techniques of international tax avoidance.
Tax rate arbitrage [23.102] MNEs may take advantage of the different tax rates applicable to their subsidiaries and shift profits to the low-tax countries. For example, if a foreign subsidiary enjoys a flat 10% tax rate on its income, while the parent company in Australia is subject to tax at 30%, the tax rate differential creates incentive for the group to shift profits from Australia to the low-tax subsidiary by say creating intra-group payments from the parent to the subsidiary. This is achievable as the group operates as one single enterprise in substance, while the international tax rules in general adopt the separate entity doctrine under which each company is treated as a separate taxpayer. Of course, in practice, the structure has to be carefully designed to avoid the application of anti-avoidance provisions, including transfer pricing and thin
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Hybrid entities [23.104] International tax arbitrage can be achieved by exploiting the different treatments of an entity in two countries. Hybrid entities in general refer to entities that are treated as a company in one country and as a look-through entity (eg, a branch or partnership) in another country. Double deduction may be achieved through the use of hybrid entities. For example, an entity is treated as a company in Australia and thus can deduct its expenses here. If the entity is treated as a look-through entity in another country, the same expenses would be regarded as incurred by the shareholders in that country and thus deductible again in the shareholders’ tax returns.
Hybrid instruments
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[23.106] Again, different tax treatments of a financial instrument in two countries may give rise to tax arbitrage opportunities. For example, an Australian company has a wholly owned subsidiary in a foreign country. It issued financial instruments to the subsidiary, which are treated as shares for Australian income tax purposes. Therefore, dividends paid by the subsidiary are non-assessable non-exempt income to the parent company (see [22.90]). However, the same financial instrument may be treated as a debt in the foreign country. The subsidiary can therefore claim deduction on the payments to the parent company. In other words, the MNE can claim deductions from the intra-group payments in the source country but does not have to pay tax on those payments in the resident country. Hybrid entities and instruments are the focus of Action 2 in the OECD’s Base Erosion and Profit Shifting Project. For more detail of the project, see [22.517]. In response to the OECD’s recommendations in Action 2, Australia has introduced hybrid mismatch rules in Division 832 ITAA 1997, which in general applies to income years starting on or after 1 January 2019.
Specific anti-avoidance provisions [23.110] The tax law is peppered with numerous specific anti- avoidance provisions, including rules dealing with: • non-arm’s length prices between associated parties; • deemed dividends for private companies; • non-commercial losses; and • personal services income. These provisions are discussed in the following paragraphs.
Non-arm’s length prices between associated parties [23.120] There are several specific anti-avoidance provisions in the tax law
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776 [23.130] PRINCIPLES OF TAXATION LAW 2020 1997 (Cth) (ITAA 1997) stipulates that excessive payments to related entities shall be reduced to so much as the Commissioner considers reasonable for the purposes of deductions. Symmetric treatment is provided to the recipient who is not taxed on the excess. Similarly, s 70-20 of the ITAA 1997 ensures that where trading stock has been purchased in a non-arm’s length transaction at a price higher than the market value, the amount of deduction is limited to the market value. There are also market value substitution rules in the CGT regimes dealing with non-arm’s length amounts with respect to cost base, reduced cost base and capital proceeds: ss 112-20 and 116-30 of the ITAA 1997, respectively.
Case study 23.2: Trading stock purchased at overvalue from associate In Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430, the taxpayer purchased trading stock at above market value from an associated company owned by family members. The effect of the transaction was to direct income to family members. The High Court upheld this transaction. Section 70-20 of the ITAA 1997 was enacted to override the court decision.
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Paradoxically, there is no specific provision dealing with the situation where a taxpayer has sold trading stock below market value to an associate. Where such a sale is substantially below market value, it may constitute a disposal outside the ordinary course of business and be deemed to have disposed of at market value under s 70-90: Pastoral & Development Pty Ltd v FCT (1971) 2 ATR 401. For depreciating assets, there are similar specific anti-avoidance provisions adjusting the cost and termination value, respectively, to market value: s 40- 180(2) Item 8 and s 40-300(2) Item 6 of the ITAA 1997. International transfer pricing between related parties poses serious challenges to tax authorities around the world. See [22.350]–[22.370] for a discussion of the issues.
Transfer of right to income from property [23.130] Income splitting may be achieved by transferring the right to income from property to an associate without transferring the property itself. For example, a taxpayer with an investment property may transfer the right to the rental income to a relative. In seeking to discourage this kind of arrangements, the government introduced Div 6A of the ITAA 1936. In broad terms, if a taxpayer transfers a right to receive income from property to an associate for
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less than seven years and the consideration received by the transferor is less than the arm’s-length amount, the transfer is ignored for income tax purposes and the income in question remains as assessable income of the transferor: s 102B of the ITAA 1936. Where a transfer of right to receive income from property is not subject to s 102B, in general s 102CA applies and the amount of consideration in respect of the transfer is included in the assessable income of the transferor.
Deemed dividends for private companies [23.140] Division 7A of the ITAA 1936 is designed to deem certain payments and loans by private companies to their shareholders as dividends paid out of profits. The Division is a specific anti-avoidance regime to tackle arrangements of disguising dividends as say salaries or loans to shareholders. See [21.110]– [21.130] for a discussion of the regime.
Non-commercial losses
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[23.150] High-income earners may reduce their tax liabilities by engaging in small businesses (such as hobby farms) with the aim to claim deductions of the losses incurred in the business against their assessable income. They may even build up a capital asset which could be sold later and enjoy CGT concessions such as the 50% discount. Division 35 of the ITAA 1997 is the specific anti-avoidance regime to deal with this kind of arrangements. In broad terms, if the Division applies, the losses of a non-commercial business carried on by an individual are quarantined and cannot be used to offset against other assessable income of the taxpayer. Instead, they can be carried forward to offset against future assessable income of the business. Case study 23.3: Hobby farms regarded as a business In Ferguson v FCT (1979) 9 ATR 873, the taxpayer was a naval officer who leased five cows for the purposes of breeding. It was held that he was carrying on a business and was able to write off losses against his salary. In FCT v Walker (1985) 16 ATR 331, it was held that the taxpayer carried on business through a manager 1,000 km away of breeding from a single female angora goat. He was able to deduct losses against his public service income. For a more detailed discussion of whether a taxpayer is carrying on a business, see Case Studies [8.20] and [8.21].
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778 [23.160] PRINCIPLES OF TAXATION LAW 2020 Division 35 is designed to ensure that such losses are quarantined, unless among other things the taxpayer satisfies one of the following exceptions: (1) the assessable income from the business for the income year is at least $20,000; (2) the business made a profit for income tax purposes in at least three of the past five income years, including the current year; (3) the total value of real property used in the business is at least $500,000; or (4) the total value of other assets (excluding motor vehicles) used in the business is at least $100,000. These exceptions are not available to taxpayers with adjusted taxable income of $250,000 or more: s 35-10(2E) of the ITAA 1997. This is an integrity measure to ensure that high-income earners cannot escape from the operation of Div 35 through these exceptions. Division 35 does not apply to losses incurred in primary production or professional arts businesses provided the taxpayer’s assessable income (excluding net capital gain) from other sources in the income year is less than $40,000: s 35-10(4) of the ITAA 1997.
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Personal services income [23.160] An individual taxpayer may seek to avoid paying tax on his salaries at his marginal tax rate by deriving the income through a company, trust or partnership. The specific anti-avoidance regime dealing with this kind of arrangements is the personal services income regime in Divs 84–87 of the ITAA 1997. If the regime applies, in general the income derived by the company, partnership or trust is deemed to be assessable income of the taxpayer, unless the amount is paid promptly to the individual as salaries: s 86-15 of the ITAA 1997. The ATO’s position on the issue of personal services income regime is explained in TR 2001/7. Even if a taxpayer is not subject to the personal services income regime, Pt IVA may still apply: see note to s 86-10. For example, the taxpayers in FCT v Gulland; Watson v FCT; Pincus v FCT (1985) 160 CLR 55 could satisfy the separate premises test, but may still attract the operation of Pt IVA.
What is personal services income? [23.170] Section 84-5 of the ITAA 1997 provides that income of a taxpayer is personal services income if it is mainly derived as a reward for personal efforts or skills. For example, a company providing computer programming services where that company uses the equipment and software of the client would fall
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within the definition. By way of contrast, where a company owns a semitrailer used in its transportation business, the income will not be personal services income because it is mainly produced by the use of the semitrailer. The critical factor is the amount of machinery and equipment and other assets used by the taxpayer to produce income. Where these assets are minimal, the proceeds will generally be personal services income: see generally TR 2001/7.
Deductions with respect to personal services income [23.180] In general, an individual who is not conducting a personal services business cannot deduct expenses that would not have been deductible if the taxpayer is an employee: s 85-10 of the ITAA 1997. For example, normally travelling expenses to and from work are not deductible: Lunney v FCT; Hayley v FCT (1958) 100 CLR 478. However, s 85-10 does not disallow expenses incurred to: • gain work through advertising, tendering or quoting for work; • insuring against loss of income or income-earning capacity; • engaging a non-associate to perform work; or
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• contributing to superannuation fund. Deductions for rent, mortgage, interest, rates and land tax for an individual taxpayer’s residence are disallowed if the amounts are related to producing personal services income: s 85-15 of the ITAA 1997. Monies paid to associates in relation to the production of personal services income is also not deductible, unless the payment is made for the associate to perform part of the principle work that generates the personal services income: s 85-20 of the ITAA 1997.
Personal services business [23.190] The personal services income regime does not apply where an individual or personal services entity (PSE) is carrying on a “personal services business”. This will be the case where one of the four tests stipulated in Div 87 of the ITAA 1997 is met: (1) results test; (2) unrelated clients test; (3) employment test; and (4) business premises test. If the results test is satisfied, there is no need to proceed to any of the other three tests. The personal services income is not included as assessable income of the individual under Div 35. If an individual fails the results test, he/ she cannot rely on the other three tests if among other things, at least 80% of
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780 [23.200] PRINCIPLES OF TAXATION LAW 2020 the personal services income (excluding amounts received as an employee) is derived from the same entity (including its associates): s 87-15(3). TR 2001/8 explains the ATO’s position on the issues with respect to a personal services business. A taxpayer may also be exempt from the personal services income regime if the ATO has made a personal services business determination. The four tests for personal services business and the PSB determination are discussed in the following parts.
Results test [23.200] The object of this test is to protect genuine independent contractors from the application of Div 35 and allow them to carry on a personal services business through an entity, such as a company, trust or partnership. Pursuant to s 87-18 of the ITAA 1997, an individual or PSE in general satisfies the results test in an income year if: • at least 75% of the personal services income (excluding amounts received as an employee) is for producing a result; • the individual or PSE is required to supply the plant and equipment needed to produce the result; and • the individual or PSE is liable for the cost of correcting any defect in the work performed.
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Case study 23.4: Results test In Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162, the taxpayer was a company controlled by an information technology consultant. It had applied for a personal services business determination (PSBD) unsuccessfully and appealed to the AAT unsuccessfully. Almost all of its income was derived from a client called PIC and the contracts with that client did not provide that the taxpayer or the consultant would be liable for the cost of rectifying any defects. The consultant was required to attend the place of work in the core hours of 9.30 am to 3.30 pm on business days and was under no obligation to supply any tools or equipment. Accordingly, the results test was not satisfied. The taxpayer in Re Nguyen and FCT (2005) AATA 876 also failed the results test. In that case, the taxpayer provided personal services to the ATO where he supplied minimal equipment, was under supervision and was subject to the ordinary annual performance evaluation of other employees.
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Unrelated clients test [23.210] Pursuant to s 87-20 of the ITAA 1997, an individual or PSE satisfies the unrelated clients test if among other things: • the individual or PSE derives income from providing services to two or more entities that are not associates of each other and are not associates of the individual or PSE. For this purpose, different government departments of the Commonwealth or States count as different entities; and • the services are provided as a result of having made offers or invitations (eg, advertising) to the public. It is not enough to meet this requirement by being available to provide the services through an entity that conduct a business of arranging for persons to provide services directly to its clients. Case study 23.5: Unrelated clients test In Cameron v Commissioner of Taxation [2012] FCAFC 76, the taxpayer and his wife provided through their company drafting services from business premises where they also carried on business as provedores which involved supplying goods to ships. In the relevant years, they had a number of clients contacted by e-mails and telephone calls and were thus able to satisfy the first limb of the unrelated clients test.
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The taxpayers however failed to satisfy the requirement in the second limb of the test. The offers had been made to specific individuals known to the taxpayer and these offers did not extend to other members of the public. There was no attempt to advertise generally to the public.
Employment test [23.220] Pursuant to s 87-25 of the ITAA 1997, an individual in general satisfies the employment test in an income year if he/she engages at least one entity (other than associates of the individual) to perform work that represents at least 20% by market value of the individual’s principal work for that year. It is clear that this test will not be met where the person employed performs only auxiliary activities such as typing, cleaning and filing. If the taxpayer in question is a PSE, the same test applies except that work performed by individuals whose personal services income is included in the PSE’s assessable income are excluded from the 20% test. The employment test is also met where an individual or PSE employs at least one apprentice for at least half of the income year.
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782 [23.230] PRINCIPLES OF TAXATION LAW 2020
Business premises test [23.230] Pursuant to s 87-30 of the ITAA 1997, an individual or PSE in general satisfies the business premises test in an income year if at all times during the income year, the individual or PSE uses business premises to conduct activities that generate the personal services income. The individual or PSE can satisfy this test even if it uses several different business premises during the year. The individual or PSE must have exclusive use of these premises which must be physically separate from the private premises of the individual, PSE or their associates. The business premises must also be physically separate from the premises of the entity (or its associates) that acquires the services of the individual or PSE. These requirements are designed to distinguish between disguised employment and genuine personal services business.
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Case study 23.6: Business premises test In FCT v Dixon Consulting Pty Ltd (2006) 65 ATR 290, the PSE of Mr Dixon operated its consulting business from an office above a garage which was on the same block of land as Mr Dixon’s private residence. The garage was physically separate from the private residence and was used by Mr Dixon and his wife for private purposes. The AAT originally decided that the PSE satisfied the business premises test on the basis that the office was physically separate from the private residence. On appeal, the Federal Court held that the AAT had erred and had to reconsider the issues of whether the PSE satisfied the “exclusive use” and “physically separate” requirements. The AAT decided in the rehearing that the PSE did not have the exclusive use of the garage/office building due to the private use of the garage, and thus failed the business premises test. The taxpayer in Cameron v Commissioner of Taxation [2012] FCAFC 76 discussed in Case Study [23.5] also failed the business premises test because the office premise was used mainly for his provedore business (which is not subject to the personal services income regime) rather than the drafting business. In determining whether the premise was used mainly for personal services business, both time and floor area were relevant factors to consider.
Personal services business determination [23.240] An individual or a PSE covered by a personal services business determination is deemed to be carrying on a personal services business and thus not subject to the personal services income regime. This is so even if the individual or the PSE would have failed the four tests discussed above.
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The detailed rules with respect to personal services business determination are stipulated in subdiv 87-B of the ITAA 1997. In very broad terms, the Commissioner may issue a personal services determination if he is satisfied that, among other things, unusual circumstances have prevented the taxpayer from satisfying the tests: s 87-60 of the ITAA 1997. Examples of “unusual circumstances” with respect to the unrelated client test include (1) the taxpayer fails the test in an income year because it has just started the business in this income year and can reasonably be expected to meet the test in subsequent income year; and (2) the taxpayer provides services to only one client this income year, but has met the test in preceding income years and can reasonably be expected to meet the test in subsequent income years: s 87-60(4) of the ITAA 1997.
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Case study 23.7: Unusual circumstances The ATO states in TR 2001/8 paragraphs 96 and 97 that the term “unusual circumstances” refers to “exceptional circumstances that are temporary, with the likelihood that the usual circumstances will resume in the short term … Unusual circumstances that exist … for less than 12 months would not be regarded as having become usual circumstances, except where that time period is significant having regard to the nature of the activity”. The ATO position must be contrasted with the decision in Creaton Pty Ltd v FCT [2002] AATA 1121. In that case, the taxpayer provided the personal services to just one entity (a not-for-profit special purpose vehicle) from the 1995 to 2001 tax years. That client went into voluntary liquidation in 2001 because its purpose had been achieved. The taxpayer satisfied the unrelated clients test for several tax years before 1995, and also for the 2002 tax year. The Tribunal held that the taxpayer had experienced unusual circumstances because it had met the unrelated clients test in one or more preceding income years and could reasonably be expected to meet the unrelated clients test in subsequent income years. In particular, the Tribunal held that the reference to “preceding income year” was not a reference to the immediately preceding income year.
Specific anti-avoidance regimes for international transactions [23.250] The tax law contains a number of specific anti-avoidance regimes targeting international tax arrangements, including the controlled foreign company regime, thin capitalisation regime and transfer pricing provisions. See Chapter 22 for a discussion of these regimes.
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784 [23.260] PRINCIPLES OF TAXATION LAW 2020
General anti-avoidance provision –Part IVA Introduction [23.260] The presence of a general anti- avoidance provision in the tax law reflects the serious challenge posed by the ingenuity of the army of tax advisors. It is impossible in practice for the government to enact specific anti- avoidance provisions to cover every tax avoidance scheme. Originally, the general anti-avoidance provision was contained in s 260 of the ITAA 1936. That section was so comprehensive that it could potentially apply to almost any transaction and the judges accordingly read into the section a number of limitations which eventually made it ineffective. As a result, a new general anti-avoidance provision in Pt IVA of the ITAA 1936 was enacted in 1981. Part IVA applies to schemes entered into after 27 May 1981 and was designed to strike down arrangements that are “blatant, artificial or contrived”, but it was not intended to have effect on arrangements of “a normal business or family kind, including those of a tax planning nature”. As discussed below, it may be relatively easy to state the key elements of Pt IVA. However, it is often difficult to see why it applies in some cases but not in others. Specific provisions were inserted in Pt IVA in 2016 and 2017 to address certain international tax avoidance structures of MNEs. See [22.517] for more detail.
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Key elements of Pt IVA [23.270] There are three key elements in Pt IVA. First, there must be a “scheme” as defined in s 177A. Second, a taxpayer must obtain from the scheme a “tax benefit” as defined in s 177C. Finally, a person must have entered into the scheme for the sole or dominant purpose of enabling the taxpayer to obtain the tax benefit: s 177D. Where all the elements are satisfied, the Commissioner is empowered to cancel the tax benefit by, for example, including the amount in assessable income or denying the deduction of the amount: s 177F. In 2013, the government enacted amendments to Pt IVA as it believed that a number of Full Federal Court cases had revealed weakness in the general anti- avoidance provision, in particular the concept of tax benefit and its interactions with the other elements of Pt IVA. The government was concerned that some taxpayers had argued successfully that they did not get a tax benefit because in the absence of the scheme, they would have done nothing at all or would have entered into a different scheme that also avoided tax.
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The amendments apply retrospectively to schemes that are entered into on or after 16 November 2012. In essence, they are designed to clarify that in determining whether a taxpayer has obtained a tax benefit, what the taxpayer would have reasonably expected to have done in lieu of the scheme must be ascertained on a postulate that is a reasonable alternative to the scheme, having particular regard to the substance of the scheme and its effect for the taxpayer, but disregarding any potential tax costs: s 177CB(3) and (4) of the ITAA 1936. Furthermore, the amendments also reflected the government’s belief that the application of Pt IVA would be more effective if the dominant purpose element is considered first before the other elements: s 177D(1) and (2) of the ITAA 1936. The three key elements of Pt IVA are discussed in the following paragraphs.
Scheme [23.280] “Scheme” is defined in s 177A(1) of the ITAA 1936 as: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or whether intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct.
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A scheme may be unilateral and does not require more than one person: s 177A(3). The concept of a scheme is important to the operation of Pt IVA for two reasons. First, Pt IVA applies only if a person has entered into a scheme with the sole or dominant purpose of enabling a taxpayer to obtain a tax benefit. It implies that in general a taxpayer may tend to argue for a “broad” scheme which involves many steps with the aim of minimising the risk of being regarded as having a “sole or dominant purpose” for the tax benefit. In contrast, the ATO may tend to argue for a “narrow” scheme that involves only a few steps, so that the dominant purpose for the tax benefit may be easier to establish. Second, before Pt IVA applies, the tax benefit must arise “in connection with the scheme”: s 177D(a) of the ITAA 1936.
Tax benefit [23.290] “Tax benefit” is defined in ss 177C and 177CA of the ITAA 1936. It includes an amount not being included in the assessable income of a taxpayer, where in the absence of the scheme it would reasonably be expected to have
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786 [23.290] PRINCIPLES OF TAXATION LAW 2020 been included. Similar definitions apply to an allowable deduction, a capital loss, a foreign income tax offset, a discount capital gain and an amount subject to withholding tax. To determine if there is a tax benefit, the section requires a comparison between what the taxpayer actually did and what the taxpayer “would have” or “might reasonably be expected to have” done. The conduct that would have occurred but for the scheme is sometimes referred to as the “counterfactual” (Commissioner of Taxation v Lenzo (2008) 71 ATR 511 at 529) or the “alternative postulate” (FCT v Hart (2004) 217 CLR 216). In Commissioner of Taxation v Peabody (1994) 181 CLR 359 at 385, the High Court said: A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.
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Case study 23.8: Alternative postulate The taxpayer in RCI Pty Ltd v Commissioner of Taxation 2011 ATC 20- 275 successfully made the “would have done nothing” argument. The case involved the relocation of the James Hardie group to offshore headquarters. An offshore subsidiary paid a large tax-exempt dividend to its Australian holding company in March 1988. In October of that year, the holding Company sold its shares in the offshore subsidiary. The Commissioner alleged that the scheme was to pay a dividend to reduce the value of the subsidiary and thereby diminish the CGT liability on the sale of its shares despite the fact that the payment of the dividend and disposal of the shares were seven months apart. The Full Federal Court, Edmonds, Gilmour and Logan JJ, ruled in favour of the taxpayer. It was held that no tax benefit arose from the scheme, because if the taxpayer had not entered into the scheme, it would be reasonable to expect that the taxpayer would have done nothing or done something else not involving the transfer of shares. Other cases in which the taxpayers successfully argued for an alternative postulate that negated the existence of a tax benefit include Futuris Corporation Ltd v FCT [2012] FCAFC 32, FCT v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 and Noza Holdings Pty Ltd & Ors v FCT [2011] FCA 46. As mentioned in [23.270], the government enacted amendments in 2013 attempting to strengthen Pt IVA by clarifying the definition of tax benefit. In particular, the amended provision is intended to prevent taxpayers from arguing that, among other things, there was no tax benefit as they would have
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done nothing if they had not entered into the scheme. It also clarifies that the “would have” and “might reasonably be expected to have” limbs in s 177C(1) represent alternative bases upon which a tax benefit may be ascertained. This reflects the government’s belief that for the purpose of ascertaining whether a tax benefit exists, the reconstruction approach under the “might reasonably be expected to have” limb should be regarded as an alternative to, rather than as an exclusion of, the annihilation approach under the “would have” limb.
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Dominant purpose [23.300] Part IVA applies if, among other things, a person has entered into a scheme with the sole or dominant purpose to enable a taxpayer obtaining a tax benefit. The subjective purpose of the person is irrelevant: Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474. Instead, the objective purpose must be inferred from applying the eight factors listed in s 177D of the ITAA 1936: • the manner in which the scheme was entered into or carried out; • the form and substance of the scheme; • the timing at which the scheme was entered into and the length of the period during which the scheme was carried out; • the result that would have been achieved by the scheme; • the change in the financial position of the relevant taxpayer; • the change in the financial position of any person connected to the taxpayer; • any other consequence for the relevant taxpayer and any person connected to the taxpayer; and • the nature of connection between the taxpayer and the person connected to the taxpayer. “Dominant” purpose means “the ruling, prevailing or most influential purpose”: FCT v Spotless Services Ltd (1996) 34 ATR 183. The case also established the principle that a person who enters into a scheme with a genuine commercial reason can still have a dominant purpose of obtaining the tax benefit. The dominant purpose may be inferred from someone else (eg, a professional advisor) other than the taxpayer: FCT v Consolidated Press Holdings Ltd (2001) 47 ATR 229. These cases are discussed in the following part.
High Court case on Pt IVA [23.310] Part IVA of the ITAA 1936 was enacted in 1981. It took more than 13 years before it received the first interpretation in the High Court in FCT v Peabody (1994) 181 CLR 359. The key issues in the case are summarised in the following case study.
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Case study 23.9: Peabody case Mrs Peabody and members of her family were beneficiaries of the Peabody Family Trust. TEP Holdings Ltd, as trustee of the trust, held 62% shares in several companies with the common name of Pozzolanic. The remaining 38% shares of those companies were held by Kleinschmidt. The plan was to float 50% of the company group on the stock exchange. However, Kleinschmidt did not want to sell to the public, so Peabody had to acquire Kleinschmidt’s shares. A shelf company Loftway Pty Ltd was formed and TEP Holdings held the shares in the company as trustee for the family trust. Loftway issued redeemable preference shares to Westpac Bank and used the fund to purchase the Kleinschmidt shares for $8 million. The price paid by Loftway for the Kleinschmidt shares was lower than the intended listing price. Peabody claimed in evidence that, due to the fear of the potential adverse effect on the listing if the purchase price was disclosed in the prospectus, those shares were made virtually worthless by converting those shares to “Z class shares” with no voting rights but only limited rights to dividend and surplus on winding up. In effect, the value of the 38% shares was shifted to the 62% shares held by TEP Holding.
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The Commissioner applied Pt IVA and assessed Mrs Peabody on the basis that if not for the scheme of shifting value from the 38% shares to the 62% shares, the trustee would have made a gain on the share purchase from Kleinschmidt, which would have been distributed to Mrs Peabody. While the Commissioner lost the case due to other technical grounds, the High Court decision provided important insight into the operation of Pt IVA. In particular, it held that though there was an overall commercial object of raising money from the public listing and only the value shifting step was involved getting a tax benefit, the Commissioner could isolate and identify that particular step as a scheme for the dominant purpose test. The second High Court case on Pt IVA was FCT v Spotless Services Ltd (1996) 186 CLR 404, which is summarised in the case study below.
Case study 23.10: Spotless case The taxpayer was an Australian resident company that had $40 million surplus cash to invest after a public flotation. At that time s 23Q of the ITAA 1936 (since repealed) provided that if a resident derived foreign- sourced income which had been subjected to income tax at source, it would be exempt in Australia. The taxpayer had a choice of investing in
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Australia or the Cook Islands. While the interest rate was lower in the Cook Islands, the after-tax income would be much higher from the Cook Islands investment. In this sense, the decision to invest in the Cook Islands was commercially justifiable. The High Court held that Pt IVA applied and the taxpayer was assessable as if the investment had taken place in Australia. The Court held that the dominant purpose means the most influential and prevailing or ruling purpose and that a reasonable person would conclude that the dominant purpose here was to get a tax benefit. If not for the scheme, it would be reasonably expected that the assessable income of the taxpayer would be higher. The Court stressed that it was not striking down the scheme simply because it represented a better investment, but a number of deliberate steps, including financial services from an English bank, had to be obtained to make the investment safe. No reasonable person would have gone through all these complicated procedures to secure a lower interest rate in the absence of the tax benefit. This case showed that, although the taxpayer may have a genuine commercial purpose, Pt IVA can still apply if the dominant purpose is to get a tax benefit. The third High Court case on Pt IVA was FCT v Consolidated Press Holdings Ltd (2001) 47 ATR 229, as summarised below.
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Case study 23.11: Consolidated Press Holdings case The taxpayer wished to acquire a UK company called Bat Industries Plc for a commercial purpose of publishing a magazine in that country. It intended to hold the UK company through another UK company, CPIL(UK). The taxpayer had to borrow $450 million to finance the transaction. At the time s 79D of the ITAA 1936 provided that certain offshore expenses (in this case, interest) could not be deducted from Australian-sourced income. Based on the advice of its professional advisor, the taxpayer incorporated an Australian resident subsidiary called Murray Leisure Group Pty Ltd (MLG) and used the borrowed funds to acquire redeemable preference shares in that entity, which in turn acquired shares in Bat Industries Plc. The interest expenses were therefore incurred in respect of Australian- sourced income. The High Court found that the dominant purpose of the scheme was to obtain a tax benefit in the form of an interest deduction, which would not
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be allowed pursuant to Pt IVA. The scheme was identified as the insertion of MLG into the holding structure. Importantly, the court indicated that the purpose of a professional adviser could be attributed to the taxpayer for the purpose of the dominant purpose test. This is so even if the taxpayer did not understand the complex tax legislations involved. The next High Court case on Pt IVA was Hart v FCT (2004) 217 CLR 216 which is summarised below. Case study 23.12: Hart case
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The taxpayers were husband and wife who owned their main residence under mortgage. In October 1996, they purchased another property to reside in and leased out the first property. They borrowed $298,000 to purchase the new property under a split loan arrangement. $202,888 was in a home loan account designated for the purchase of the new property and $95,112 in an investment loan account for the repayment of moneys owed on the investment property which was producing rental income. The taxpayers directed all their repayments to the home loan account and no repayments were made to the investment loan account, where the interest continued to compound which would be deductible under s 51(1) of the ITAA 1936. The split-loan arrangement was a mass-marketed scheme. The High Court was satisfied that there was a commercial purpose of increasing wealth, but all the judges agreed that the dominant purpose of the persons implementing the scheme, however defined, was for the taxpayers to obtain a tax benefit, though the five judges formed different opinions of what constituted the scheme in the case. Some accepted the wider scheme which included all the steps leading to, the entering into, and the implementation of the loan arrangements between the lender and the taxpayers. Others accepted the narrower scheme which referred in particular to the provision in the loan splitting into the two portions. A more recent High Court case on Pt IVA was Mills v FCT [2012] HCA 51. As the case involved s 177EA which is a specific provision in Pt IVA dealing with franking credit schemes and adopts a different purpose test instead of the sole or dominant purpose test, detailed discussion of this case is beyond the scope of this chapter.
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Application of Part IVA to specific transactions Leasing [23.320] A taxpayer who is carrying on a business may choose to borrow against the security of its assets. In that case, only interest will be deductible as an operating expense. Alternatively, the taxpayer may choose to lease plant and equipment, in which case the entire rental payments will be fully deductible as all leases are treated as operating leases for income tax purposes: FCT v Citibank Ltd (1993) 26 ATR 423. Under a standard operating lease, the lessor claims depreciation on the asset and is fully assessable on the rental payments while the lessee is able to fully deduct the rental payments. The Commissioner has challenged lease financing and sought to characterise it as a loan: FCT v Metals Manufactures Ltd (2001) 46 ATR 497; Eastern Nitrogen Ltd v FCT (2001) 46 ATR 474.
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Case study 23.13: Finance lease In FCT v Metals Manufactures Ltd (2001) 46 ATR 497, the taxpayer was a manufacturer of electrical cables and pipes who had a large amount of short-term debt. It needed to refinance and the choice was between sale and leaseback or borrowing on the security of factory and land which were acquired pre-CGT. The taxpayer decided to finance by means of sale and leaseback. The term of the lease was five years with a possible extension of two further periods of five years. At the end of the lease, the assets were to be sold by the financier, but it is safe to say that the only possible purchaser was the lessee, even though there was no such purchase option in the agreement. The Commissioner attacked the transaction on the threshold issue that it was not legally possible to sell a fixture without selling the land to which it was attached. In that case, the taxpayer was paying rent in respect of an asset which it owned and therefore the transaction represented a disguised loan where repayments had to be split into principal and interest. The Commissioner also sought to attack the arrangement by invoking Pt IVA. At first instance, Emmett J held that there was sufficient equitable interest in the financier with regard to the fixtures to justify the rental payments and allow their deductibility. The Full Federal Court upheld this decision. With respect to Pt IVA, the Federal Court held that the tax benefit was not the dominant purpose of the scheme. Instead, the dominant purpose was
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commercial and unrelated to the taxation advantages which were present. In this context, TR 2006/13 states that in general the ATO will not apply Pt IVA to sale and leasebacks unless among other things, particular steps are taken by the taxpayer giving rise to inappropriate values of the sale price of the asset, the lease payments or the residual value of the asset.
Agricultural schemes
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[23.330] Agricultural schemes involving forestry, horticultural produce, breeding and maintenance of animals may attract Pt IVA. A taxpayer may outlay one dollar and borrow three from the promoter, giving rise to a four- dollar deduction, and the promoter’s finance may be given by way of a round robin of cheques and non-recourse or limited recourse loans. Under a non- recourse loan, the debt need only be repaid out of the proceeds of the venture. The sums lent by the promoter are often in the form of a cheque which is handed to the investor who immediately hands it back to the promoter or to the manager of the scheme. This is known as round-robin financing and provision will be made for it in the contractual documents between the investor and the promoter, which is often in the form of a deed. If a court finds that the transaction is a sham, there would be no tax benefit upon which Pt IVA of the ITAA 1936 could operate. Sometimes taxpayers fail on the ground of threshold issues, such as the failure to establish that the business has commenced or, where a business has commenced, the taxpayer not being sufficiently involved to be carrying on a business or even a profit-making scheme. As a result, there was no tax benefit and accordingly no reason to apply Pt IVA: Howland-Rose v FCT (2002) 49 ATR 206. In Ruling TR 2007/8, the Commissioner ruled that the taxpayer’s lack of real involvement in the running of the business meant that in general most deductions would not be available. Case study 23.14: Howland-Rose case The taxpayer invested $24,000 in tea tree plantation scheme which was entirely lent by the promoters in a round-robin arrangement. The taxpayer agreed to pay back 25% of the loan within two years. The money was spent in investigating whether there was a market for the product in Europe and the USA and, although there was research and development, no business had been commenced. There had been no manufacture and sale of the product. Conti J held that a business cannot commence, at least until the taxpayers are definitively committed to it. As the deduction was not allowed on general principles, Pt IVA was a non-issue.
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Where a taxpayer satisfies the threshold test of carrying on a business, the Commissioner may apply Pt IVA, especially to mass- marketed schemes involving non- recourse loans that result in the taxpayer getting a refund regardless of the commercial viability of the venture. Case study 23.16: Sleight case In FCT v Sleight (2004) 55 ATR 555, the Full Federal Court applied Pt IVA of the ITAA 1936 to a scheme involving the planting, growing and harvesting of tea trees for the purpose of producing tea tree oil. The trial judge held that the dominant purpose was not the gaining of a tax benefit because among other things, there was expert evidence to the effect that the scheme was commercially viable, that the taxpayers would increase their ownership of assets and that the venture was carried out in a businesslike way. The Full Federal Court reversed this finding. The initial outlay by the taxpayers was $4,745 and a further $21,000 was invested through round- robin finance, giving a total deduction of $25,445 on revenue account. There was some capital investment involving the purchase of seeds. On these figures, the taxpayer would receive tax refunds even if the venture produced not a single dollar. Therefore, a reasonable person would conclude that the dominant purpose was to get the tax benefit.
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CGT losses through wash sales [23.340] Section 177C(1)(ba) of the ITAA 1936 includes as a tax benefit a capital loss being incurred by a taxpayer where it might reasonably be expected not to have been incurred if the scheme had not been entered into or carried out. The following case illustrates the operation of this provision. Case study 23.17: Wash sales attract operation of Pt IVA In Cumins v FCT (2007) 61 ATR 625, the taxpayer was a trustee of a family trust. The trust owned Cash Converters International Ltd. In the relevant year, the trust made a capital gain of $790,000. One day later, the trust sold some listed shares to another family trust controlled by the same taxpayer and realised a capital loss of $800,000. The taxpayer and his family were the beneficiaries of both family trusts. The Full Federal Court upheld the decision of the trial judge that Pt IVA applied to this wash sale, as the dominant purpose of which was to gain a tax benefit. TR2008/1 explains the ATO position on wash sales.
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Questions
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[23.350] 23.1 John is a full-time teacher and also a keen cyclist. He spends most of his spare time practicing and spends a lot of money on his bike and gears. He regularly enters cycling competitions and sometimes wins small amounts of prize money. Advise what he can do to be in a position to argue for deductions of his expenses incurred on cycling, and assuming he is regarded as a professional cyclist, whether he can offset his losses from cycling against his salaries. 23.2 P, a company incorporated in the US, is in the business of providing online cloud services. It has a subsidiary in Australia, A, which promotes and liaises with customers in the country. It also negotiates the terms of contracts with customers in Australia. The finalised contracts are entered into between the customers and another subsidiary in Singapore, S. The two subsidiaries have entered into a service agreement under which A provides the marketing services as well as after-sale supporting services to S for a service fee calculated on a cost plus basis. S has entered into similar agreements with P’s subsidiaries in other Asian countries. Discuss whether the structure may be subject to Pt IVA, including the arguments that the group may put forward to support its position. 23.3 Since 1960, X Co Ltd has owned and operated a factory which manufactures ammonia for supply to the fertiliser industry. The factory was built at a cost to the taxpayer of $3 million. Of that $3 million, $2 million was attributable to the cost of the building and $1 million for the cost of plant. The factory and plant, which consists of heavy machinery firmly attached to the base of the factory, is now worth $15 million. X Co Ltd currently draws down loans on the short-term money market at 8% interest. In the previous income year, X Co Ltd was approached by a financier, Y Co Ltd, which suggested that if X Co Ltd entered into a sale and leaseback agreement in respect of the land, factory and plant, finance could in effect be obtained at 5%, which would result in considerable savings. X Co Ltd does not wish to sell the land because it is a pre-CGT asset and is expected to increase in value in years to come. Y Co Ltd then proposes that X Co Ltd retains the land and, instead, sells the factory and plant to Y Co Ltd for $15 million and leases back the factory and plant for 10 years at $2 million per year. The lease agreement provides that (1) X Co Ltd acknowledges that the factory and plant are personal property and they vest in Y Co Ltd; and (2) after 10 years Y Co Ltd will sell the factory and plant at a residual value of
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$2 million. The lease explicitly provides that X Co Ltd has no option to purchase the factory and plant at the end of the lease. On 1 July, this income year, the sale and leaseback agreement on the above terms was executed by X Co Ltd and Y Co Ltd. X Co Ltd claimed a deduction of $2 million in respect of the lease payments and Y Co Ltd claimed depreciation of $2 million in respect of the plant. Advise X Co Ltd and Y Co Ltd as to the tax implications of the sale and leaseback agreement. 23.4 George is an accountant with an income of $300,000 per year and he is looking for a tax-effective investment in agriculture. He decides to invest in Hardwood Forests Pty Ltd, the promoter of a scheme for growing trees in northern New South Wales. Forty-nine other investors have already signed for the scheme. The promoter has a private ruling from the Commissioner that the non-commercial loss rules will not apply to the investment. George was supplied with contractual documents that give him the right to be informed of the progress of the venture and the right to remove the promoter and substitute another by majority vote of the investors. On 29 June, this income year, George writes out a cheque for $50,000 and hands it to Smith, a director of the promoter, who in turn hands him a cheque for $200,000 made out to George. George endorses the cheque to Hardwood Forests Pty Ltd and hands it back to Smith. The promoter has 50 hectares of land in northern New South Wales and one hectare is allocated to George, but it is not identified by the end of the income year. The clearing and planting of the trees commences on 29 June this income year. No returns are expected from the venture until at least 10 years later. Advise if George can claim a tax deduction of $250,000 in this income year. 23.5 George is a fund manager with Bathurst Pty Ltd. His strategy is to buy shares in companies that have a low price-earnings ratio, and when the shares rise in price, he switches his investment to different companies. In June 2004, George caused the fund to buy 1 million shares in the Ajax Mining Ltd at $4 per share. In June this income year, Ajax Mining Ltd’s shares are listed at $12 each and George decides it is time to sell. The fund also has a parcel of 2 million shares in Hill Ltd which were purchased in the year 2000 for $10 each and are now worth $4 each. On 30 June this income year, George causes the fund to sell the 1 million shares in Ajax Mining Ltd, as well as all the shares in Hill Ltd at $4 each. Two months later, George asks the analysts at the Bathurst Pty Ltd to analyse all financial documents of Hill Ltd including the profit and loss
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account, the balance sheet and a new prospectus just issued by Hill Ltd. Based on a favourable report concerning the prospects of Hill Ltd, George instructs Bathurst Pty Ltd to purchase 2.5 million shares in Hill Ltd at $4.50 each. Advise the tax implications of the disposal of the shares on 30 June this income year. 23.6 Sara Lee entered into a contract in April 2014 to sell part of its business to a Swiss company Roche Holdings Ltd for $60 million. The sale is to be effected in November 2014. In August 2014, the board of directors was advised by Sara Lee’s lawyers that the company has made a CGT loss of $6 million in the income year, and the sale of its business to Roche will result in a CGT gain of $8 million. Subsequently, Sara Lee and Roche entered into a deed of release in October 2014, whereby the contract of April 2014 was discharged for a consideration of $900,000 payable to Roach. Two hours later after negotiation and change of some contractual terms, Sara Lee entered into a new contract to sell the identical part of the business to Roche holdings for $61 million. The minutes of the director’s meeting said that the reason for discharging the earlier contract was that the lawyers advised that the change in consideration meant that the original contract could not be ratified, and that a new contract had to be entered into. The minutes also declared that changes in the redundancy entitlements also meant that discharge and entry into another contract was the safest path to create a binding contract. Advise the tax implications of these transactions and whether Pt IVA will apply. 23.7 Jessica is a financial accountant working in the finance department of an engineering consulting firm. The firm recently reviewed their internal operations and decided that the finance department should be outsourced to independent third-party contractors, with existing staff being made redundant. The firm was however keen to retain Jessica due to her intricate industry knowledge. To achieve this, the following steps were undertaken: 1. Jessica incorporated a company with the registered name of Jessica’s Accountancy Services Pty Ltd (JAS). Jessica is the sole director and shareholder of JAS; 2. The firm and JAS entered into a “Services Contract” for the provision of accountancy services for an annual sum of $130,000. This annual sum is equivalent to what would have been Jessica’s annual salary.
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Jessica is required to attend the premises of the engineering firm during normal business hours each working day. A bungalow located at the rear of Jessica’s home, which is separate to her house, is dedicated to Jessica to undertake any JAS business matters. JAS also employs her son at an annual salary of $30,000 to undertake administrative tasks. Advise Jessica and JAS of the tax implications of the annual sum of $130,000 and the salary of $30,000 paid to her son.
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24
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Tax administration Key points.................................................................................................... [24.00] Introduction................................................................................................ [24.10] Taxpayer lodgements................................................................................. [24.20] Annual tax returns................................................................................ [24.20] Business Activity Statements.............................................................. [24.35] Assessments............................................................................................... [24.40] Self-assessment................................................................................... [24.40] Definition of assessment..................................................................... [24.50] Deemed assessments.......................................................................... [24.70] Tentative assessments......................................................................... [24.80] Default assessments............................................................................ [24.90] Assets betterment statements........................................................... [24.100] Serving a notice of assessment......................................................... [24.110] Effect of technical shortcomings....................................................... [24.120] Presumption of validity of assessments........................................... [24.130] Amendments of assessments........................................................... [24.140] Collection of tax........................................................................................ [24.150] Methods of collection........................................................................ [24.160] Collection of tax from third parties owing money to a taxpayer..... [24.170] Collection of tax from person in control of foreign resident’s money........................................................................ [24.175] Mareva injunctions/freezing orders................................................... [24.180] Departure prohibition orders............................................................. [24.190] Penalties.................................................................................................... [24.200] Administrative penalties.................................................................... [24.201] Director penalty notices..................................................................... [24.202] Tax offences under the Taxation Administration Act....................... [24.203] Return prepared by a tax practitioner............................................... [24.205] Remission of administrative penalties.............................................. [24.206] Promoter penalties............................................................................. [24.207] Objections, reviews and appeals............................................................ [24.210] Onus of proof..................................................................................... [24.225] Commissioner’s decision on taxation objections............................. [24.230]
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800 PRINCIPLES OF TAXATION LAW 2020 Application for appeal or review....................................................... [24.240] Choice between AAT and Federal Court........................................... [24.260] ATO Test Case Litigation Program.................................................... [24.290] The role of the ATO.................................................................................. [24.300] Commissioner’s statutory remedial power....................................... [24.305] Compliance approach........................................................................ [24.310] Third party reporting.......................................................................... [24.330] Australian Business Number............................................................. [24.340] Taxpayers’ Charter............................................................................. [24.350] Compliance model............................................................................. [24.360] ATO support for taxpayers...................................................................... [24.370] Common rules that apply to all rulings............................................. [24.380] Inconsistent rulings............................................................................ [24.390] Public rulings...................................................................................... [24.410]
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Law companion rulings......................................................................... [24.415] Product rulings....................................................................................... [24.420] Class rulings........................................................................................... [24.430] Taxation determinations........................................................................ [24.440] Private rulings..................................................................................... [24.450] Oral rulings......................................................................................... [24.490] Non-ruling guidance.......................................................................... [24.500] Commissioner’s powers of access and investigation............................ [24.510] Record-keeping requirements........................................................... [24.520] Full and free access............................................................................ [24.530] Commissioner’s power to obtain information and evidence........... [24.540]
Legal professional privilege and the power to obtain information............................................................................. [24.560] Elements of legal professional privilege........................................... [24.570] Access to lawyer’s premises............................................................. [24.575] Access to professional accounting advisers’ papers....................... [24.590] Access to corporate board advice papers........................................ [24.595] Statutory privilege.............................................................................. [24.600] Offshore information notices............................................................. [24.610] Secrecy............................................................................................... [24.620] Taxpayers’ statutory rights to obtain information................................ [24.630] Freedom of Information Act 1982..................................................... [24.640] Administrative Decisions (Judicial Review) Act 1977...................... [24.650] Other taxation authorities....................................................................... [24.670] Inspector General of Taxation........................................................... [24.670] Board of Taxation............................................................................... [24.680] Regulation of tax practitioners................................................................ [24.690] Tax Practitioners Board...................................................................... [24.690] The Code of Professional Conduct.................................................... [24.695] Complaints and investigations.......................................................... [24.698] Questions................................................................................................... [24.700]
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Key points [24.00] • The quality of a country’s tax administration affects all stakeholders: taxpayers, tax professionals, the revenue authority and the broader community. The ideal system is transparent and applies equally and fairly to all taxpayers. • The Australian Taxation Office (ATO) cannot sue a taxpayer for unpaid tax until the taxpayer has been served with a valid assessment. • “Assessment” is defined in s 995-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and, in the context of income tax assessments, by reference to s 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). An income tax assessment is ordinarily issued after a taxpayer has lodged an annual return. If a taxpayer refuses to lodge, under s 167 of ITAA 1936, the Commissioner can issue a default assessment. For some taxpayers, the income tax return serves as a deemed assessment. • Tentative or provisional assessments are not valid assessments. • Section 175 of ITAA 1936 enables the Commissioner to rely on the validity of an assessment, except where bad faith or conscious maladministration is involved. • The Commissioner is subject to time limits when amending assessments. • The Commissioner can sue for unpaid tax when it is due and owing. The General Interest Charge (GIC) or the Shortfall Interest Charge (SIC), as well as administrative penalties, may be imposed for late lodgment or to compensate the revenue for late payment. • The ATO has the power to collect money from third parties who owe money to a taxpayer. • Taxpayers can object to their assessments. If they wish to appeal against the Commissioner’s decision on their objection, they choose between the Administrative Appeals Tribunal (AAT) (best for exercise of the Commissioner’s discretion and questions of fact) and the Federal Court (best for complicated questions of law). • The ATO has many products to assist taxpayers: Rulings (Public, Private, Product, Class, Oral), guidance materials, online tools and apps, and phone help line. • Methods of collection include withholding at source and payments of instalments of tax in advance under the Pay As You Go (PAYG) system. • Third- party reporting mechanisms bolster the integrity of the tax system. • The Taxpayer’s Charter is an unlegislated “Bill of Rights” for taxpayers.
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802 [24.10] PRINCIPLES OF TAXATION LAW 2020 • The ATO uses a regulatory pyramid (the Compliance Model) to assist it in managing taxpayer compliance and imposing penalties on taxpayers. • The Commissioner’s powers of access and information collection are very wide ranging. These powers are subject to the common law doctrine of legal professional privilege (LPP). This doctrine only applies to lawyers, but the ATO has granted an administrative privilege in relation to tax advice given by accountants. • Taxpayers may be able to obtain information and assistance under the Freedom of Information Act 1982 (Cth) (FOI Act), the Inspector-General of Taxation Act 2003 (Cth) or the Administrative Decisions (Judicial Review) Act 1977 (Cth) (ADJR Act). • The Inspector- General of Taxation (IGT) investigates taxpayer complaints and undertakes reviews of systemic issues dealing with tax administration. • The Board of Taxation oversees research into tax law issues and commissions external advice in relation to new legislation. • Tax professionals must be registered with the Tax Practitioners Board and must comply with the Code of Professional Conduct.
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Introduction [24.10] This chapter deals with the importance of tax administration to all stakeholders: taxpayers, tax professionals, the ATO and the broader community. The way the ATO administers the law is as important as the quality of the legislation. Tax administration involves two competing principles: collection of the revenue due and owing to the State and fair and efficient use of public resources. The focus of this chapter is the administration of the income tax, but many of the principles, policies and mechanisms apply equally to the other taxes that the ATO administers, such as the Fringe Benefits Tax (FBT) and the Goods and Services Tax (GST). Australia currently has a system of self-assessment. This puts the onus on taxpayers to ensure all the details in their returns and other lodgements are correct. To assist and encourage taxpayers, the ATO uses a mixture of support and enforcement. The support consists of things such as the rulings system, publications dealing with specific technical or compliance issues and lodgment systems that are increasingly electronic to assist in speedy refunds. The enforcement mechanisms include audits, court action, and penalties and interest imposed on unpaid tax. The ATO publicises its activities in order to encourage compliance and deter non-compliance. Figure 24.1 details the taxation administration issues covered in this chapter.
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Figure 24.1: Overall guide
Taxpayer lodgements Annual tax returns [24.20] Section 161 of ITAA 1936 provides that every person must, if required by the Commissioner, lodge an annual return in relation to income tax. The Commissioner publishes an annual notice specifying the persons required to lodge and the due dates for lodgment. For many years, the date for most taxpayers has been 31 October. Similarly, an annual return is required for FBT, due on 21 May each year: s 68 of the Fringe Benefits Tax Assessment Act 1986 (Cth) (FBTAA). There is a penalty for non-lodgement that applies to returns, notifications and other provision of information as required under a taxation law: s 8C of the Taxation Administration Act 1953 (Cth) (TAA).
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804 [24.30] PRINCIPLES OF TAXATION LAW 2020 Sections 162 and 163 of ITAA 1936 give the Commissioner the power to request that a taxpayer lodge a return, a further or fuller return, or any information about a person’s financial affairs. When such a request is made, the courts have consistently stated that the taxpayer must be given reasonable time to comply with the request. The Commissioner has power under Div 286, Sch 1 of TAA, to impose penalties for late lodgement of returns or other documents. A taxpayer who wishes to lodge after the due date must make a request to the Commissioner before that date, setting out in writing the reasons for the delay, an alternative lodgment date and an assurance that this will not be a regular practice. The Commissioner then exercises his discretion under s 388-55, Sch 1 of TAA, when considering whether to grant the taxpayer’s request. The tax return must be in the “approved form” (s 161A(1) of ITAA 1936), containing all relevant information, with a signed declaration by the taxpayer and, where relevant, the taxpayer’s tax agent. This declaration confirms the veracity of the information supplied in the return and that the taxpayer can substantiate where relevant all deductions claimed. There are different forms for different types of taxpayers and others required to lodge: individuals, companies, partnerships and trusts.
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The ATO offers assistance to taxpayers on phone help lines and web-based materials. The ATO released its “Digital by Default” initiative in 2015 stating its intention to deliver to taxpayers a simpler and more flexible method of interaction. Although the ATO is committed to 100% digital interaction with taxpayers, including electronic lodgment of annual returns, it still accepts a very small number of paper returns. Returns may be lodged by mail or electronically. The ATO is encouraging all taxpayers to use its myTax online web-based lodgement system. Taxpayers must use myGov to access myTax. [24.30] Once a taxpayer has lodged an annual return, the Commissioner processes the assessment and issues the taxpayer with a notice of assessment. Under the self-assessment system, the onus is on taxpayers to ensure all the details in their returns are correct. Usually returns are accepted as lodged and a refund is issued or a notice of tax payable is sent to the taxpayer. In order to reduce compliance costs for individual taxpayers with straightforward tax issues, Australia’s Future Tax System (the Henry Review) Recommendation 11 proposed that taxpayers be offered the alternative of accepting a standard deduction to cover work-related expenses and the cost of managing their tax affairs. Taxpayers would have the choice of accepting the standard deduction without the necessity of complying with the substantiation requirements or claiming actual expenses subject to meeting the substantiation requirements. This proposal was withdrawn, but the concept is often raised when considering issues such as simplicity. Recent research conducted by the ATO on the “tax
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gap” for individuals (an estimate of the difference between the tax the ATO collects and the amount that would be collected with full compliance) reveals that most of the tax gap for individuals not in business comes from incorrectly over-claiming work-related expenses. As a result, this issue is a focus of the taxpayer education program, and the ATO has launched a myDeductions tool to assist taxpayers to claim the correct amount and keep the necessary records. To assist taxpayers more generally, the ATO has a system of “pre filling” items where it has been given information by a third party. Examples include salary and wages and amounts withheld, dividends received including the imputation credits and interest received from financial institutions. Taxpayers still have the responsibility of ensuring that the information is correct.
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Section 5-5(2) of ITAA 1997 provides that for an individual or an entity that is not a “self-assessment taxpayer” tax is due and payable only if the Commissioner has made an assessment of tax for the year. Section 5-5(5) of ITAA 1997 provides it is due and is payable 21 days after the day on which a taxpayer was required to lodge their return. If the taxpayer lodges early, the tax is due and payable 21 days after the Commissioner gives the notice of assessment: s 5- 5(6) of ITAA 1997. Full self-assessment taxpayers pay tax instalments under the Pay As You Go (PAYG) instalment system, and their final income tax is due and payable on the first day of the sixth month after the end of the income year: s 5-5(4) of ITAA 1997. These dates are important for calculating any amount of GIC or SIC that may be due. The ATO uses risk-assessment measures to detect and prevent tax avoidance and tax fraud. If a taxpayer appears to be claiming an unusually large refund, the ATO might investigate further before paying it or check the return in detail and refuse to pay it. If a taxpayer is not satisfied with the assessment as issued, even if it is in accordance with the return as submitted, the taxpayer can lodge an objection setting out in detail the grounds relied on. The Commissioner then will allow the objection either wholly or in part or disallow it. Avenues of appeal or objection are available to the taxpayer: see [24.210].
Business Activity Statements [24.35] Taxpayers may also be required to lodge a Business Activity Statement (BAS) at least annually to report information in relation to a number of different taxation laws that the Commissioner administers. The main element of the BAS is the reporting of GST amounts but the BAS reporting system also covers PAYG withholding and instalments (see [24.160]), FBT instalments, wine equalisation tax, luxury car tax and fuel tax credits. The BAS form allows a taxpayer to record both amounts payable to the Commissioner (such as PAYG instalments) and amounts due from the Commissioner (such a GST input tax credits) so that the net amount payable or refundable for the period can be calculated. The Commissioner has created many alternative approved
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806 [24.40] PRINCIPLES OF TAXATION LAW 2020 forms of the BAS to suit the variety of reporting obligations that a taxpayer may face. Depending on the taxpayer’s circumstances, a BAS may be required on an annual, quarterly or monthly basis and taxpayers are encouraged to lodge online. Further details on the administration of the GST can be found at [25.300]–[25.315].
Assessments Self-assessment [24.40] The tax system in Australia is based on the requirement that taxpayers complete and lodge an annual return. Before 1986, taxpayers lodged returns which were checked by ATO officers in the assessing section. They would either accept the return as lodged or make adjustments prior to posting a Notice of Assessment to taxpayers.
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Self-assessment was introduced in 1986. Self-assessment requires taxpayers to ascertain their taxable income by considering their assessable income and deductions. For individual taxpayers, there is effectively partial self- assessment. The ATO ordinarily accepts the return at face value –checking its accuracy is accomplished by a system of random audits. The ATO checks the information supplied by the taxpayer against information provided by third parties, such as companies which paid dividends and financial organisations which paid interest to taxpayers. Penalties and interest are imposed when errors are discovered. For companies, corporate limited partnerships, public trading trusts, super annuation funds and approved deposit funds (both complying and non- complying), and pooled superannuation trusts, there is “full self-assessment”. Under s 166A of ITAA 1936, the Commissioner is deemed to have made an assessment of the taxable income and the tax payable on that income in accordance with the amounts specified in the return as required by s 161AA of ITAA 1936. The assessment is deemed to be made on the day the return is lodged, and the return becomes the notice of assessment, deemed to have been served on the same day.
Definition of assessment [24.50] Section 166 of ITAA 1936 provides that from the returns and any other information in his or her possession, the Commissioner must make an assessment of the amount of taxable income (or that there is no taxable income) of any taxpayer, the tax payable thereon (or that there is no tax payable) and the total tax offset refunds (or that no such refund is due).
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For these purposes, “assessment” is defined in s 6(1) of ITAA 1936 as the ascertainment of these three amounts. The elements in parentheses stating that a taxpayer may have no taxable income or no liability to pay tax were inserted in 2005 to overcome the decision in FCT v Ryan (2000) 43 ATR 694. What constitutes an “assessment” was discussed by Isaacs J in R v DCT; Ex parte Hooper (1926) 37 CLR 368 at 373. An “assessment” is not a piece of paper: it is an official act or operation; it is the Commissioner’s ascertainment, on consideration, of all relevant circumstances, including sometimes his own opinion, of the amount of tax chargeable to a given taxpayer. When he has completed his assessment of the amount, he sends by post a notification thereof, called a “notice of assessment”. But neither the paper nor the notification it gives is the “assessment”. That is and remains the act or operation of the Commissioner.
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[24.60] The courts consistently interpreted the pre- 2005 definition of “assessment” as meaning that a positive amount of tax was due and owing: Batagol v FCT (1963) 109 CLR 243; FCT v Ryan (2000) 43 ATR 694. This caused commercial problems. If no tax was due, and there was no assessment, the Commissioner was free to issue an original assessment at any time, as happened in Batagol, where the taxpayer had received a refund notice stating that no tax was payable. Because there was no original assessment, time limits under s 170 of ITAA 1936 in relation to the Commissioner’s power to issue amended assessments never commenced to run. The High Court majority (Kirby J dissenting) in Ryan followed Batagol, although they were aware of the problems this interpretation caused. If a taxpayer did not owe tax because there was no assessment, the taxpayer could not object to the disallowance of a deduction, nor did the taxpayer ever have finality in relation to that tax year. The amended definition of “assessment” has solved these problems. The current position is that if taxpayers have no taxable income and do not owe tax because their deductions exceed their assessable income or they have a taxable income but no tax is payable because their income is below the tax-free threshold or their tax offsets reduce the tax payable to nil, this determination constitutes an assessment. However, this degree of finality is not available in relation to tax losses, where a taxpayer has a negative, not a nil, assessment. Whether a tax loss is deductible is only decided in the tax year in which the taxpayer has positive income and the loss may apply to reduce it.
Deemed assessments [24.70] Companies, funds and other full self-assessment taxpayers calculate the amount of tax they owe and, when they lodge their return under s 166A of ITAA 1936, the Commissioner is deemed to have made an assessment on that date. The return is deemed to be a notice of the deemed assessment and to have been served on the entity. These entities have the same rights of objection and further appeal as individuals in relation to their notices of assessment: see [24.210].
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808 [24.80] PRINCIPLES OF TAXATION LAW 2020
Tentative assessments [24.80] Where an assessment is tentative or provisional, the courts have consistently held that there is not at that stage a valid assessment: FCT v Hoffnung & Co Ltd (1928) 42 CLR 39. If the notice of assessment contains a note that it is subject to review, this does not mean it is tentative. However, when a taxpayer received three notices of assessment, each fixing a different sum of tax payable, and all three dealing with the same year of income, the Federal Court held it was impossible to determine that there was a single valid assessment that the ATO could enforce: FCT v Stokes (1996) 34 ATR 478. Where the ATO issues alternative assessments to two taxpayers in relation to the same income and the same year of income, providing they are not made in bad faith and fix a definite tax liability, they remain valid assessments. The ATO can only collect tax on one assessment but may issue the alternatives in order to ensure that the taxpayer does not escape their liability, for example, by issuing an assessment to a trustee and also to a beneficiary of a trust: DCT v Richard Walter Pty Ltd (1995) 29 ATR 644.
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Default assessments [24.90] Where a taxpayer has not lodged a return (this may be deliberate) or the Commissioner is not satisfied with the return (eg, where taxpayers in a service industry or small business deliberately do not declare cash receipts), the Commissioner has power under s 167 of ITAA 1936 to issue a default assessment. The High Court in George v FCT (1952) 86 CLR 183 stated that the power under s 167 is not an independent power but is an additional supportive power to enable the Commissioner to exercise the power under s 166. The two most important cases on default assessments involve a taxpayer, Mr Peter Briggs. Case study 24.1: Default assessments In Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031, the taxpayer had been totally uncooperative and refused to engage with the ATO. In frustration, the Commissioner issued notices of assessment and amended assessments with respect to a number of tax years under s 167 of ITAA 1936. The taxpayer applied to the Federal Court seeking orders to quash the assessments and for writs of mandamus (to compel a public official to do their duty) and prohibition (to prevent a public official from exceeding their jurisdiction), alleging that the ATO had acted in bad faith. The Federal Court referred the issue of whether s 177 of ITAA 1936 (now s 350-10, Sch
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1 of TAA) operated in relation to the assessments to therefore strike out the taxpayer’s claims in relation to judicial review. Section 177 provided that the production of a notice of assessment was conclusive evidence of the due making of the assessment. For the purpose of the proceedings in the Full Federal Court, the ATO conceded that there had been no genuine attempt to ascertain the taxpayer’s taxable income. The Full Court found that in these circumstances, there were no “assessments” and therefore the protection of s 177 did not operate. The Full Court’s alternative view was that even if the notices were to have effect as an “ambit” claim to be followed by further and more definitive assessments, they were merely provisional and therefore did not attract s 177. As the protection of s 177 was not available, the Federal Court, in subsequent proceedings, considered the judicial review application. The Court held that the taxpayer had received valid notices of assessment and made some very important statements about the ambit of s 167: Re DCT (WA); Ex parte Briggs (No 2) (1987) 18 ATR 570. Sheppard J said (at 587):
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It may be true … that Section 167 is not the gateway to fantasy and that it is not open to the Commissioner either to pluck a figure out of the air or to make an uninformed guess. But that process may go close to guesswork, and yet be lawful, …. [T]he legislature did not intend to confer upon a potential taxpayer the valuable privilege of disqualifying himself in that capacity by the simple and relatively unskilled method of losing either his memory or his books; or, I would add, by … his failure to lodge returns of income.
Law Administration Practice Statement (PS LA) 2007/24 sets out the issues which the ATO takes into account when issuing s 167 assessments. The Practice Statement says that tax officers should make a genuine attempt to determine the taxpayer’s taxable income, and it is not necessary to estimate assessable income and then consider every potential deduction. In Marijancevic v Mann (2008) 73 ATR 709, the Full Federal Court confirmed that when making an assessment under s 167, the Commissioner is entitled to exercise his judgment when ascertaining the amount of taxable income. In Rigoli v FCT [2014] FCAFC 29, the Full Federal Court confirmed that under s 167 the taxpayer has the burden of proving on the balance of probabilities the actual taxable income such that therefore the assessment is excessive: see also Gashi v FCT [2013] FCAFC 30. Merely proving that the Commissioner has made a mistake by not considering all individual items of assessable income or allowable deductions is insufficient. When this case was remitted to the AAT for the second time, the taxpayer submitted his accountant’s report as evidence of his taxable income. The AAT found again that the taxpayer had not discharged the onus of proof that on the balance of probabilities the taxpayer’s
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810 [24.100] PRINCIPLES OF TAXATION LAW 2020 taxable income was less than the amount on which the Commissioner had assessed him: Re Rigoli v FCT [2015] AATA 169. This decision was upheld by both the Federal Court: Rigoli v FCT [2015] FCA 803 and the Full Federal Court: Rigoli v FCT [2016] FCAFC 38. In FCT v Donoghue [2015] FCAFC 183, the Full Federal Court held that default assessments were valid, and the ATO was able to use privileged documents that had been received from a third party in making the assessments. There was no conscious maladministration as required by the High Court decision in FCT v Futuris (2008) 69 ATR 41: see Case Study [24.4].
Assets betterment statements [24.100] When issuing a default assessment under s 167 of ITAA 1936, the Commissioner may rely on an asset betterment statement. This involves comparing a taxpayer’s assets at the end of the year with those at the beginning.
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If a taxpayer declares a fairly low income but during the year has purchased and paid for luxury items, accumulated assets or otherwise led an extravagant lifestyle, then the Commissioner may assume that these items have been paid for with undeclared income: L’Estrange v FCT (1978) 9 ATR 410. In Gashi v FCT [2013] FCAFC 30, the taxpayers failed to demonstrate that the unexplained accumulated wealth was derived from non-income sources. Taxpayers commonly argue that the source of the money that the Commissioner attempts to tax as income was a family gift or gambling winnings. In the small business sector, undeclared income is often cash that has been skimmed from the till. As Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031 demonstrated (see Case Study [24.1]), the Commissioner has to make a genuine attempt to ascertain the true source of the funds, but then the burden shifts to the taxpayer to show that this is incorrect and what the correct amount should be.
Serving a notice of assessment [24.110] Under s 174 of ITAA 1936, after making an assessment, the Commissioner is required to serve notice of it on the person liable to pay the tax. In Batagol v FCT (1963) 109 CLR 243, the High Court emphasised that this was the last step after a valid assessment has been made. The normal method of service is to post or deliver it, either by hand or electronically, to the taxpayer’s preferred address for service. If a taxpayer employs a tax agent, often the preferred address for service is the office of that agent. Many electronic communications are now made through the myGov platform.
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Section 29 of the Acts Interpretation Act 1901 (Cth) provides that where a document such as a notice of assessment has been properly addressed, prepaid and posted, it will be deemed to be delivered in the ordinary course of post, unless the taxpayer can prove the contrary. Electronic delivery occurs when an electronic communication is capable of being retrieved by the addressee: s 14A of the Electronic Transactions Act 1999 (Cth).
Effect of technical shortcomings [24.120] Section 175 of ITAA 1936 provides that the validity of any assessment is not affected merely because any of the provisions of the Act have not been complied with. This section covers technical irregularities, such as where the Commissioner might describe what is in fact an original assessment as an amended assessment: Cadbury-Fry-Pascall Pty Ltd v FCT (1944) 70 CLR 362.
Case study 24.2: Validity of assessment
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In FCT v Prestige Motors Pty Ltd (1994) 28 ATR 336, the Full High Court unanimously held that notices of assessment which were correct in all details except the name of the taxpayer were valid assessments. The taxpayer was a trustee, and the notices of assessment were addressed to the trust, and not the trustee. They were served at the trustee’s address for service and contained the trustee’s correct tax file number. The Court held that s 174 of ITAA 1936, which provides for the notice of assessment to be served on the person liable to pay the tax, does not also require that the notice include the name of the taxpayer.
Presumption of validity of assessments [24.130] As noted above, s 175 of ITAA 1936 provides that the validity of any assessment is presumed. Section 350-10(1) (Table Item 2) Sch 1 of TAA (formerly s 177 of ITAA 1936) provides that the production of a notice of assessment is conclusive evidence of the proper making of the assessment and, except for proceedings on review or appeal against the assessment, that the amount and all the particulars of the assessment are correct. Cases such as Re DCT (WA); Ex parte Briggs (1986) 17 ATR 1031 (see Case Study [24.1]) have established that the Commissioner cannot rely on the section unless a valid assessment has been made. This threshold issue must be dealt with before recovery action can be commenced.
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812 [24.130] PRINCIPLES OF TAXATION LAW 2020
Case study 24.3: Validity of assessment In FJ Bloemen Pty Ltd v FCT (1981) 147 CLR 360, the High Court held that the Commissioner is entitled to rely on s 177 of ITAA 1936 when a taxpayer objects to an assessment and that the ITAA 1936 sets out clear procedures to be followed by taxpayers when there is a dispute. The taxpayer had argued that the Commissioner had not exercised his powers bona fide when making the original assessments. The Court rejected this claim.
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Case study 24.4: Validity of assessment In FCT v Futuris Corporation Ltd (2008) 69 ATR 41, the Commissioner issued a second amended assessment which contained overlapping amounts with the first amended assessment. The second amended assessment relied on Pt IVA of ITAA 1936, and when it was issued, the taxpayer’s appeal to the Federal Court in relation to the first amended assessment had not been finalised. The High Court held any errors in relation to the second assessment would be covered by s 175. The High Court found that there was no jurisdictional error which permitted the taxpayer to rely on s 75(v) of the Constitution and s 39B of the Judiciary Act 1903 (Cth). The substantive issues were being dealt with under Pt IVC of TAA, and the availability of this Part by virtue of s 175A of ITAA 1936 would preclude the use of alternative declaratory relief. The Court found there was no conscious maladministration or bad faith by the Commissioner, s 177(1) is not a privative clause, and there was no conflict between ss 175 and 177(1) and the assessment requirements of the Act. The Commissioner was entitled to use s 177F(3) at a later time to make an adjustment in relation to the double counting of the same item of income in both amended assessments. In Hii v FCT [2015] FCA 375, the taxpayer was audited and amended assessments were issued. Subsequently, several more amended assessments were issued. The Federal Court held that because the assessments were neither tentative nor provisional and there was no evidence of bad faith, the Commissioner could rely on ss 175 and 177 of ITAA 1936 and the taxpayer was precluded from relying on s 39B of the Judiciary Act 1903. In Allan J Heasman Pty Ltd v FCT [2015] FCAFC 119, the taxpayer claimed a deduction for payments to an offshore superannuation fund. The Full Federal Court held the taxpayer was not entitled to the deduction and that the ATO had validly issued an assessment in 2012 even though it
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had called it an amended assessment. Because the transactions took place in 1998–1999, the situation in FCT v Ryan applied. The time limit for amendments was not triggered as the document stating that no tax was payable was not an assessment. The Court stated the taxpayer could still challenge the validity of the assessment under s 39B of the Judiciary Act 1903 but that no relevant jurisdictional ground was alleged.
Amendments of assessments [24.140] Section 170 of ITAA 1936 deals with amendments of assessments. Legislative changes in 2005 reduced the time available to the Commissioner to amend assessments. The policy behind this was to provide more certainty and finality to taxpayers.
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The general rule now is that, in relation to taxpayers with simple affairs, the Commissioner has two years from the date on which the notice of assessment is given to amend it: s 170(1) (Table Items 1–3) of ITAA 1936. Most other taxpayers are subject to a four-year amendment period. These other taxpayers include those who are partners and the partnership is not a small business entity, trustees and beneficiaries who are not small business entities, companies that are not small business entities and taxpayers whose affairs might be subject to the application of “scheme benefit” anti-avoidance provisions, including Pt IVA of ITAA 1936. Where a taxpayer has been involved in fraud or evasion, the Commissioner has an unlimited time to amend: s 170(1) (Table Item 5) of ITAA 1936. In 2018, the ATO updated its practice statement regarding reliance on this unlimited amendment period: PS LA 2008/6. The concept of “fraud” is common law fraud where a taxpayer makes a statement either knowing it is false or not believing it is true or with reckless indifference as to its truth or falsity. “Evasion” involves a blameworthy act or omission on the part of the taxpayer. An obvious example of evasion is undeclared cash economy income. A taxpayer’s return may be amended at any time if the fraud or evasion is committed by his or her agent, even if the taxpayer is unaware of the agent’s conduct: Kajewski v FCT (2003) 52 ATR 455. The Full Federal Court in Denlay v FCT (2011) 83 ATR 625 held that when considering the validity of an amended assessment, the Court considers the accuracy of the information and the competence and honesty of the ATO officers who make the assessment. Providing the assessment is not made in bad faith and there is no evidence of maladministration, it is not an issue that the information on which the assessment was based may have been obtained illegally by the party supplying it to the ATO.
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814 [24.150] PRINCIPLES OF TAXATION LAW 2020 Before the time limit expires, a taxpayer can apply for an amendment. This can happen, for example, where a taxpayer has lodged promptly and is later informed that he or she has received a distribution of trust income in his or her capacity as a beneficiary of a discretionary trust. The Commissioner will also amend assessments to give effect to a decision on review or appeal or to give effect to a private ruling. The Commissioner can also amend an amended assessment within the original time limit for amending the original assessment. Where an amended assessment increases taxpayers’ taxable income or reduces the amount of an offset which has been claimed, the SIC is payable from the date the original liability was payable until the date of notice of amendment: Div 280, Sch 1 of TAA. The underlying policy is to compensate the revenue for the income forgone during that period. This is in addition to any administrative penalties which may be imposed, such as a late lodgment fee. The Commissioner has the power to remit the SIC: s 280-160, Sch 1 of TAA. The GIC applies to unpaid tax liabilities and is at a higher rate: s 8AAG of TAA. It applies from the time that the tax is due and is also subject to remission by the ATO: s 8AAB of TAA. Both interest charges are deductible under s 25- 5(1)(c) of ITAA 1997.
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Collection of tax [24.150] An amount of a tax-related liability, including an amount of income tax due and payable, is a debt due to the Commonwealth and payable to the Commissioner: s 255-5, Sch 1 of TAA. The time when income tax becomes due and payable is dealt with in s 5-5 of ITAA 1997. For taxpayers who do not fully self assess, tax is due and payable only after the Commissioner has issued an assessment. Under s 5-5(5) of ITAA 1997, tax is due and payable 21 days after the date the taxpayer is required to lodge their annual return. When taxpayers lodge their returns either on or before the due date for lodgment and the Commissioner has issued an assessment, income tax is due and payable 21 days after the taxpayer receives the notice of assessment. Full self- assessment taxpayers for whom lodgment constitutes a deemed assessment and who have been subject to the PAYG instalment system are required to pay their tax on the first day of the sixth month after the end of the income year: s 5-5(4) of ITAA 1997. When a taxpayer does not lodge a return, then tax is due and payable 21 days after the scheduled lodgment date. The GIC is levied on late payment of income tax as well as other unpaid tax- related amounts: s 8AAB of TAA. The rate is calculated under s 8AAC of TAA on a daily compounding basis. The policy behind the GIC is to compensate the revenue for the loss of revenue caused by the late payment. Section 8AAG of TAA gives the Commissioner power to remit the GIC in specified circumstances, for example, if the delay in making a timely payment was not caused by the taxpayer.
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Under s 340-5, Sch 1 of TAA, individual taxpayers and trustees of deceased estates may apply to the Commissioner for the release of specified tax liabilities, including income tax, in a case of serious hardship. Otherwise, tax debts can only be extinguished by the Finance Minister. However, the ATO may grant any taxpayers an extension of time to pay or other payment arrangements when they have difficulty in meeting the full amount by the due date: ss 255-10 and 255-15, Sch 1 of TAA. When a tax liability is due and payable, the Commissioner may sue and recover in any court of competent jurisdiction: s 255-5(1), Sch 1 of TAA. In debt recovery proceedings, the notice of assessment is conclusive evidence that the assessment was properly made and that the amounts are correct: s 350-10(1) Table Item 2, Sch 1 of TAA, formerly s 177 of the ITAA 1936. The Commissioner can pursue recovery even when there is a current and pending Pt IVC review or appeal of the assessment which gave rise to the liability: ss 14ZZM and 14ZZR of TAA; DCT v Broadbeach Properties (2008) 69 ATR 357. Nor can a taxpayer rely on provisions of another Act, such as in the Broadbeach case the Corporations Act, to side-step the Commissioner’s recovery action. In Rawson Finances Pty Ltd v DCT [2011] FCA 1231, the Federal court held that the Commissioner was entitled to pursue recovery and was not required to exercise its discretion to delay recovery under s 255-10 TAA despite the fact the taxpayers had lodged objections to their assessments. The ATO has published its policies in relation to collection and recovery of tax due in a series of PS LAs setting out the circumstances when it will sue to recover tax or, alternatively, come to an arrangement with the taxpayer.
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Methods of collection [24.160] In Australia, much of the income tax revenue is collected under the PAYG system. This system has two separate strands: 1. PAYG withholding –The payer deducts amounts from payments to others and remits these to the ATO. This is the system imposed on employers when paying employees. 2. PAYG instalments –Taxpayers who have business or investment income report and make regular payments to the Commissioner towards their anticipated annual tax liability. The PAYG system means that the Commissioner progressively receives money from and in relation to taxpayers throughout the tax year. There is less risk to the revenue, and it is harder for taxpayers to escape the system. A taxpayer is required to pay PAYG instalments only once they have been given notice of an instalment rate from the Commissioner: s 45-15, Sch 1 of TAA. PAYG instalments must be reported by way of an instalment activity statement or a BAS and paid at various intervals as required by Pt 2-10, Sch 1 of TAA. Large
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816 [24.170] PRINCIPLES OF TAXATION LAW 2020 taxpayers, those with base instalment income of $20 million or more, must report and pay their instalments electronically on a monthly basis. The PAYG withholding system applies to the various payments listed in s 10-5, Sch 1 of TAA. As noted above, the main category of payments includes various remuneration payments such as salary and wages to employees. Where a taxpayer has not quoted their tax file number (TFN) to a company that pays the taxpayer a dividend or a financial institution that pays the taxpayer interest, then the no-TFN withholding mechanism within the PAYG withholding system will be triggered and the payer must withhold and remit to the Commissioner tax at the maximum personal income tax rate. When the taxpayer subsequently lodges their return, the taxpayer receives credit against the amount of tax payable for any amounts withheld under the PAYG withholding system: s 18-15, Sch 1 of TAA. The taxpayer also receives a credit for the total PAYG instalments payable: s 45-30, Sch 1 of TAA.
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The PAYG system also incorporates the withholding tax system with respect to certain payments of unfranked dividends, interest and royalties to foreign residents. These withholding taxes are at flat rates and act as final taxes (ie, the taxpayer is not required to lodge a return in relation to this income). One of the big risks to the PAYG withhold system is when an employer’s business is failing and the employer retains the money collected from employees as working cash for the business, instead of remitting it to the ATO. A new initiative of the ATO, Single Touch Payroll, commenced on 1 July 2018 for employers with 20 or more employees and provides a mechanism whereby PAYG withholding and superannuation information are automatically reported in real time to the ATO by the employer’s payroll software. This system was extended to all employers from 1 July 2019. The ATO is working on integrating this information into the reporting processes. The Director Penalty Notice (DPN) regime is also designed to protect against risk of non-remittance of PAYG withheld amounts (see [24.202]).
Collection of tax from third parties owing money to a taxpayer [24.170] Where a taxpayer owes a debt to the Commonwealth that is being collected by the ATO and a third party owes money to the taxpayer, the Commissioner can issue a notice in writing under s 260-5, Sch 1 of TAA, directing the third party to pay the money directly to the ATO to meet the taxpayer’s outstanding tax liability. The Commissioner’s policy in relation to these notices is set out in Practice Statement PS LA 2011/18. This type of notice is called a “garnishee” notice and is also used in non-tax proceedings. It is very hard for a taxpayer to establish that such a notice has been issued in bad faith: see Saitta Pty Ltd v FCT (2002) 50 ATR 565. The third party needs to
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assure itself that the notice is valid, because if it pays the client’s money directly to the ATO, it may be in breach of its contract with its client and therefore may be liable to be sued. When complying with a valid notice, the third party is indemnified for the payment by s 260-15, Sch 1 of TAA. In Brown v Brown (2007) 69 ATR 533, the Federal Court held that s 260-5(3)(b) (which states that money is deemed to be owed to a debtor, whether or not it is actually due and payable to the debtor, if it is held for or on account of the debtor) applied to a notice issued by the Commissioner to a firm of solicitors who were holding money in their trust account on behalf of the taxpayer. In Marijancevic v Mann (2008) 73 ATR 709, the Commissioner accidentally issued the garnishee notice before he issued the default assessments. The Full Federal Court upheld the validity of the default assessments, stating that they had not only been made to support the garnishee notices, and found that there was no improper purpose or conscious maladministration in relation to the assessments. Section 260-5 creates an obligation on the third party which is enforceable by an action in debt or alternatively by civil process: FCT v Barnes Development Pty Ltd (2009) 76 ATR 570. Where the notice contained conflicting statements as to when the payment was due, it was held to be invalid: FCT v De Martin (2011) 82 ATR 906. PS LA 2011/13 deals with the application of the section where the taxpayer lives overseas. In DCT v Conley (1998) 40 ATR 227, the Full Federal Court held that “money” for the purposes of s 218 of ITAA 1936 (the predecessor to s 260- 5) is limited to Australian currency.
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Collection of tax from person in control of foreign resident’s money [24.175] Under s 255 of ITAA 1936, the Commissioner can serve a notice on a person who has receipt, control or the disposal of money belonging to a foreign resident who is liable to pay Australian income tax, requiring that person to pay the tax which is due and payable under an Australian assessment. The recipient of the notice is: • authorised to retain sufficient amounts from the money they receive: s 255(1)(b); • made personally liable to the extent that they should have retained the money: s 255(1)(c); and • entitled to be indemnified for any amounts paid under the ITAA 1936: s 255(1)(d). The Commissioner may serve a notice prior to the person having receipt, control or the ability to dispose of the money, but the notice will only be effective if the foreign resident is liable to pay tax in Australia by virtue of an assessment at the time of service: DCT v Bluebottle UK Ltd (2007) 67 ATR 1.
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818 [24.180] PRINCIPLES OF TAXATION LAW 2020 The Full Federal Court in FCT v Resource Capital Fund IV LP [2013] FCAFC 118 held that “money” is not confined to Australian currency, and the fact that the notice directed the taxpayer to pay the debt in Canadian currency did not render the notice invalid.
Mareva injunctions/freezing orders [24.180] In accordance with r 7.32 of the Federal Court Rules, on application of the Commissioner the Federal Court may issue an asset freezing order (also referred to as a Mareva injunction after the case Mareva Compania Naviera SA v International Bulkcarriers SA, The Mareva [1980] 1 All ER 213). The purpose of a freezing order is to prevent the frustration or inhibition of the Court’s processes, which in the tax context ordinarily would involve recovery proceedings for a tax debt. The order may prevent a party (in this case a taxpayer) either from moving assets out of the jurisdiction or from disposing of them to a third party. The intention to frustrate the judgement does not need to be shown, and these orders cannot prevent a person from dealing with assets in the ordinary course of business: FCT v Regent Pacific Group Ltd [2013] FCA 36. The Commissioner must present evidence that there is a danger that the debt will be unsatisfied because the assets are removed and the Court will consider the impact of the requested order on the taxpayer as well as third parties: DCT v Hua Wang Bank Berhad [2010] FCA 1014.
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Departure prohibition orders [24.190] When the Commissioner believes a taxpayer intends to leave Australia without discharging their tax liability or without making arrangements to discharge it, he or she can issue a departure prohibition order (DPO) under s 14S of TAA. Practice Statement PS LA 2011/18 discusses the issues that will be considered by the Commissioner when deciding whether or not to issue the order. If the Commissioner is satisfied that the tax liability will be discharged or, alternatively, will never be recovered, he or she can vary or revoke the DPO: s 14T; Skase v FCT (1991) 22 ATR 889. It is possible for a tax debtor to be granted permission to leave Australia temporarily when there is a DPO in place. Under s 14U of TAA, the Commissioner will issue a departure authorisation certificate where he or she is satisfied that the taxpayer will return to Australia after a short absence and will then make satisfactory arrangements to discharge the debt. The onus is on the taxpayer to establish that it should be granted. Section 14U(1)(b) of TAA provides that a departure authorisation certificate may also be granted where a person has provided security to the satisfaction of the Commissioner or, if the person is unable to give security, the Commissioner is satisfied that a departure authorisation certificate should be issued on “humanitarian grounds”: Lui v FCT (2009) 76 ATR 633.
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It is an offence for a taxpayer to leave Australia if they know that a DPO is in force: s 14R of TAA. A person aggrieved by the issue of a DPO may appeal to the Federal Court or a State Supreme Court: s 14V of TAA. If the Commissioner refuses to revoke or review a DPO or refuses to issue a departure authorisation certificate, the taxpayer can apply to the AAT for a review of that decision: s 14Y of TAA.
Penalties [24.200] The underlying rationale for any penalty regime is to deter non- compliance. Penalties in a tax regime can also compensate the government for the opportunity cost of not having the use of the tax revenue. Effective penalties are: • understandable and fair; • flexible; and • administered consistently. The Australian tax system contains a variety of administrative, civil and criminal penalties including: • Administrative penalties –Pt 4-25, Sch 1 of TAA; • Tax Offences –Div 2, Pt III of TAA; • Promoter Penalties –Div 290, Sch 1 of TAA. Financial Penalties are imposed using penalty units. The Commonwealth penalty unit is currently the amount of $210: s 4AA of the Crimes Act 1914 (Cth).
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There are also interest regimes described at [24.140] and [24.150].
Administrative penalties [24.201] The uniform administrative penalties regime in Pt 4-25, Sch 1 of TAA consists of three categories of penalty and applies in relation to income tax as well as the other taxes that the Commissioner administers, such as GST and FBT. Division 284 deals with statement penalties. Division 286 deals with failure to lodge documents on time. Division 288 deals with a range of other issues, including failure to keep or retain a record and failure to provide reasonable facilities to an authorised ATO officer who is exercising access and inspection powers under s 353-15 or s 353-10, Sch 1 of TAA, discussed at [24.510]. Some of the penalties can overlap. The main administrative penalties are: • a taxpayer makes a false or misleading statement to the Commissioner, such as in a tax return, either because of things included or omitted from it (s 284-75(1));
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820 [24.201] PRINCIPLES OF TAXATION LAW 2020 • a taxpayer makes a statement that treats an income tax law as applying to a matter or identical matters in a way that was not reasonably arguable (s 284-75(2)); • penalties in relation to tax avoidance schemes (s 284-145); • a taxpayer fails to give a return, notice or other document to the Commissioner by the day it is required to be given (s 286-75); and • a taxpayer fails to keep or retain records (s 288-25). The amount of the false or misleading statement penalties in Div 284 depends upon culpability, where the base penalty amount can range from 25% to 75% of the tax shortfall amount or 20–60 penalty units if there is no shortfall. The penalty for taking a position that is not reasonable arguable is limited to 25% of the shortfall: s 284-160. The scheme penalty is 25% or 50% of the scheme shortfall amount: s 284-160. All of these penalties may be doubled in relation to significant global entities (defined in s 960-555 of ITAA 1997). The Commissioner must make a formal assessment of these penalties (s 298- 30) and can increase or reduce the base penalty amount depending on the behaviour of the taxpayer: ss 284-220 and 284-224, Sch 1 of TAA. The taxpayer may object to such an assessment as set out in Pt IVC of TAA: s 298-30(2); see [24.210].
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The other administrative penalties arise by operation of law, but the Commissioner must give notice of the penalty (s 298-10) and has the power to remit the administrative penalties: s 298-20, Sch 1 of TAA. A taxpayer who is dissatisfied with the Commissioner’s decision not to remit can object to this decision under Pt IVC of TAA: s 298-20(3). PS LA 2012/5 states that if a statement is unclear or creates a false impression, it may be “misleading” even if it is literally accurate. In the same way, a statement that is erroneous will be “false” and it is not necessary to show dishonesty. Section 284-75(4) extends this penalty to taxpayers who give statements to someone other than the ATO which are required under a tax law. The false or misleading statement penalty does not operate if the taxpayer can demonstrate that reasonable care was taken when making the statement: s 284- 75(5), Sch 1 of TAA. What constitutes reasonable care depends on the individual circumstances of the taxpayer: Ruling MT 2008/ 1. It is an objective test and considers the circumstances of the individual taxpayer, for example, education, health, age, experience: see also PS LA 2012/5. Tax professionals, lawyers and accountants are subject to higher standards than individual taxpayers. Using a professional does not excuse taxpayers from checking their individual returns: Re Necovski and FCT (2009) 75 ATR 152. However, there is a safe harbour for the false and misleading penalty if the taxpayer uses a tax agent and has provided the tax agent with all relevant information: s 284-75(6).
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Taxpayers are expected to rely on a reasonably arguable position in relation to income tax, and if they fail to do so they are liable to pay an administrative penalty: s 284-75(2). The meaning of “reasonably arguable position” is given in s 284-15 and requires that the taxpayer take into account all relevant authorities. Taxpayers may demonstrate that they have a reasonably arguable position because they have followed public rulings, applied for a private ruling or consulted specialists. This is considered to be an objective test: Walstern v FCT (2003) 54 ATR 423. The false or misleading statement penalty and the failure to a reasonably arguable position penalty are separate and distinct: Sanctuary Lakes v FCT [2013] FCAFC 50. Case study 24.5: Division 284 –Re Andriopoulos and FCT (2009–2010) 78 ATR 654 The taxpayer, a sole trader, owed money to the ATO. Her husband colluded with an ATO officer to bypass ATO procedures and lodged two Business Activity Statements (BAS), which had the effect of extinguishing the debt. When the taxpayer was notified that she would be audited, she consulted a lawyer and disclosed the “mistake”. The AAT held that including figures in the BAS constituted a statement under s 284-75(1) and that the penalty was correctly imposed at the 75% base amount. The Commissioner reduced the penalty by 20% because of the voluntary disclosure.
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Director penalty notices [24.202] In order to encourage companies to comply with their tax obligations with regard to PAYG withholding and the superannuation guarantee charge, Div 269, Sch 1 of TAA, empowers the Commissioner to issue the directors of the company with a DPN. The DPN system is designed to encourage the company either to promptly pay the amounts owing to the Commissioner or to go into voluntary administration or liquidation by imposing the liability to pay the amounts on the directors. The penalty is imposed automatically by law, but the Commissioner must issue a notice to the directors and wait 21 days before commencing recovery: s 269-20, Sch 1 of TAA. The penalty is automatically remitted if the company pays the amount or goes into administration within the 21 days: s 269-30, Sch 1 of TAA. However, if the required payment is neither reported nor paid for three months, the penalty will only be remitted if the company pays the amount: s 269-30(2). This is referred to as the “lock down rule”. Legislation before Parliament in the second half of 2019 proposes to expand the DPN regime to a company’s GST liabilities: Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019.
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Tax offences under the Taxation Administration Act [24.203] The TAA also establishes criminal offences in relation to tax matters: ss 8A– 13C of TAA. In some cases, these offences overlap with the administrative penalty provisions in Sch 1, but the two sets of rules are alternatives: one cannot be both prosecuted for a tax offence and subject to an administration penalty in relation to the same act: s 8ZE of TAA. For example, making a false or misleading statement to a tax officer is an offence under s 8K but could also give rise to an administrative penalty under s 284-75(1).
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The potential penalties vary in relation to the offences but can be quite serious, including imprisonment. The Commonwealth Department of Public Prosecutions (CDPP) is responsible for all prosecutions, but the ATO is granted to power to prosecute the less serious cases. The offences contained in s 8C (failure to lodge a return, produce information, etc) are absolute liability offences, meaning that there are no fault elements and the defence of mistake of fact is not available. The offences contained in s 8D (failure to answer questions or produce documents when attending before a taxation officer) are strict liability such that there are no fault elements, but the defence of mistake of fact is available. However, in both cases, a person will only be liable if they were capable of complying. The offence under s 8K (false and misleading statements) is also an absolute liability offence, but the TAA provides a number of defences. The other main tax offences are s 8L (incorrectly keeping records) (absolute liability); ss 8N and 8Q (recklessly making false or misleading statements or recklessly and incorrectly keeping records) (strict liability); and ss 8T and 8U (acts done with the intention to deceive or mislead). Serious cases of tax evasion and other tax-related crimes may be prosecuted under the Criminal Code Act 1995 (Cth) or the Crimes (Taxation Offences) Act 1980 (Cth). For example, prosecutions in the tax context can rely on the offences of dishonestly obtaining a gain or financial advantage from the Commonwealth and conspiracy to defraud the Commonwealth: Criminal Code Act 1995, Sch 1, ss 135.1, 135.2 and 135.4, respectively. In a case of tax evasion or tax fraud, both the taxpayer and others involved in the offence, such as tax advisors, may be prosecuted: R v Issakidis [2018] NSWSC 378 and Dickson v R [2017] NSWCCA 78. The most serious tax crimes are managed by the Serious Financial Crimes Taskforce, a cross-agency group that include the ATO, the Australian Federal Police, Australian Securities and Investments Commission (ASIC), Border Force and the CDPP.
Return prepared by a tax practitioner [24.205] Section 284-75(5) provides a taxpayer is not liable to pay false or misleading statement penalties where they or their agent took reasonable care in making the statement. This test is objective and where a taxpayer uses the
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services of a lawyer, accountant or tax/BAS agent, there is a higher standard of care than if they were a self preparer: Re Necovski and FCT (2009) 75 ATR 152. A taxpayer is not liable to pay the penalty if they gave a registered tax agent or BAS agent all relevant tax information and the agent made the statement without recklessness or intentional disregard of a taxation law: s 284-75(6), Sch 1 of TAA. This is called a “safe harbour” for taxpayers who use the services of registered agents (see [24.690]). The penalty for late lodgment is also relieved on a similar basis if one uses a registered tax agent: s 286-75(1A), Sch 1 of TAA.
Remission of administrative penalties [24.206] The administrative statement penalties in Div 284 are imposed at a base rate, but the Commissioner has the discretion in assessing such a penalty whether or not reduce it or increase it because of the taxpayer’s behaviour. In relation to Div 284 as well as the administrative penalties that operate automatically, the Commissioner also has the discretion to remit the penalty: s 298-20, Sch 1 of TAA. A taxpayer has objection rights to the assessment of the statement penalties (s 298-30(2)) and the non-remittance of penalties (s 298-20(3)), subject to time limits: s 14ZW(1)(c) and (1BB) of TAA. The onus is on the taxpayer to prove that the penalty is excessive. The ATO policy on remission of penalties is set out in several Practice Statements that are continually reviewed.
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Promoter penalties [24.207] Division 290, Sch 1 of TAA deals with promoters of tax exploitation schemes and persons who implement arrangements not in accordance with a relevant product ruling (PR). On application by the Commissioner to the Federal Court, the Court may impose civil penalties (s 290- 50(3)) or issue injunctions: s 290-125. The Commissioner also has the power to enter into voluntary undertakings with an entity: s 290-200, Sch 1 of TAA. The division deals with promoters who market or encourages growth of a tax exploitation scheme. The term “tax exploitation scheme” is defined to include cases where it is reasonable to conclude that an entity that entered into or carried out the scheme did so with the sole or dominant purpose of obtaining a scheme benefit and it is not reasonably arguable that the scheme benefit is available at law: s 290-65. This language is similar to that used on Pt IVA of ITAA 1936 but is broader as it is designed to include avoidance of income tax as well other tax obligations and it can apply to schemes that have not yet been implemented. There have only been a few applications by the Commissioner for this penalty since the introduction of these measures in 2006 but all have been successful: FCT v Ludekens [2013] FCAFC 100. In FCT v Arnold (No 2) [2015] FCA 34, Edmonds J in the Federal Court found all elements of the division
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824 [24.210] PRINCIPLES OF TAXATION LAW 2020 applied and imposed very large fines as a deterrent. There was “deliberate wrongdoing, sustained denials of contraventions and lack of remorse”. In FCT v Ludekens (No 2) [2016] FCA 755, the Court considered those factors relevant when deciding what penalties should be imposed on promoters. The penalty imposed should achieve a just and fair result but must not be oppressive or punish for the same behaviour twice. The Court stressed that the appropriate penalties must serve as both general and specific deterrence. The most recent case, FCT v International Indigenous Football Foundation Australia Pty Ltd [2018] FCA 528, involved a research and development (R&D) tax offset incentives scheme. In that case, the Commissioner was again successful, and Court emphasised the import message of deterrence served by the significant penalty assessed. Tax agents, lawyers, accountants, financial planners and other entities who merely give tax planning advice about a scheme are not caught under the legislation: s 290-60(2), Sch 1 of TAA. On the other hand, tax agents who give aggressive tax advice or false and misleading information to clients may be prosecuted and also referred to the Tax Practitioners Board (see [24.690]).
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Objections, reviews and appeals [24.210] The procedure for an objection, review or appeal relating to any reviewable tax decision of the Commissioner is set out in Pt IVC of TAA. This is a merits review system that tests whether the decision is accurate and goes to the substantive liability. This operates alongside the right of an aggrieved person to apply for judicial review of an administrative action, such as a decision of the Commissioner, under s 39B of the Judiciary Act, which tests whether the administrative power was validly exercised. The tax legislation must contain a provision that specifically states that the decision is reviewable in order to access the Pt IVC process and not all actions of the Commissioner are reviewable. The main reviewable decisions are assessments and private rulings. For the purposes of this process, an objection is called a taxation objection. Figure 24.2 sets out the appeal process in relation to an assessment. The general rule is that the time limit for lodging an objection to an assessment is the same as the time limit the Commissioner has to amend an assessment, so two or four years: s 14ZW(1)(aa). Where the taxpayer has been served with an amended assessment, the right of objection in relation to the amended assessment is limited to the issues or particulars of the amendment: s 14ZV. The objection period for amended assessments is the later of the objection period for the original assessment and 60 days after the notice of amended assessment was served on the taxpayer: s 14ZW(1B) and (1BA) of TAA. A taxpayer can apply to the Commissioner for an extension of time
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Figure 24.2: Appeal process
to lodge an objection: s 14ZX. When deciding whether to grant the request, relevant issues include the following: the reason for the delay (eg, taxpayer overseas and unaware of the issue, ill health of the taxpayer, or negligence of tax agent); the merits of the objection; whether the Commissioner will be prejudiced; and fairness to the taxpayer compared to other taxpayers in a similar position: Hunter Valley Developments Pty Ltd v Cohen (1984) 3 FCR 344 and FCT v Brown (1999) 43 ATR 1. The Commissioner’s views can be found in PS LA 2003/7. An objection must be in an approved form in writing, stating fully and in detail the taxpayer’s grounds of objection: s 14ZU. Unless the court or AAT hearing the objection exercises its discretion, a taxpayer cannot amend the grounds stated in the objection: ss 14ZZK and 14ZZO; Lighthouse Philatelics Pty Ltd v FCT (1991) 22 ATR 707. [24.220] A taxpayer can object to an assessment even if it is made exactly in accordance with the original tax return. This may be a desirable strategy to test
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826 [24.225] PRINCIPLES OF TAXATION LAW 2020 an issue as it minimises potential penalties. It is also possible to object even when the result is to increase the taxpayer’s liability: Gulland v FCT (1984) 15 ATR 892. A taxpayer can also withdraw an objection at any time after it has been lodged. A taxpayer is entitled to request the Commissioner to supply details of the material on which the assessment is based: Bailey v FCT (1977) 136 CLR 214. Under s 25-5 of ITAA 1997, taxpayers can claim a deduction for non-capital expenditure incurred in managing their tax affairs. This includes costs paid to a tax agent to prepare a taxation objection.
Onus of proof [24.225] The onus (burden) of proof when challenging an assessment, amended assessment or default assessment rests with the taxpayer. The taxpayer has to prove that the assessment is excessive and what the correct assessment should be: ss 14ZZK(b) and 14ZZO(b) of TAA.
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Case study 24.6: Discharge of onus of proof In FCT v Dalco (1990) 20 ATR 1370, the Commissioner had issued amended default assessments under s 167 of ITAA 1936 alleging that the amount of income disclosed in the taxpayer’s returns was insufficient to maintain his lavish lifestyle. The issue in the case involved what was required of the taxpayer to discharge his burden of proof. The High Court held that, in discharging the burden of proof, a taxpayer needs to show that their actual taxable income is less than the amount assessed. That burden is not discharged if the taxpayer only demonstrates that the Commissioner’s assessment is wrong. The taxpayer needs to establish on the balance of probabilities what amendments need to be made to the assessment to correct it.
Commissioner’s decision on taxation objections [24.230] When a taxation objection is lodged within the prescribed time limit, the Commissioner must decide whether to allow it wholly or in part or disallow it: s 14ZY of TAA. The Commissioner must inform the taxpayer of their further rights of review, including any fees relating to the review and relevant time limits.
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The Commissioner makes the objection decision and serves the taxpayer with written notice of the decision. There is no prescribed time limit within which the Commissioner must make an objection decision. However, Pt IVC contains a mechanism under s 14ZYA for a taxpayer to take action and ensure an objection is not ignored for a long period by the ATO. If an objection decision has not been made within 60 days of receipt of the objection, or within 60 days after the taxpayer has responded to the ATO’s request for further information, the taxpayer can send a written notice requesting it to be made. If the decision is not made within 60 days of receipt of the notice, the objection is deemed to be disallowed. This then gives taxpayers the option of seeking a review of the decision by the AAT or appealing the decision to the Federal Court: see [24.240]. In FCT v McGrouther [2015] FCAFC 34, the Full Federal Court had held that taxpayers could withdraw a s 14ZYA notice which they had given the Commissioner before the 60-day period had expired and thereby waive their right to the deemed objection decision. They would also be able to issue a new s 14ZYA notice within the relevant time period if they wished. It may not always be in the best interests of taxpayers to rush to use the s 14ZYA procedure. The Commissioner may require longer than 120 days to deal with a very complex matter. If the objection is deemed to be disallowed under s 14ZYA, it is still possible for the Commissioner subsequently to consider the matter.
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Application for appeal or review [24.240] Section 14ZZ of TAA provides that if a taxpayer is dissatisfied with the Commissioner’s objection decision, the person may either: 1. apply to the AAT for a review of the decision; or 2. appeal to the Federal Court against the decision. The application must be in writing, using the prescribed form, stating the reasons for the application and lodged within 60 days after the objection decision has been served: ss 14ZZC and 14ZZN of TAA. If the taxpayer is delayed in lodging the application for review, and the circumstances causing delay are reasonable (eg, a taxpayer’s agent failed to follow instructions to lodge an application to the AAT), a taxpayer may be granted an extension of time to lodge an application for review to the AAT: s 29(7) of Administrative Appeals Tribunal Act 1975 (Cth) (AAT Act). The Federal Court does not have the power to extend the time for lodging an appeal later than the 60-day period. [24.250] Part IVC of TAA contains two categories of decision: appealable objection decision and reviewable objection decision (s 14ZQ). The type of decision dictates whether a taxpayer applies to the AAT or the Federal Court. Most objection decisions are both appealable and reviewable, and a taxpayer has
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828 [24.260] PRINCIPLES OF TAXATION LAW 2020 to choose between commencing proceedings in the AAT or the Federal Court. If the taxpayer is not satisfied with the decision of the AAT, they can appeal on a question of law to the Federal Court: s 44 of AAT Act. In all proceedings, the onus of proof remains with the taxpayer to prove that the assessment is excessive.
Choice between AAT and Federal Court [24.260] There are several factors for taxpayers to consider when deciding whether to elect to start proceedings in the AAT or the Federal Court: s 14ZZ of TAA. Time, cost, availability of further avenues of appeal and the powers exercised by the AAT and the Court will all be important. The powers of the tribunal are set out in the AAT Act. The AAT has all the powers and discretions of the original decision-maker and it may confirm, vary or set aside a decision. In March 2019, a Small Business Taxation Division was established within the AAT to provide a more accessible and cost-effective option for the resolution of small business tax disputes. Factors to consider when choosing the AAT include: • It can exercise all the powers of the Commissioner, including the exercise of a discretion. • It can use evidence not before the Commissioner in making its decision.
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• Parties bear their own costs. These are a lot less than in court proceedings because taxpayers may act for themselves. They do not need representation by either a lawyer or an accountant, although they may have it if they wish. • There are no formal rules of evidence, unlike in a court: s 33(1)(c) of AAT Act. • It must follow the rules of procedural fairness/natural justice (hear both sides of the issue and neither party is allowed to be a judge in relation to their own matter). • It follows previous court decisions but, where there are conflicting decisions, it makes a choice which one to follow. • It can consider and make the final decision on questions of fact. • Applicants can request that hearings be held in private (s 14ZZE of TAA) or, alternatively, request that the identity of the taxpayer or some of the evidence not be made public: s 35 of AAT Act. Factors to consider when choosing the Federal Court include: • It limits itself to the evidence available before the Commissioner. • Court costs are higher as the taxpayer requires legal representation. Party and party costs are awarded, that is, the losing party pays the costs of the winning party. At times when a test case is involved,
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the Commissioner undertakes to pay agreed costs regardless of the outcome. • It is bound to comply with the formal rules of evidence. • Hearings are conducted in public. There is no right to privacy. • Courts are bound by the doctrine of precedent. • Taxpayers have the normal procedural rights available for obtaining information. [24.270] Under s 43(1) of AAT Act, the AAT may exercise all the powers and discretions which any relevant Act confers on the person who made the decision, such as the Commissioner, and shall make a decision in writing: 1. affirming the decision under review; 2. varying the decision under review; or 3. setting aside the decision under review and making a decision in substitution for the decision set aside or remitting the matter for reconsideration in accordance with any direction or recommendations. The AAT is the better choice for taxpayers where the exercise of the Commissioner’s discretion is an issue or a simple question of fact is involved. Where there are complicated legal issues, the Federal Court is preferable.
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The AAT gives the reasons for its decision either orally or in writing but where the decision is given orally, a party may within 28 days after receiving the decision request the AAT to supply written reasons for its decision: s 43(2A) of AAT Act. The AAT cannot amend an assessment, but the Commissioner is given 60 days to amend the assessment to implement the decision of the tribunal: s 14ZZL of TAA. The Commissioner and the taxpayer have 28 days after the AAT’s decision has been handed down to appeal to the Federal Court, providing there is a point of law involved: s 44 of AAT Act. A point of law, as distinct from a question of fact, usually involves the interpretation of a section of an Act or the meaning of a precedential case and a question of law will include a mixed question of fact and law: Haritos v FCT [2015] FCAFC 92. The facts as found by the AAT stand for all further appeals from its decision: FCT v Brixius (1988) 19 ATR 506. An appeal from the decision of a single judge of the Federal Court is available to the Full Federal Court (usually three judges): ss 24 and 25 of Federal Court of Australia Act 1976 (Cth). A further appeal to the High Court is only available when special leave has been granted: s 33(3) of the Federal Court of Australia Act 1976 (Cth) and s 35A of the Judiciary Act 1903 (Cth).
ATO Test Case Litigation Program [24.290] The ATO has a Test Case Litigation Program, whereby it agrees to fund some or all of a taxpayer’s costs in relation to a case (up to the High Court
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830 [24.300] PRINCIPLES OF TAXATION LAW 2020 if necessary) to assist in clarifying the law. These cases involve issues where there is uncertainty or contention about how the law operates and it is in the public interest that the matter be litigated, so ordinarily the issue will be one that is significant to a substantial section of the public or an industry sector. The program is not available for cases that only involve factual issues. In most cases, taxpayers must apply for funding and the applications are considered by a Panel, made up of internal senior ATO members and external members, which makes recommendations with respect to funding. The ATO maintains an online register that shows a brief description of the matters accepted and declined for funding and also tracks the progress of funded cases.
The role of the ATO [24.300] In a self-assessment environment, it is impossible for the ATO to check every return it receives. Instead, it relies on “risk-assessment” techniques in order to target which returns or taxpayers should be the subject of closer examination or an audit. The ATO’s overall strategy consists of a mixture of assistance and enforcement.
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Revenue authorities rely on voluntary compliance, that is, that taxpayers are honest, declare all their income and only claim the deductions to which they are entitled and for which they have the required substantiation documents. However, there will always be taxpayers who do not comply, for example, criminals such as drug dealers or cash economy participants. The integrity of the tax system depends on an administration which encourages or, where necessary, forces these taxpayers into the system. The Commissioner’s speeches since 2015 have continued with the theme of “re-inventing” the ATO. The ATO should be known for its contemporary service, expertise and integrity. It has concentrated on efficiency and improving a taxpayer’s interaction with the ATO with the use of streamlined processes. It wants to make the legislation understandable and fair and its administration consistent and flexible. The ATO wishes to build trust, respect and confidence at both an individual and organisational level. Core values include the following: fairness and professionalism; openness and transparency; and consultation, collaboration and co- design. The ATO strives to understand the individual problems faced by all types of taxpayer, engage with them in a useful supportive manner, assist them to be compliant and do this while upholding the rule of law. Tax administration is no longer a single country issue but instead it has become borderless particularly in the area of organised crime. The ATO has engaged with international co-operative networks of tax administrations. In 2018, the ATO released its Corporate Plan for 2018–2019 that includes a longer term set of strategic objectives for the period to 2024. The intention is
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to build on the gains realised through the re-invention program and focus on two objectives. From the Commissioner’s forward, these are “to build trust and confidence in the tax and superannuation systems and to create a streamlined, integrated and data-driven future”. This is further detailed in nine strategic objectives related to government, client (taxpayers and tax professionals), workforce, operational and financial perspectives. In relation to taxpayers, the Corporate Plan highlights a number of initiatives that will support the “future goal” of having a system where dealings between the ATO and clients are seamless and easy, where many interactions occur automatically. More specifically, the ATO has identified the following strategic initiatives in relation to clients (taxpayers): • to embed fair and timely dispute resolution; • to use independent advice to assure that ATO decisions are fair and reasonable; • to continue the roll-out of Single Touch Payroll; • to develop public advice and guidance from a forward- looking perspective and use data to guide this process; • to interact digitally with clients where possible; and • to provide tailored and integrated support for small business.
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Commissioner’s statutory remedial power [24.305] Division 370, Sch 1 of TAA provides the Commissioner with the power to make disallowable legislative instruments that modify taxation laws to ensure that they can be administered in such a way that their intended purpose or effect is achieved. This will reduce disproportionate compliance costs and benefit the community. It will also give greater flexibility where legislative problems cannot be solved by administration or interpretation and recognises that the process of legislative amendment is often slow. The power may only be exercised where there will be a negligible revenue impact and gives affected taxpayers a beneficial outcome. It cannot be exercised in a way inconsistent with the purpose or object of the provision or where there is a negative impact on taxpayers. Before exercising this power to issue a legislative instrument, the Commissioner will consult publicly. As is the case with all legislative instruments, Parliament has 15 sitting days during which the modifications can be disallowed.
Compliance approach [24.310] The ATO divides taxpayers into main client groups: • Individuals; • Small Business;
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832 [24.320] PRINCIPLES OF TAXATION LAW 2020 • Privately Owned and Wealthy Groups (resident individuals who, with associates, have net wealth exceeding $5 million and privately owned companies which, with associated entities, have a turnover in excess of $10 million); • Public and Multinational Businesses; • Not-for-profits; • Superannuation funds; and • Tax professionals and other intermediaries. There is a separate business line which deals with serious non-compliance and prosecutions. The ATO works with other law enforcement agencies, such as the Australian Federal Police, when dealing with these taxpayers. [24.320] As part of its commitment to transparent tax administration, the ATO publishes online material dealing with various topics, for example, capital gains tax (CGT) and record keeping, to assist taxpayers to comply. It has recently issued a Corporate Plan that covers the period from 2018 to 2024 and deals with the ATO’s role in administering the tax and superannuation systems on a more macro level. This Plan identifies both the priorities for the year ahead and longer term strategic objectives. The Corporate Plan also includes the ATO’s plans in relation to other aspects of its work, including running the Australian Business Register, the Tax Practitioners Board and the Australian Charities and Not-for-profit Commission.
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Third party reporting [24.330] The ATO uses computerised data-matching systems to check the accuracy of the information in tax returns and to pre-fill certain elements of individuals’ tax returns. Much of this is done using TFNs, which are issued to all taxpayers, including companies, or ABNs. Investment bodies, including financial institutions such as banks which pay interest on deposits and companies that pay dividends on shares, must annually report the amounts paid to taxpayers to the ATO: Div 393, Sch 1 of TAA. When an investor fails to give a TFN to a financial institution, that institution must withhold tax at the maximum individual rate plus Medicare levy before paying the money or dividend to the taxpayer: s 12-140, Sch 1 of TAA. From 1 July 2016, a variety of other government and private entities must report tax-related information about transactions to the Commissioner: subdiv 396-B, Sch 1 of TAA. For example, government revenue collection departments, such as the Land Titles Office, must report on transfers of real property. There are also rules in Div 405, Sch 1 of TAA, that impose special reporting obligations on the building and construction industry: see also s 70 of the Taxation Administration Act Regulations 2017. These formal reporting obligations are complemented by data matching programs that operate under the Commissioner’s general
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access to information power (see [24.510]) and are notified by way of Gazette Notices. Through the development of international information exchange agreements and processes, the ATO now has access to large volumes of information provided by foreign revenue authorities. Financial institutions must report financial account information to the ATO in a specified format under the Common Reporting Standard, where the ATO then exchanges information with other jurisdictions based on the identification of relevant taxpayers. With respect to company information, the Country- by- Country (CbC) reporting system has recently commenced where countries will exchange CbC statements that include details of revenues, profits, taxes paid, cross-border transactions and other specific information at different levels of a multinational. The CbC reporting obligations only apply to significant global entities.
Australian Business Number [24.340] The Australian Business Number (ABN) is a single number issued to business taxpayers for use in their dealings with government and other businesses. Taxpayers who register for GST have the same number for their ABN and GST registration. The ABN was introduced as an integrity measure when the GST was introduced and taxpayers must have an ABN to register for GST.
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Any person who makes a payment of over $75 to a taxpayer who is conducting a business for profit is required to withhold and remit to the Commissioner the maximum personal rate plus Medicare levy if the supplier of the goods or services fails to quote an ABN: s 12-190, Sch 1 of TAA.
Taxpayers’ Charter [24.350] The Taxpayers’ Charter was first issued on 1 July 1997 and sets out the treatment taxpayers can expect to receive in their dealings with the ATO. It is not a legislated Bill of Taxpayer Rights, unlike the position in the United States. Although it lacks the force of law, it sets out taxpayers’ rights and obligations and the ATO’s client service commitments. The ATO views the Charter as part of its professional approach to tax administration. The rights of taxpayers include: • Taxpayers can expect the ATO to treat them fairly and reasonably, taking individual differences into account. • There is a presumption that taxpayers are honest unless their conduct demonstrates otherwise. • The ATO accepts accountability for its actions and assists taxpayers to meet their tax obligations.
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834 [24.360] PRINCIPLES OF TAXATION LAW 2020 • The ATO is also committed to minimising compliance costs for taxpayers, provided the revenue is not compromised. The Taxpayer’s Charter also contains obligations which taxpayers are expected to meet. These include: • Honesty –taxpayers are expected to be honest in their dealings with the ATO. • Record keeping –taxpayers are expected to accurately prepare and keep required tax records. • Taxpayers are expected to take reasonable care, meet lodgment deadlines and pay their tax on time.
Compliance model [24.360] The Compliance Model was developed for the ATO as part of its acknowledgment that taxpayers are individuals and there is no “one-size-fit- all” approach. It is a responsive regulatory pyramid that has been adapted to specifically relate to tax matters. A pictorial representation of the pyramid is provided on the ATO website.
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Figure 24.3: ATO Compliance Model [see https://www.ato.gov.au/ about-ato/managing-the-tax-and-super-system/strategic-direction/ how-we-help-and-influence-taxpayers/Compliance-model/]
The ideal taxpayer is at the base of the pyramid: the taxpayer is willing to do the right thing; the compliance strategy is to make it easy to comply; and the level of compliance costs is low. The left side describes the attitude of
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taxpayers towards compliance, and the right side describes the strategies to be used by the ATO to encourage taxpayers back to the base. In relation to those taxpayers who have decided not to comply, the ATO will use the full force of the law. The Compliance Model is accompanied by the business, industry, sociological, economic, psychological (BISEP) concept, reinforcing that many different factors influence taxpayers’ behaviour. The ATO also uses risk differentiation or assessment frameworks to assess tax risk and determine an appropriate choice of remedy. These frameworks are sometimes provided to taxpayers in ATO guidance materials, such as the Practical Compliance Guidelines, so that taxpayers can self-assess risk and adjust behaviours to qualify for a lower risk rating (see, eg, PCG 2017/1 on transfer pricing issues).
ATO support for taxpayers
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[24.370] Tax legislation is becoming more complex every year. This makes it very hard for taxpayers to comply with their obligations because self- assessment requires them to ascertain their taxable income and, if they make a mistake, they may be subject to penalties and interest. In addition, in a review or appeal, the burden of proof rests with them, not the ATO. The ATO offers a range of products to assist taxpayers and reduce their uncertainty and risk of error. Some of these products, such as rulings, are provided for in the legislation while others have been developed by the ATO to further assist taxpayers. These products include: • public rulings (including product rulings (PRs), class rulings (CRs) and taxation determinations (TDs)): see [24.410]–[24.440]; • private rulings: see [24.450]; • oral rulings: see [24.490]; • interpretative decisions: see [24.500]; • practice statements; • practical compliance guidelines; • policy statements; • decision impact statements; • online self-help tools, calculators and apps; • Taxpayer Alerts; • telephone guidance; • written guidance;
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836 [24.380] PRINCIPLES OF TAXATION LAW 2020
• • • •
press releases; booklets and public information videos; fact sheets; and a comprehensive website: http://www.ato.gov.au. This website con tains, in addition to ATO Policy papers, a schedule of documents containing ATO precedential views and technical discussion papers. A distinction is drawn between binding advice (which protects taxpayers from additional tax, penalties and interest if the advice applies to them) and guidance (which only protects taxpayers from penalties and interest if it is reasonable for them to rely on the guidance). Schedule 1 of TAA sets out the legislative regime for ATO advice: Div 357 (common rules), Div 358 (public rulings), Div 359 (private rulings), Div 360 (oral rulings) and Div 361 (non-ruling advice and administrative practices).
Common rules that apply to all rulings
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[24.380] Division 357, Sch 1 of TAA, permits the ATO to make a ruling on issues relating to any provision in an Act or regulation of which the Commissioner has the general administration and specifically dealing with income tax, Medicare levy, FBT, franking tax, withholding tax, mining withholding tax, petroleum rent resources tax, indirect tax including GST, excise duty, the major banks levy and the administration and collection of those taxes, as well as other matters: s 357-55, Sch 1 of TAA. Rulings bind the Commissioner when a taxpayer acts or fails to act, either deliberately or through ignorance, in accordance with the ruling: s 357-60, Sch 1 of TAA. It is critical that the taxpayer’s affairs fall within the scope of the ruling if the taxpayer wishes to rely on it: Bellinz Pty Ltd v FCT (1998) 39 ATR 198. Taxpayers can cease to rely on a ruling by deliberately or unknowingly acting in a manner contrary to its ambit, but, if their behaviour later changes, they can opt back in and receive the benefit of the system. There is no automatic penalty if a taxpayer chooses not to follow a ruling, but naturally the ATO will apply the law in accordance with the position stated in the ruling. In Mt Pritchard & District Community Club Ltd v FCT [2011] FCAFC 129, the taxpayer argued that the Commissioner had raised assessments which were contrary to an earlier private ruling which had been issued, in contravention of the former s 170BB of ITAA 1936 and s 357-60, Sch 1 of TAA. The taxpayers sought judicial review of the assessment decisions under s 39B of the Judiciary Act 1903 and a declaration that the assessments were invalid. The Full Federal Court unanimously held that there were no provisions in the private ruling regime which limited the ability of the Commissioner to issue an assessment and noted that the substantive issues would be resolved through the Pt IVC proceedings also on foot in the AAT.
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Inconsistent rulings [24.390] Section 357-75, Sch 1 of TAA deals with inconsistent rulings. Where there is a conflict between a public ruling and any later ruling, the taxpayer can choose which one to rely on. When a taxpayer has a private or oral ruling and then applies for a subsequent private ruling, the taxpayer must follow the earlier ruling unless the Commissioner has been informed of its existence when the later ruling is applied for: s 357-75(1), Table Item 2, Sch 1 of TAA. When a taxpayer has a private or oral ruling and a public ruling is subsequently published, the taxpayer can rely on either ruling unless, when the public ruling is published, either the scheme or the period of time to which the private ruling relates has not commenced: s 357-75(1), Table Item 3, Sch 1 of TAA. When the Commissioner has issued a ruling and the law is subsequently re-enacted or modified, the ruling will still apply provided the new section expresses the same ideas as the repealed one: s 357-85. The validity of a ruling is not affected merely because a provision in Div 357, Div 358, Div 359 or Div 360 has not been complied with: s 357-90.
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[24.400] When a taxpayer has applied for a private or an oral ruling or has lodged an objection against a private ruling they have received, a taxpayer is still required to lodge a return, and the Commissioner can still make or amend an assessment: s 357-125, Sch 1 of TAA. Where a taxpayer has applied for a private or an oral ruling, the Commissioner has the power to request further information before making the ruling. If the taxpayer does not supply the information in a reasonable time, the Commissioner may decline to make the ruling: s 357-105(2), Sch 1 of TAA. If it is a private ruling, written reasons for declining to make it must be given: s 359-35(4). Where necessary, the Commissioner can make assumptions about a future event when issuing a private or oral ruling, but the applicant must be informed of the assumptions made and be given time to respond to them: s 357-110(2). The Commissioner can also take into account information from third parties, provided the applicant is fully informed and given the opportunity to respond: s 357-120.
Public rulings [24.410] Public rulings (Div 358, Sch 1 of TAA) may apply to all entities or a class of entities either generally or in relation to a particular scheme or class of scheme. They are named as follows: Taxation Ruling TR, the year of issue and the particular number in sequence of the ruling issued. For example, Ruling
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838 [24.415] PRINCIPLES OF TAXATION LAW 2020 TR 2006/10 is a public ruling issued in 2006. The number 10 merely means it is the tenth ruling issued that year and has no other significance. Ruling TR 2006/10 explains the current public rulings system. A ruling must state that it is a public ruling. Other public rulings include CRs, PRs, law companion rulings (LCR), TDs and other ruling specific to the other taxes and regimes of which the Commissioner has general administration, such as GST rulings (GSTR) and superannuation guarantee rulings (SGRs). Prior to 1992, the Commissioner issued formal rulings in the Income Tax series. These rulings are not public binding rulings, but the Commissioner considers that they are administratively binding on the ATO: see TR 2006/10 at [23]. The ATO’s Project Refresh commenced in 2017 and has the objective to review all public rulings which are over five years old, and if necessary or appropriate withdraw, update, amalgamate or rewrite them. Through this process, some of the old ITs have been withdrawn and replaced by binding TRs. The Commissioner issues public rulings when the area of the ruling affects a sufficiently wide group of taxpayers, the application of the law or its administration would benefit from clarification and there is a need to give taxpayers further guidance. A public ruling applies from its date of issue or a later or earlier date if specified in the ruling. It applies until it is withdrawn either wholly or in part (s 358-20, Sch 1 of TAA) when the Commissioner publishes a notice in the Gazette.
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A taxpayer has no right of objection against a public ruling. If taxpayers wish to challenge a public ruling, they can lodge their return, following the ruling and then object to the assessment. Alternatively, they can apply for a private ruling in relation to the same issue, knowing the ATO will follow its own public ruling and then object to that private ruling.
Law companion rulings [24.415] LCRs are a relatively new initiative of the ATO, and the first LCR was issued in 2015. The LCRs are public rulings that state the ATO’s view of how some recently enacted law applies. They are developed when the new legislation is at draft bill stage and are finalised when the bill has received royal assent and becomes law. They supplement the Explanatory Memorandum that accompanies the bill. This process provides early certainty about the application of the new law for taxpayers.
Product rulings [24.420] PRs are a type of public ruling that deal with the availability of tax benefits, usually tax deductibility of expenses, in relation to “product” which is generally a tax-effective investment. These investments are often classified
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and they usually involve financial products or rural investments, such as in timber, olive growing, or macadamia nuts. Before PRs were developed in 1998, it was necessary for every investor in these schemes to apply individually for a private ruling. A promoter of a product applies to the ATO for a PR. If the ATO issues it, then all investors in the scheme are entitled to the protection of the ruling, such as being able to claim a deduction for their expenses, provided the promoter carries out the scheme in accordance with the documentation given to the ATO. The promoter penalty rules protect the integrity of the PR system by penalising promoters who do not implement the scheme in accordance with the Ruling. The ATO audits these schemes and will withdraw a ruling if the facts differ from the documents it had ruled on: Carey v Field (2002) 51 ATR 40. The ATO does not investigate the commercial viability of the scheme. Usually a PR in relation to a financial product is given for a maximum period of three years, but rulings in relation to forestry investment schemes, for example, are often longer. PRs have been a very successful part of advice given by the ATO. Investors would now be reluctant to invest in a product which does not have a PR because of the uncertainty of their own tax position, unless they applied for a private ruling. The Federal Court has held that the decision of the Commissioner not to issue a product ruling was reviewable under the ADJR Act on application by the product developer: Agriwealth Capital Ltd v C of T [2019] FCA 56.
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Class rulings [24.430] Ruling CR 2001/1 contains an outline of the CR system. CRs enable the Commissioner to give a public binding ruling to an entity that needs advice about the application of the tax legislation to a specific class of person in relation to a particular taxpayer. Examples include the tax effect for shareholders of a share buy-back and the tax effect for employees in relation to an employment termination scheme. As with PRs, this saves each individual taxpayer who is affected by the arrangement from having to apply for a private ruling. Where the arrangement is carried out in accordance with the information supplied to the Commissioner, the ruling is legally binding on the Commissioner and all taxpayers in the class can rely on it.
Taxation determinations [24.440] TDs were introduced as part of the public rulings system. The ATO issues them when it wishes to clarify its approach to a single issue. Taxation rulings usually involve multiple issues, they are written in conjunction with
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840 [24.450] PRINCIPLES OF TAXATION LAW 2020 detailed analysis or alternative viewpoint but are confined to a single issue without extensive reference to the ATO’s legal analysis of how it reached its position. Some of the TDs are issue to provide notice of relevant thresholds for the given income tax year, such as the reasonable travel and overtime meal allowances. TDs are binding on the Commissioner in the same way as other public rulings and apply either from the date specified in the determination or from the date of issue.
Private rulings [24.450] Private rulings are dealt with in Div 359, Sch 1 of TAA, and the system is explained in Ruling TR 2006/11. Private rulings are statements of the Commissioner’s view of how a relevant provision applies or would apply to a taxpayer (the rulee) in relation to a particular set of facts. Taxpayers may apply for a private ruling in relation to an administrative matter or a question of fact. Examples of questions of fact are: Is the taxpayer carrying on a business? Is there a partnership? Is the taxpayer a resident?
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[24.460] A private ruling only applies to the rulee, except for a trust situation, where the rulee is a trustee and the ruling relates to trust matters and therefore applies to a replacement trustee and the beneficiaries of the trust: s 359-30, Sch 1 of TAA. The Commissioner has the power to request further information, and the taxpayer must supply it within a reasonable time or the Commissioner may decline to rule: s 357-105(2), Sch 1 of TAA. The Commissioner can also decline to make a private ruling on the basis that to do so would require assumptions to be made about future events: FCT v Hacon Pty Ltd & Ors [2017] FCAFC 181. Under s 359-35, the Commissioner can also decline to make a ruling on various grounds, such as when the application is frivolous, vexatious, or the scheme is not seriously contemplated, or if the matter is already being considered by the Commissioner in relation to the applicant. If the Commissioner decides not to make a ruling, the rulee must be notified in writing with reasons: s 359-35(4). [24.470] If the Commissioner has not issued a private ruling within 60 days after receipt of the application and the rulee has not been informed of the reasons for the delay under s 359-50(1), Sch 1 of TAA, the applicant can issue a notice requiring the Commissioner to rule. If the ruling is not then issued or formally declined within 30 days, the applicant has the right to object as set out in Pt IVC: s 359-50(3).
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[24.480] As part of its commitment to transparent administration, the ATO publishes edited versions of private rulings as “edited private advice” on the ATO legal database. It is important for privacy purposes that individual taxpayers cannot be identified, so many of the details of the scheme in question may need to be removed. These edited versions are provided to taxpayers as information but cannot be relied upon, provide no protection and are not binding: PS LA 2008/4. Taxpayers receive a copy of the edited version for comment before it is published. The published documents are not updated, but in some cases may be annotated if, for example, the edited version is determined to be misleading.
Oral rulings [24.490] Under Div 360, Sch 1 of TAA, an individual taxpayer may apply for an oral ruling in relation to a simple tax matter. The Commissioner can decline to rule where the matter is too complex, a business taxpayer is involved or the issue is already or has been considered by the Commissioner: s 360-5(3). If the Commissioner requests further information and the taxpayer does not supply it, the Commissioner can refuse to rule. Oral rulings are made orally, and the taxpayer is not entitled to request a written version but is given a registration identifier. The Commissioner is bound by an oral ruling provided the facts supplied by the taxpayer do not change. At times, taxpayers prefer to ask for non-binding oral guidance, for example, by using the ATO phone help line.
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Non-ruling guidance [24.500] The ATO also provides taxpayers with non- ruling guidance and although it is not legally bound by it, it has usually considered itself administratively bound. Various descriptions of administrative practice are set out in the PS LAs. These inform taxpayers of the ATO’s approach when administering the law. They are followed by the ATO officers. Other helpful material includes approved policy documents published by the ATO, for example, speeches by ATO officers. The ATO’s Interpretative Decisions (ATO IDs) are summaries of decisions on technical issues. Often they are produced based on a private ruling, but they merely state the ATO’s interpretation of a particular issue. These are never updated but are rather withdrawn and are neither legally nor administratively binding on the Commissioner. No new ATO IDs have been added to the database since 2016. Decision Impact Statements are sometimes released by the ATO after a court has handed down a decision. They inform taxpayers of the ATO’s position
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842 [24.510] PRINCIPLES OF TAXATION LAW 2020 after the decision and how it will administer and apply the law in future to take it into account. Taxpayers are also informed whether the ATO intends to appeal. Taxpayer Alerts are published when the ATO becomes aware of a new, specific, high risk tax- planning arrangement. They describe the ATO’s concerns and what they intend to do, such as issue advice or guidance in the future.
Commissioner’s powers of access and investigation
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[24.510] Under s 8 of ITAA 1936 and s 3A of TAA, the Commissioner is charged with the general administration of the tax system under the tax legislation. When self- assessment was introduced, the focus of the ATO changed from assessing taxpayers by scrutinising their returns to accepting returns at face value and subsequently conducting audits or reviews. It is impossible to do this for every taxpayer, so the ATO chooses taxpayers, either individuals, small businesses, large companies or the clients of certain tax agents on the basis of various risk-assessment techniques. Most taxpayers are surprised when they learn that the Commissioner of Taxation in Australia has greater powers than the police. For example, ATO officers may access premises without notice at all reasonable times for the purposes of a taxation law and copy documents by virtue of s 353-15, Sch 1 of TAA, while the police must obtain a search warrant in order to access private premises, though the police may seize documents rather than merely copy them: ss 3E and 3F of Crimes Act 1914 (Cth).
Record-keeping requirements [24.520] Section 262A of ITAA 1936 requires every taxpayer carrying on a business to keep sufficient written records in English (or readily convertible to English) of income, expenditure and other relevant transactions and retain them for a period of at least five years after the completion of the transactions. Recipients of payment summaries must also keep them for five years, from the end of the financial year: s 18-100, Sch 1 of TAA. This is one year longer than the time the Commissioner usually has to make an amended assessment under s 170 of ITAA 1936: see [24.140]. Information stored or recorded by means of a computer is recognised as a document for the purposes of Commonwealth law, and therefore such storage will satisfy tax record keeping requirements. The ATO’s views regarding electronic records can be found in TR 2018/2.
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Failure to keep or retain records can give rise to an administrative penalty under s 288-25, Sch 1 of TAA. It is an offence to keep any required records in a way that does not correctly reflect the matter or transaction: s 8L of TAA.
Full and free access [24.530] Section 353-15, Sch 1 of TAA (formerly s 263(1) of ITAA 1936) states that, for the purposes of a taxation law, the Commissioner or any individual authorised by the Commissioner:
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(a) may at all reasonable times enter and remain on any land, premises or place; and (b) is entitled to full and free access at all reasonable times to any documents, goods or other property; and (c) may inspect, examine, make copies of or take extracts from, any documents; and (d) may inspect, examine, count, measure, weigh, gauge, test or analyse any goods or other property and, to that end, take samples. In relation to its previous version as s 263 of ITAA 1936, the High Court has always given a very wide interpretation to the section: South Western Indemnities Ltd v Bank of New South Wales (1973) 129 CLR 512, involving access to records of an Australian taxpayer held in a bank on Norfolk Island. Section 353-15(2) provides that any individual authorised by the Commissioner for the purposes of the section is not entitled to remain on any land, premises, or place if, after having been requested by the occupier to produce proof of her or his authority, the individual does not produce an authority signed by the Commissioner stating that the individual is authorised to exercise powers under this section. A so-called “wallet authorisation” is sufficient for these purposes: FCT v Citibank (1989) 20 ATR 292. Section 353-15(3) states that you commit an offence: (a) if you are an occupier of land, premises or a place; and (b) an individual enters, or proposes to enter the land, premises or place under this section; and (c) the individual is the Commissioner or authorised by the Commissioner for the purposes of the section; and (d) you do not provide the individual with all reasonable facilities and assistance for the effective exercise of powers under this section. One difference between the former s 263 of ITAA 1936 and the current s 353- 15(1)(b), Sch 1 of TAA is the limitation that access is available at all “reasonable” times. This could prove a practical problem if the ATO sought access without notice at an early time where they are worried that documents may be destroyed.
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Case study 24.7: Accessibility of records In Industrial Equity Ltd v DCT (1990) 170 CLR 649, the High Court held that the Commissioner was entitled to obtain records relating to Industrial Equity which were held by Bankers Trust, where the purpose of obtaining those records was in the conduct of a random tax audit. Although the powers must be exercised for the purposes of the Act, such as ascertaining taxable income or general administration, a “fishing expedition” was not an improper use of the power.
Commissioner’s power to obtain information and evidence [24.540] Section 353-10, Sch 1 of TAA (formerly s 264 of ITAA 1936) gives the Commissioner the power to issue a notice in writing requiring all or any of the following for the purpose of the administration or operation of a taxation law: (a) to give the Commissioner any required information; and (b) to attend and give evidence before the Commissioner, or an individual authorised by the Commissioner; and (c) to produce to the Commissioner any documents in your custody or under your control.
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Case study 24.8: Commissioner’s power to require information In Smorgon v Australia and New Zealand Banking Group Ltd, Smorgon v FCT (1976) 134 CLR 475, the High Court held that the Commissioner’s power under s 264 of ITAA 1936, requiring a bank to produce documents held in a safety deposit box, overrode the bank’s contractual duty to its client, the taxpayer. Further, in FCT v ANZ; Smorgon v FCT (1979) 143 CLR 499 (Smorgon (No 2)), the expression “custody or control” was satisfied by the fact that the bank had physical custody over the safe deposit box within which the documents were kept. The Court further held that s 264 was a wide power, and it enabled the Commissioner to make a roving inquiry and “fish” for information without needing to specify with total precision which documents he wished to see. [24.550] For a notice to be valid, it must specify the relevant taxpayer if the person on whom the notice is served is not that taxpayer. It should not be too wide, or the court will strike it down: Australia and New Zealand Banking Group Limited v Konza [2012] FCAFC 127. Section 264 of ITAA 1936, when
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read in conjunction with s 8C of TAA, abrogates the common law privilege against self-incrimination: Stergis v Boucher (1989) 20 ATR 591; DCT v De Vonk (1995) 31 ATR 481; Binetter v DCT (No 2) [2012] FCAFC 126. In Australian Crime Commission v Stoddart [2011] HCA 47, the Full High Court by majority held that the privilege against spousal incrimination did not exist at common law at the date of the case or at any time. In Australia and New Zealand Banking Group Limited v Konza [2012] FCAFC 2012, the Full Federal Court unanimously held that s 264 notices requesting information from an affiliate of the bank about customers using the Vanuatu branch were valid. The information was stored in a database maintained in Australia. It was often easier for the Commissioner to use s 263 rather than s 264 because there are more technicalities involved in ascertaining that a notice under s 264 is valid. Case study 24.9: Commissioner uses s 263 to gain access to safety deposit box
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In JJ Kerrison & Banich Management Pty Ltd v FCT (1986) 17 ATR 338, the Commissioner used s 263 of ITAA 1936 to gain access to safety deposit boxes kept with a bank. Unlike the facts in (Smorgon (No 2)) (see Case Study [24.8]), the bank did not have duplicate keys to the boxes. The Court held that a box was a “place” under s 263, and the Commissioner’s authorised officer was entitled to have full and free access to it and, if necessary, to use reasonable force to open the boxes (such by employing locksmiths or, if necessary, breaking them open). In relation to both ss 263 and 264, the occupier of premises is entitled to request time to obtain legal advice before granting access to the Commissioner, and if the delay is temporary and not unreasonable, it will not constitute obstruction and a breach of the sections: Swan v Scanlan (DCT Qld) (1982) 13 ATR 420. In Darling, it was held that the ATO could have access to documents which had been disclosed in a family court dispute on the basis that the taxpayer had not disclosed everything to the ATO: FCT v Darling (2014) 285 FLR 428. More recently, the Full Federal Court held that a liquidator was required to provide to the ATO documents that it had obtained pursuant to a Court order issued under the Corporations Act, and they could not rely on the so-called “Harman obligation” that imposes on a party to litigation not to use or disclose information obtained for any other purpose outside of the proceedings: DCT v Rennie Produce (Aust) Pty Ltd (in liq) [2018] FCAFC 38.
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Legal professional privilege and the power to obtain information [24.560] The only restraint on the Commissioner’s access powers under ss 353-10 and 353-15, Sch 1 of TAA (former ss 263 and 264 of ITAA 1936) is the doctrine of LPP. This is a common law doctrine giving citizens the opportunity of speaking frankly to their lawyer without their communications being disclosed. The rationale is that lawyers are part of the justice system and need to be in full possession of the facts of a case in order to give their clients the best possible advice. The Commissioner is obliged to give taxpayers the opportunity to claim the privilege. Case study 24.10: Legal professional privilege overrides s 353-10 (former s 263) In FCT v Citibank Ltd (1989) 20 ATR 292, 37 ATO officers conducted an unannounced raid on the taxpayer’s premises because the taxpayer had been stalling for several months in complying with s 264 notices. The Full Federal Court held that in exercising the access power under s 263, ATO officers must give the person with custody of the documents (in this case Citibank) a practical and realistic opportunity to claim legal professional privilege.
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Elements of legal professional privilege [24.570] LPP cannot always be claimed with respect to confidential communications with advisers. LPP protects from disclosure communications between a lawyer and a client made for the dominant purpose of giving or obtaining legal advice, including advice regarding litigation: Daniels Corp v ACCC [2002] HCA 49 and Esso Australia Resources Ltd v FCT (2000) 43 ATR 506. To substantiate a claim, all the elements of privilege need to be made out: 1. there are communications between a lawyer and a client which have been produced in the context of a lawyer–client relationship; 2. the communications are made in circumstances of confidentiality; and 3. the communication must have been produced or created for the dominant purpose of providing legal advice to the client. The High Court has recently confirmed that the nature of LPP is an immunity from a requirement to disclose: Glencore International AG v C of T [2019] HCA 26. Documents or communications which would otherwise enjoy privileged
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status will lose that status if disclosed to a third party because confidentiality has been lost. Documents provided by a third party to the ATO will not be protected by privilege, and rather, the Commissioner has a duty to use all information available to him in determining an assessment: FCT v Donoghue [2015] FCAFC 183. The privilege belongs to the client taxpayer and not the legal advisor or tax agent. Taxpayers can choose to waive privilege and give the Commissioner the documents being sought. The purpose of the communication must be established at the time the document is created. If subsequently a copy is made for the dominant purpose of providing legal advice, the copy may attract the privilege even though the original did not: Commr of Australian Federal Police v Propend Finance Pty Ltd (1997) 188 CLR 501; Barnes v FCT (2007) 67 ATR 284. In Australian Crime Commission v Stewart [2012] FCA 29, the taxpayers claimed LPP for documents obtained by the Australian Crime Commission on the grounds that many of the documents were prepared in California and were governed by the law of that state. The Federal Court held that there was not an issue in relation to choice of law and that the claim of LPP was to be decided under Australian law.
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On public policy grounds, a communication which would otherwise be privileged will lose that status if the communication is made in furtherance of fraud or crime, but is not limited to these objects: Attorney-General (NT) v Kearney (1985) 158 CLR 500. The problem with disclosure to a third party is the fact that all tactical advantage is lost once the other side (usually the ATO) has seen the privileged document. One development in case law is the concept called a “quick peek”. Case study 24.11: LPP –quick peek In JMA Accounting Pty Ltd v Carmody (2004) 57 ATR 365, the ATO sought unannounced access to two separate premises of promoters of tax schemes. The ATO scanned relevant documents onto discs –one copy for the applicants and one for the ATO to be held by the Australian Government Solicitor for a fortnight in case the applicant’s clients wished to claim LPP. The applicant was excluded from one of its offices for two days. The Full Federal Court suggested that the ATO was fortunate not to be sued for trespass. However, the Court was only concerned with the ATO’s copying and taking of the records in question. The Court upheld the s 263
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848 [24.570] PRINCIPLES OF TAXATION LAW 2020 access and said that the ATO had made reasonable provision for legal professional privilege to be claimed. In relation to the specific facts, the Court stated that copying a privileged document without reading it was not a breach of the privilege. It was necessary to glance at, but not closely read, the documents to determine their relevance, and it was also “lawful” for the ATO officers to read the privileged material for the limited purpose of deciding whether it might be privileged. LPP does not extend to third parties but may apply to third-party communications to a taxpayer.
Case study 24.12: LPP –Third-party communications to taxpayer In Pratt Holdings Pty Ltd v FCT (2004) 56 ATR 128, the taxpayer had sought advice from its lawyers, and in conjunction with that advice, documents were created by the taxpayer’s accountants.
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When the Commissioner sought access to those documents (valuation details), the Full Federal Court confirmed that LPP extends to communications by third-party experts to the taxpayer or to the legal advisor provided that the communications are made for the dominant purpose of obtaining legal advice. It is not necessary that the third party is an agent of the client. LPP can be waived explicitly or impliedly. In Krok v FCT [2015] FCA 51, it was held that the taxpayer had impliedly waived his right to claim legal professional privilege on the grounds that he had sworn affidavits about legal advice he had been given to assist his appeal against his assessments. The Court held that this was not consistent with the intention of maintaining confidentiality. In LHRC v DCT (No 3) [2015] FCAFC 184, the Full Federal Court held that the ATO was entitled to use evidence which the taxpayer had given to the Australian Crime Commission (ACC) in a Project Wickenby matter when considering whether to issue a notice under s 264. The taxpayer acknowledged he had no privilege against self incrimination in the ACC but argued he was entitled to protection under the Australian Crime Commission Act 2002 (Cth). The Court rejected this argument on the grounds that the protection only applied to disclosing the information in later criminal proceedings. In addition, although the ATO officer had already drafted a decision which disallowed the objections, this did not preclude him from subsequently examining the taxpayer.
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Access to lawyers’ premises [24.575] The ATO and the Law Council of Australia have developed guidelines for access to lawyers’ premises. These guidelines specifically retain the sole purpose test for LPP, which seems to be contradictory to the decision in Esso Australia Resources Ltd v FCT (2000) 43 ATR 506.
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An example of when LPP will generally be recognised is when a client is seeking legal advice in advance of litigation or for a transaction which is actual or contemplated. The privilege will not be available if the client is merely using the lawyer to obtain immunity from production of the documents. It is also not available in relation to physical objects such as cash. It belongs to the client not the lawyer, and the client can choose to waive the claim. Items subject to the claim include: • advice and opinions of a solicitor or legal counsel; • drafts or copies of documents created for the purpose of submitting a report or seeking the advice of a solicitor; • briefs and copies of solicitors’ briefs to counsel; • written communication, formal or informal by the client to the solicitor/ barrister or vice versa; and • solicitors’ draft notes, including counsel’s advice. [24.580] To assist taxpayers, the ATO provides a guidance document entitled Our Approach to Information Gathering. This document is available online, is written in plain English and is comprehensive. It details the various procedures that the ATO takes in exercising the Commissioner’s access powers and includes many examples, such as when it might seek access without notice. The ATO provides approved forms that can be used for claiming LPP.
Access to professional accounting advisers’ papers [24.590] After the decision in FCT v Citibank Ltd (1989) 20 ATR 292 (see Case Study [24.10]), the ATO issued guidelines setting out the procedures it would follow when seeking access to papers prepared by professional accounting advisers. The Commissioner acknowledged that in the tax area many accountants do very similar work to that done by lawyers, so the ATO granted an administrative privilege to documents prepared by accountants. The material is contained in the ATO’s Our Approach to Information Gathering. The guide categorises classes of documents held by accountants and lists the Commissioner’s approach to access. 1. Source documents –These are prepared, usually by accountants, setting out the planning, implementation and recording of a
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850 [24.590] PRINCIPLES OF TAXATION LAW 2020 transaction or agreement. Included in this category are accounting records, such as ledgers, journals, profit and loss statements and balance sheets. Working papers of accountants in preparing trial balances and all formal documents, such as the memorandum and articles of association and transaction documents, are also source documents. The ATO states that it expects unrestricted access to these documents. 2. Non-source documents –These include advice papers prepared after the transaction is complete (including tax return opinions), advice papers on arrangements that have not been and are not intended to be put into effect, and advice that does not materially contribute to a tax strategy as well as papers prepared during a statutory or prudential audit or due diligence. However, this classification only applies to documents prepared by external advisers. Despite the fact that LPP could in many cases not be claimed in relation to non- source documents, the ATO states that the Commissioner will only seek access to them in exceptional circumstances, such as cases involving fraud or evasion, or where other avenues of access have been exhausted.
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3. Restricted-source documents –These include tax advice prepared by accountants on how to structure or present a transaction prepared solely to advise a client on a tax- related matter. The ATO states that the Commissioner will only seek access to these documents in extraordinary circumstances, the same way as access is sought to non-source documents. The Commissioner will first request further information from taxpayers before proceeding to enforce access. The guidelines are an administrative concession by the ATO and apply only to documents prepared by external professional accounting advisers who are independent of the taxpayer. The guidelines apply when the request for access is made in the course of an audit. Case study 24.13: ATO’s Access guidelines In Deloitte Touche Tohmatsu v DCT (1998) 40 ATR 435, the Federal Court held that the Commissioner is required to take the guidelines into account before issuing a notice under s 264 of ITAA 1936. Although they do not constitute a set of rights, ATO officers must have regard to them and there is a legitimate expectation by taxpayers and their professional accounting advisers that the ATO will comply with the guidelines. This was the first case decided under the original guidelines. Subsequent cases moved away from the concept of “legitimate expectation” and adopted the standard of “procedural fairness”, a fundamental tenant in Australian administrative law.
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As a related issue to a claim for legal professional privilege relating to documents prepared by both lawyers and accountants, the taxpayer in Hogan v Australian Crime Commission (No 4) (2008) 72 ATR 107 and Hogan v Australian Crime Commission (2010) 75 ATR 794 failed in his claim for confidentiality on the grounds that disclosure would prejudice the administration of justice.
Access to corporate board advice papers [24.595] The Commissioner has also granted an administrative concession in relation to access to advice prepared for corporate boards regarding tax compliance risk. This advice may be prepared by either in- house or external advisers and relates to tax compliance risk management relating to a major transaction or arrangement or a corporate process. Like restricted source and non-source documents, the ATO will only seek access to these papers in exceptional circumstances. Further details are provided in PS LA 2004/14.
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Statutory privilege [24.600] The Evidence Act 1995 (Cth) contains sections granting statutory privilege in court proceedings, such as for the recovery of tax. Section 118 of that Act permits the client to claim “client privilege” in relation to confidential communications prepared with the dominant purpose of providing legal advice to the client. Section 119 provides a “litigation privilege” when the advice relates to anticipated or pending litigation. Section 120 gives litigation privilege to parties lacking representation, but only when the litigation has commenced. In New Zealand, s 20B of the Taxation Administration Act 1994 (NZ) provides that any tax adviser who belongs to an approved professional body can refuse to disclose a “tax advice document” as defined. This right cannot be claimed for information in the advice which is factual (so called “tax contextual information”). The operation of these rules was considered by the High Court of New Zealand in Blakeley v CIR (2008) 23 NZTC 21,865.
Offshore information notices [24.610] Section 353-25, Sch 1 of TAA (former s 264A of ITAA 1936) gives the Commissioner the power to obtain information and documents that are located offshore. He does this by serving a notice on the taxpayer. Before issuing a notice, the Commissioner must have an objective basis for believing that the taxpayer has knowledge of the information or the documents requested, it is
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852 [24.620] PRINCIPLES OF TAXATION LAW 2020 offshore, and it is relevant to the taxpayer’s assessment: FCT v Pilnara Pty Ltd (2000) 43 ATR 581. The taxpayer must be given at least 90 days to respond to the notice. There is no penalty if the taxpayer fails to respond, but the taxpayer is precluded from later using any of the information which is the subject of the notice if there is a dispute about the taxpayer’s assessment, except with the consent of the Commissioner: s 353-30, Sch 1 of TAA. Operation Wickenby was a major project undertaken by the ATO involving tracking the offshore income of high net wealth individuals. Section 264A notices were used as well as the provisions of Taxation Information Exchange Agreements. These are bilateral tax information exchange agreements, which deal with the sharing of tax information between developed countries and low tax jurisdictions where Australia has no comprehensive tax treaty in place.
Secrecy
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[24.620] Division 355, Sch 1 of TAA prohibits taxation officers from divulging “protected information”. This covers information disclosed or obtained for the purposes of a taxation law that relates to the affairs of an entity and may identify the entity: s 355-30, Sch 1 of TAA. This applies to ATO officers, both during their employment and after it has ceased. It applies to information dealing with a person’s business matters, professional conduct or personal affairs. Often the ATO uses the services of external professional advisers (eg, on their public rulings panels, to review the quality of its work in its various business lines or to advise on developing policy) for various technical issues and may outsource some functions such as debt collection. Section 355-15 deems these consultants to be “taxation officers” for the purposes of Div 355, and therefore they are bound by the secrecy provisions. Case study 24.14: Secrecy In Consolidated Press Holdings v FCT (1995) 30 ATR 390, the Federal Court upheld the right of the ATO to employ external advisers to assist in understanding material given to it by the taxpayer, but stated that the taxpayer had a reasonable and legitimate expectation that the information they provided would not be given to third parties without first consulting them. The rules of natural justice had not been followed. There are additional statutory exceptions in Div 355 permitting information to be disclosed to other bodies, such as Ministers, courts of law, Royal
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Commissions, the Australian Federal Police and the Australian Security Intelligence Organisation.
Taxpayers’ statutory rights to obtain information [24.630] Taxpayers have no general right at common law to have the Commissioner’s decisions reviewed on their merits or to be given information about a government department’s reasoning process when dealing with them. The main Acts relating to taxpayers’ rights to information are the FOI Act (see [24.640]), the ADJR Act (see [24.650]) and the Inspector-General of Taxation Act 2003 (Cth) (see [24.670]).
Freedom of Information Act 1982 [24.640] The philosophy behind the FOI Act is to give members of the public the right of access to official documents of the Commonwealth Government and its agencies, including the ATO. The FOI Act also requires government agencies to publish certain information concerning their functions.
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The FOI Act gives members of the public a legally enforceable right of access to a government document other than an exempt document: s 11 of FOI Act. The information acquired under this Act can be useful to taxpayers if they are negotiating a settlement after a tax audit. The information requested may be provided by way of a right to inspect, or by provision of a copy, or a recording or transcript for recorded materials, with the person making the request being able to specify the means by which the material should be supplied, providing it is reasonable. If a document is classified as an “exempt document”, the agency is not required to give it. If a document is “conditionally exempt”, the agency is not required to give it if to do so would be contrary to the public interest. Categories of documents that are “exempt” include documents affecting national security (s 33), Cabinet documents (s 34) and documents subject to LPP (s 42). Those documents that are “conditionally exempt” include documents that would reveal the deliberative processes of an agency (s 47C) and those that would unreasonably reveal personal information (s 47F) or information concerning business or commercial affairs of a person or organisation (s 47G) (documents containing trade secrets or commercial in confidence information are exempt: s 47). There is a specific conditional exemption for documents that could prejudice the effectiveness of audits (s 47E). In order to comply with its obligations under s 11A of the FOI Act, the ATO published an online FOI disclosure log that lists documents that have been provided under FOI requests and which are available to others for inspection.
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854 [24.650] PRINCIPLES OF TAXATION LAW 2020
Administrative Decisions (Judicial Review) Act 1977
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[24.650] The ADJR Act provides a statutory right of judicial review in relation to administrative decisions. This is in addition to the right to seek judicial review of a decision or act of the Commissioner under s 39B of the Judiciary Act. The ADJR Act also provides a statutory right to reasons for decisions covered by the Act: s 13 of ADJR Act. For the decision to be reviewable, it must be “under an enactment” and this has been held to require that the specific decision-making power is provided under the act and does not, therefore, include decisions made by the Commissioner under the power of general administration: Hutchins v DCT (1996) ATR 620. A person aggrieved by a decision may apply to the Federal Court for judicial review of that decision. Section 5(1) of the ADJR Act sets out the grounds for review of administrative decisions: • where breaches of the rules of natural justice have occurred; • where procedures required by the law to be observed were not followed; • where the person did not have jurisdiction to make the decision; • where the decision was not authorised by the enactment; • where the making of the decision was an improper exercise of power (which is expanded on in s 5(2)); • where the decision involved an error of law; • where the decision was affected by fraud; • where there was no evidence to justify it; or • where it was otherwise contrary to law. Under s 5(2), an improper exercise of power is expressed to cover many traditional bases for judicial review such as taking irrelevant matters or failing to take relevant matters into account, acting in bad faith or at the direction of another, acting contrary to the merits of the matter and acting unreasonably or in a manner which could produce an uncertain result. FCT v Citibank Ltd (1989) 20 ATR 292 is an example of the use of the ADJR Act in relation to the Commissioner’s access power: see Case Study [24.10]. The Federal Court may set aside the decision, refer the matter for reconsideration subject to directions, make a declaration regarding the parties’ rights or make an order directing a party to do or restraining a party from doing an act or thing: s 16 of ADJR Act. Importantly, many classes of administrative decisions are excluded from the operation of the ADJR Act: Sch 1 of ADJR Act. This list includes many decisions of the Commissioner, listed at paras (e)–(gab), including those forming part of the process of making an assessment of tax, decisions disallowing objections to assessments and decisions regarding amending assessments.
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Other taxation authorities Inspector General of Taxation [24.670] The office of the IGT was established as an independent statutory agency following a recommendation of the Ralph Review of Business Tax: Inspector General of Taxation Act 2003 (Cth). The IGT undertakes broad reviews into tax administration matters and makes recommendations to the ATO and to Government. Recent reviews of the IGT have been completed on the future of the tax profession (2019) and the ATO’s use of garnishee notices (2019). From 2015, the IGT also assumed the role of investigating specific taxpayer complaints with regard to the administration of the tax system by the ATO, taking over the role previously undertaken by the Commonwealth Ombudsman. The IGT is not empowered to investigate issues going to substantive tax liability. The IGT is also responsible for complaints made against the Tax Practitioners Board.
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Board of Taxation [24.680] The Board of Taxation was established in 2000 following a recommendation of the Ralph Review of Business Tax. It is an independent non-statutory body, which advises the Government on the formulation and development of tax policy. Part of its role is to commission research into areas of difficulty as requested by the Treasurer and arrange for community consultation, including input from relevant practitioners. Some reviews are self-initiated by the Board. For example, in 2017, the Board undertook a self- initiated review into the tax issues arising from the sharing economy. In 2018, the Minister for Revenue and Financial Services requested the Board of Tax to conduct a review of the compliance costs associated with the FBT regime and to compare that to the experience in overseas jurisdictions with similar regimes. In order to gather relevant information, the Board ran focus groups, conducted on-line surveys and conducted case study interviews with employers.
Regulation of tax practitioners Tax Practitioners Board [24.690] Tax agents are professionals employed by taxpayers to assist them in managing their tax affairs. The Tax Agents Services Act 2009 (Cth)
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856 [24.695] PRINCIPLES OF TAXATION LAW 2020 (TASA) established a national Tax Practitioners Board (TPB), which replaced the previous State-based system. The underlying rationale of the system is consumer protection. The TPB was established as an independent statutory body within the Treasury portfolio but administrative support is provided by the ATO. The TPB deals with the registration and, where relevant, the deregistration of tax agents, BAS agents (BAS service providers) and tax (financial) advisers (since 2014). Civil penalties can apply if one provides these services for a fee or advertises to do so without the necessary registration. The Government announced a review into the regulatory framework established by the TASA and the TPB in early 2019 and Treasury issued a Discussion Paper in August 2019. According to the Discussion Paper, there are currently more than 78,000 active tax practitioners. There are “safe-harbour” provisions for taxpayers who have consulted a registered tax agent, such as the false or misleading statement penalty safe harbour at s 284-75(6), Sch 1 of TAA. One proposal canvassed in the Discussion Paper is the introduction of an administrative penalty regime that would apply to tax practitioners where a taxpayer has a tax shortfall owing to the tax practitioner’s fault. The final report is due to be provided to the Government by 31 October 2019.
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An individual will be eligible for registration as a tax agent, BAS agent or tax (financial) advisor if the individual is a fit and proper person who has met the requirements in relation to qualifications and experience, maintains professional indemnity insurance and has completed any necessary continuing professional education requirements: s 20-5 of TASA. The criteria for determining if someone is a fit and proper person are prescribed in s 20-15 of TASA. The qualifications and experience requirements for each category of tax professional are given in Sch 2 of the Tax Agent Services Regulations 2009 (Cth). Applications for registration and renewals are made to the TPB, which will evaluate the applicant against the relevant eligibility criteria: s 20-20 of TASA. The TPB can grant registration, deny registration or grant registration with conditions: s 20-25 of TASA. An applicant can apply to the AAT for review of a decision to deny the application or specify conditions: s 70-10 of TASA.
The Code of Professional Conduct [24.695] All registered tax agents, BAS agents and tax (financial) advisers must comply with the Code of Professional Conduct: s 30-5 of TASA. Non- compliance with the Code can lead to a written caution, an order to take specific action, suspension of registration or, in the most extreme cases, termination of registration: s 30-15 of TASA. Section 30-10 of the TASA provides the 14 elements of the Code, which are grouped together under the following main headings:
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• Honesty and integrity: this includes a requirement to comply with the taxation laws in the conduct of the tax professional’s own affairs and to keep proper trust accounts in relation to clients’ funds. • Independence, which requires adequate arrangements for the management of conflicts of interest. • Confidentiality. • Competence: this includes both maintaining one’s knowledge and skills, taking reasonable care in determining a client’s state of affairs, and taking reasonable care to ensure that taxation laws are applied correctly. • Other responsibilities, including the requirement that one not knowingly obstruct the proper administration of the taxation laws and maintaining professional indemnity insurance. The TPB has published a number of information sheets to assist tax professionals in complying with the Code.
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Complaints and investigations [24.698] Section 60- 95 grants formal investigation powers to the TPB in relation to matters including breaches of the Code of Professional Conduct or other breaches of the TASA. Such investigations may commence as a result of a complaint lodged with the TPB in relation to a registered tax professional or someone providing tax services without the proper registration. For the purposes of an investigation, the TPB has the power to request that information or documents be provided and to require witnesses to appear and give evidence, and failure to comply is an offence under the TAA: ss 60-100 and 60-105 of the TASA. Complaints regarding the conduct of the TPB can be made to the IGT. As a result of an investigation, the TPB may determine that the appropriate action is to suspend or terminate the registration of the tax professional. The professional may apply to the AAT seeking a review of such decisions: s 70- 10 of the TASA. By way of example, the AAT confirmed the TPB’s decision to terminate the registration of a tax agent on the basis that he was not a “fit and proper” person: Shmuel and Tax Practitioners Board [2019] AATA 2168. The grounds asserted by the TPB included that the agent had been issued with a DPN and the tax related liability had not been paid, that he had been issued with a default judgment in relation to this tax liability and had been declared a bankrupt but had not disclosed this as required, and that he had pled guilty to a criminal charge involving dishonesty against the Commonwealth. In contrast, a decision of the AAT confirming the TPB’s termination of a tax agent’s registration was set aside on appeal to the Federal Court on the basis that the tax agent had been denied procedural fairness in the AAT proceedings: Beckett v Tax Practitioners Board [2019] FCA 353.
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858 [24.700] PRINCIPLES OF TAXATION LAW 2020 While a review by the AAT is underway, the applicant can apply to have the operation and implementation of the deregistration decision stayed pending resolution of the review: s 41 of AAT Act. An example of such an application can be found in Hill and Tax Practitioners Board [2019] AATA 756. In that case, the TPB had decided to cancel the tax agent’s registration on the basis that he had failed to comply with the Code of Professional Conduct specifically that he had failed to act honestly and to comply with taxation laws in the conduct of his own affairs. The practitioner’s application to stay the termination decision was unsuccessful.
Questions [24.700] 24.1 If a taxpayer is dissatisfied with an objection decision, Pt IVC of the TAA gives the option to seek a review of the decision by the Administrative Appeals Tribunal, which may consider questions of fact, or appeal on a question of law to the Federal Court. The distinction between a question of law and one of fact can therefore be very important. Required: a) Give five examples of a question of fact. b) Give five examples of a question of law.
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24.2 An Australian taxpayer is intending to live and work in Dubai for three years. Before she departs, she applies to the ATO for a private ruling as to whether she will be an Australian resident during that period. Discuss the process for obtaining a private ruling and the protection such a ruling provides. 24.3 Ten officers from the ATO arrive unannounced at the premises of BDE Ltd, a firm of chartered accountants which specialises in promoting agricultural tax investments. The ATO copies the entirety of the hard disk of the chief accountant and as a result copies and removes advice prepared by BDE on proposed tax investment arrangements, documents prepared for a prudential audit for a client and documents prepared by legal advisors on how to avoid being caught under the promoters’ penalties legislation. Discuss. 24.4 Robert Jones consults a local lawyer in relation to his tax affairs. He has invested in an olive-growing scheme which did not have a product ruling. Robert gave details of his tax affairs, including expenditure in the scheme, to the lawyer in August. The lawyer did not lodge Robert’s return until the following June. The lawyer also omitted to include in the return the rental income Robert derived from a property in New York. Robert was fined for late lodgment and subsequently audited, resulting in an amended assessment, a false or misleading statement penalty and the shortfall interest charge. Discuss. What difference would it make if Robert consulted a registered tax agent?
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24.5 Elizabeth Wilson prepared and lodged her income tax return on 1 October. On 10 October, she received notice that she was entitled to a $120,000 distribution from a family discretionary trust in relation to the prior year. She assumed the trustee would have paid the tax on her behalf, but in case this was wrong she notified the ATO of the distribution. Her notice of assessment was issued on 25 October, stating no tax was payable. She was unaware that the ATO did not take the trust distribution into account when making the assessment. Elizabeth later realised that she had failed to claim deductions she had incurred in relation to her home office. Three years later, she was contacted by the ATO seeking further information regarding the trust entitlement. Discuss whether the Commissioner can issue an amended assessment to Elizabeth and what new issues can now be taken into account. 24.6 ABC Lumber Pty Ltd mills Australian grown timber and sells it wholesale to other businesses as well as on a retail basis to individual customers. Bill is in the business of making custom designed timber furniture and has taken delivery of some recycled timber from ABC, with payment due in 90 days. The ATO has been seeking to recover an outstanding tax liability from ABC and decides that, due to ABC’s reluctance to enter into a payment arrangement, more aggressive debt recovery actions are required. The ATO issues a s 260-5 notice to Bill requiring that Bill pay the amount owing to ABC instead to the ATO. What is the nature of Bill’s obligation as a result of this notice and what if he ignores it and pays the money to ABC? 24.7 Mary Jones is an accountant and registered tax agent who specialises in small business clients, especially those running restaurants and cafes. As part of the investigations of the Black Economy Taskforce, Mary has been identified as a potential facilitator of tax evasion. In particular, evidence suggests that Mary makes arrangements to allow non-declared cash income to be funnelled overseas and then back into legitimate accounts in Australia. The ATO issues a s 353-10 notice to Mary requiring that she provide any and all information she has regarding the business accounts of clients running cafes (including balance sheets and profit and loss accounts) and any employees of those businesses. Is Mary required to comply with this notice? Can she object to supplying this information on the basis that to do so would violate her duty of confidentiality to her clients? 24.8 Over the last income tax year, Kate sold her investment property and made a capital gain of $50,000. When preparing her income tax return, Kate inadvertently omitted the gain. A Notice of Assessment was issued and one year later, Kate received a letter in the mail from the Commissioner of Taxation asking her to explain her undeclared income and to take necessary steps to amend her income tax return. Explain to Kate how the Commissioner may have discovered the undeclared income and of the potential penalties and interest she might face.
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860 [24.700] PRINCIPLES OF TAXATION LAW 2020
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24.9 Sam works on a full-time basis for WonderWorks, which pays him a salary on a monthly basis. Sam also derives significant investment income from shares he inherited from his grandmother. Sam has just received a notice of a PAYG instalment rate from the ATO. Explain how the PAYG system will apply in relation to these income amounts. How are advance payments of tax under this system taken into account when Sam later lodges his tax return for the year? 24.10 Simon Wilson is a registered tax agent. Most of his clients are individual taxpayers. After he has lodged their returns, he advises the clients what he calculates their refund will be. Then he contacts the ATO and amends the returns which results in a larger refund. When he receives the refund, Simon forwards to the client the amount he had informed them they would receive and keeps the difference. A complaint is made to the TPB about Simon. What options are available to the TPB?
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Part 7 Indirect and State Taxes
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Part 7 of this book focuses on indirect and state taxes. An indirect tax is one generally embedded in the price of goods or services and is collected by an intermediary from the entity that bears the ultimate responsibility for the tax. The Income Tax Assessment Tax 1997 (Cth) (ITAA 1997) defines “indirect tax” to mean GST, wine and luxury car taxes. The most important of these indirect taxes is GST and, as such, Chapter 25 outlines the GST regime contained in A New Tax System (Goods and Services Tax) Act 1999 (Cth). Chapter 25 explains that GST is a consumption tax for which the ultimate economic burden falls on the private consumer. This tax was introduced in Australia on 1 July 2000 and is currently at the rate of 10%. The chapter goes on to outline the registration process for GST and the rules which give rise to a GST liability along with the various concepts contained in the GST regime, such as taxable supply, GST-free supply, input taxed supply, creditable acquisition and importations. Finally, Chapter 25 outlines the administrative procedures for GST and its interaction with other taxes. Separate to Commonwealth taxes, each of the states and territories of Australia may impose their own taxes. Where this occurs, each jurisdiction implements its own tax regimes based on its specific legislation and regulations. Chapter 26 deals with the three major state taxes that students should be aware of. First, there is stamp duty which is a tax on various transactions such as property, motor vehicles, mortgages and insurance policies. Second, there is land tax which is a tax imposed annually on the holder of land where certain criteria are met. Third, employers may be liable for payroll tax based on wages paid to employees.
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25
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Goods and services tax Key points.................................................................................................... [25.00] Introduction................................................................................................ [25.10] Registration................................................................................................. [25.50] Enterprise............................................................................................. [25.60] Registration turnover threshold.......................................................... [25.70] Choosing to register............................................................................. [25.80] Taxable supply............................................................................................ [25.90] Supply................................................................................................. [25.100] Consideration..................................................................................... [25.110] In the course or furtherance of an enterprise................................... [25.115] Connection to the indirect tax zone.................................................. [25.120] Consequences of making a taxable supply...................................... [25.130] GST-free supply........................................................................................ [25.140] Food.................................................................................................... [25.142] Health.................................................................................................. [25.144] Education............................................................................................ [25.146] Other GST-free supplies.................................................................... [25.148] Consequences of making a GST-free supply................................... [25.150] Input taxed supply.................................................................................... [25.160] Financial supplies: subdiv 40-A......................................................... [25.163] Residential rent: subdiv 40-B............................................................. [25.165] Residential premises: subdiv 40-C.................................................... [25.167] Consequences of making an input taxed supply.............................. [25.170] Mixed or composite supply..................................................................... [25.175] Supply summary....................................................................................... [25.180] Creditable acquisition.............................................................................. [25.190] Acquisition.......................................................................................... [25.200] Creditable purpose............................................................................. [25.210]
Acquisitions related to input taxed supplies........................................ [25.214] Solely or partly....................................................................................... [25.220] Supply to the entity was a taxable supply........................................ [25.225] Consequences of making a creditable acquisition........................... [25.230]
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864 [25.00] PRINCIPLES OF TAXATION LAW 2020 Special rules....................................................................................... [25.235]
Non-deductible expenses...................................................................... [25.240]
Importation............................................................................................... [25.250] Taxable importation........................................................................... [25.260]
Consequences of making a taxable importation.................................. [25.270]
Creditable importation....................................................................... [25.280]
Consequences of making a creditable importation.............................. [25.290]
Offshore supplies............................................................................... [25.295]
Intangible supplies................................................................................. [25.297] Low value goods.................................................................................... [25.299] Administration.......................................................................................... [25.300] Timing................................................................................................. [25.304] Tax invoice......................................................................................... [25.306] Adjustments....................................................................................... [25.310] Non-residents..................................................................................... [25.313] GST groups........................................................................................ [25.315] Interaction with other taxes.................................................................... [25.320] Income tax.......................................................................................... [25.320] Fringe benefits tax.............................................................................. [25.330] Questions................................................................................................... [25.340]
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Key points [25.00] • Goods and services tax (GST) is imposed on the consumption of goods and services in Australia. • The current rate of GST is 10% on the value of the goods or services. • Registration for GST purposes is central to the imposition of GST, and entities may be required to register for GST or may choose to register for GST depending on their circumstances. • Liability to pay GST is imposed on the supplier of goods or services. • A limited number of supplies, categorised as GST-free supplies and input taxed supplies, do not attract GST. • Entities may be entitled to a refund of GST paid on the acquisition of goods or services where the acquisition is for a business purpose. • Importers of goods into Australia will be liable for GST in most cases regardless of whether the entity is carrying on a business or whether the goods are imported for business or private purposes. However, importers may be entitled to a refund of GST paid on the importation where the goods are acquired for a business purpose. • GST is administered by the Australian Taxation Office (ATO), and entities are required to report their GST obligations on a quarterly or monthly basis, depending on their circumstances. • Entities may make an adjustment where there is a change in their circumstances which alters their GST obligations.
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Introduction [25.10] GST came into effect in Australia on 1 July 2000. GST is a different type of tax in that it is a tax on consumption and not, for example, on income. In fact, one reason for its introduction was to reduce Australia’s reliance on income tax as a source of government funding. Although GST is administered federally through the ATO, all GST revenue is distributed to the State Governments under an agreement between the Federal and State Governments. In return, various State-based taxes, such as the financial institutions duty and the debits tax, were abolished. The current GST rate is 10%, which is imposed upon the consumption of goods and services, including imports, in Australia. GST is a broad-based tax as it is imposed on the consumption of most goods and services with few exceptions. Although all consumers (whether private individuals, businesses or companies) pay GST upon consumption, GST is effectively borne by the final private consumer due to the ability of certain entities to obtain a refund of GST paid on acquisitions (known as “input tax credits”).
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As discussed in Chapter 3, under the Federal Constitution, taxation laws must deal with one subject of taxation only. As such, the provisions regarding GST are contained in separate legislation: A New Tax System (Goods and Services Tax) Act 1999 (Cth) (GST Act) and A New Tax System (Goods and Services Tax Administration) Act 1999 (Cth). Further, the imposition of tax must be dealt with in separate legislation. In the case of GST, this is through A New Tax System (Goods and Services Tax Imposition –General) Act 1999 (Cth); A New Tax System (Goods and Services Tax Imposition –Customs) Act 1999 (Cth); and A New Tax System (Goods and Services Tax Imposition –Excise) Act 1999 (Cth). [25.20] Example 25.1 provides an overview as to the application of GST in practice. Example 25.1: GST overview A furniture wholesaler purchases a table for $110 (inc GST) from a furniture manufacturer. The furniture wholesaler sells the table to a furniture retailer for $220 (inc GST). The furniture retailer sells the table to a private consumer for $330 (inc GST). The GST consequences of the transaction are as outlined in the following table:
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866 [25.30] PRINCIPLES OF TAXATION LAW 2020
Transaction
Consequences
Manufacturer sells table to wholesaler for $110 incl GST.
Manufacturer collects $10 in GST upon the sale of the table and must send the $10 to the ATO.
Wholesaler purchases table from manufacturer for $110 incl GST; sells table to retailer for $220 incl GST.
Wholesaler has paid $10 in GST upon purchase of the table but has collected $20 in GST upon sale of the table. Wholesaler can net off the two amounts and must send $10 in GST collected to the ATO.
Retailer purchases table from wholesaler for $220 incl GST; sells table to consumer for $330 incl GST.
Retailer has paid $20 in GST upon purchase of the table but has collected $30 in GST upon sale of the table. Retailer can net off the two amounts and must send $10 in GST collected to the ATO.
Consumer purchases table from retailer for $330 incl GST.
Consumer has paid $30 in GST and is not entitled to a refund of the GST paid (known as “input tax credits”).
Therefore, there is effectively $30 of GST on the “consumption” of the table, which has been paid by the consumer and collected by the ATO progressively from the manufacturer, wholesaler and retailer. Source: Adapted from the example of how the GST works in the Explanatory Memorandum to the A New Tax System (Goods and Services Tax) Bill 1998, pp 7–8.
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[25.30] In the rest of this chapter, the rules which give rise to the outcomes in Example 25.1 are outlined. We will learn why the manufacturer, wholesaler and retailer charged GST on the sale of the table (because it is a “taxable supply”), why the wholesaler and the retailer were entitled to input tax credits (ie, a refund of GST paid) on the acquisition of the table (because it is a “creditable acquisition”) and why the private consumer was not entitled to input tax credits on the acquisition of the table (because it is not a “creditable acquisition”). This chapter also briefly discusses the provisions regarding importations, administration and adjustments. Although the fundamentals of the GST are reasonably straightforward, there are a large number of special rules which complicate the operation of the GST in practice. Some of these special rules are highlighted in the chapter, but an extensive discussion of them is beyond the scope of this book. [25.40] Figure 25.1 provides a guide to dealing with GST.
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Figure 25.1: GST overview
Registration [25.50] Registration is a key aspect of GST and is central to both the imposition of GST and the entitlement to a refund of GST paid. One exception to the general rule is that registration may not be relevant to the imposition of GST on importations: see [25.250]. Note that registration refers to registration for GST purposes and not to obtaining a Tax File Number (TFN) for income tax purposes or obtaining an Australian Business Number (ABN), although a corollary of registering for GST is that entities will obtain an ABN.
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868 [25.60] PRINCIPLES OF TAXATION LAW 2020 A wide range of entities, including individuals, companies, trusts and partnerships, can register for GST. However, an entity must be carrying on an enterprise in order to register: s 23-10 of GST Act; see [25.60]. Registration for GST purposes is prima facie optional, but entities will be required to register in certain circumstances: see [25.70].
Enterprise [25.60] “Enterprise” is defined in s 9-20 of GST Act and includes an activity or series of activities conducted: • in the form of a business; • in the form of an adventure or concern in the nature of trade; or • in the form of leasing, licensing or other grant of an interest in property on a regular or continuous basis. Therefore, the income tax topics on whether a taxpayer is carrying on a business for tax purposes (see Chapter 8) or an isolated commercial transaction that constitutes a business (such as in FCT v Whitfords Beach Pty Ltd (1982) 14 ATR 247: see Case Study [8.7]) are relevant in determining an entity’s entitlement to register for GST.
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Example 25.2: Carrying on an “enterprise” Jesse cleans shoes for his friends and family. He is so good at it that many people ask him to clean their shoes. He enjoys cleaning shoes, and so he readily agrees to clean the shoes. He charges for the cost of his products and his time, and he has found it to be a very profitable activity. He has decided to become a full-time shoe cleaner. The fact that Jesse performs his shoe-cleaning activities repetitively and on a regular basis and the fact that he intends to and does make a profit from the activity indicate that Jesse is carrying on a business for income tax purposes: see Chapter 8. As Jesse is carrying on a business for income tax purposes, his activities constitute an enterprise for GST purposes. He is entitled to register for GST if he so chooses but may be required to do so depending on his circumstances. Certain activities, such as the provision of labour as an employee or a private recreational pursuit or hobby, are specifically excluded from the meaning of “enterprise” (s 9- 20(2)), while the activities of certain entities, such as charitable and religious institutions, are specifically included as constituting an enterprise: s 9-20(1)(d) to (h). There is some uncertainty as to the operation
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of the exception for employees following Spriggs v FCT; Riddell v FCT (2009) 72 ATR 148 (see Case Study [8.9]), where the High Court found that employment activities can form part of a business. Unless there is a taxable importation (see [25.260]), GST is not relevant if the entity is not carrying on an enterprise.
Registration turnover threshold [25.70] Entities that are carrying on an enterprise must register for GST where their annual turnover exceeds the registration turnover threshold: s 23-5 of GST Act. From 1 July 2007, the registration turnover threshold is $150,000 for non- profit organisations and $75,000 for all other entities: s 23-15; regs 23-15.01 and 23-15.02 of A New Tax System (Goods and Services Tax) Regulations 1999. Prior to that date, the registration turnover thresholds were $100,000 and $50,000, respectively.
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There is one exception to the general rule which is that suppliers of “taxi travel” are required to register for GST regardless of their annual turnover: s 144-5. “Taxi travel” is defined in s 195-1 as “travel that involves transporting passengers, by taxi or limousine, for fares”. In Uber BV v Commissioner of Taxation [2017] FCA 110, the Federal Court held that the provision of UberX services constituted the supply of “taxi travel”. As such, entities that carry on an enterprise and provide ride-sourcing services must register for GST, regardless of turnover. “Ride- sourcing” refers to an ongoing arrangement where a taxpayer makes a car available for public hire; a passenger uses a website or smart phone application provided by a third party to request a ride; and the taxpayer uses the car to transport the passenger for payment with a view to profit. The meaning of “annual turnover” is outlined in Div 188. An entity’s annual turnover is the value of all of its supplies during the relevant 12-month period related to its enterprise, excluding any input taxed supplies (see [25.160]) and supplies not made for consideration: s 188-15. The relevant 12-month period includes the current-year annual turnover (ie, annual turnover for the current month and the preceding 11 months) and the projected annual turnover (ie, annual turnover for the current month and the following 11 months). Broadly, an entity’s annual turnover is its GST-exclusive sales revenue arising from its enterprise. See GST Ruling GSTR 2001/7 for further guidance on the meaning of “annual turnover”.
Choosing to register [25.80] Entities with an annual turnover below the registration turnover threshold may still choose to register for GST provided that they are carrying on an enterprise. Entities generally choose to register for GST in order to obtain a
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870 [25.90] PRINCIPLES OF TAXATION LAW 2020 refund of GST paid on acquisitions: see [25.190]. However, the consequences of registration are that the entity may incur additional compliance costs in satisfying its administrative responsibilities (see [25.300]) and that the entity may be required to impose GST on its supplies, potentially increasing the cost of its supplies to the customer: see [25.130]. Example 25.3: GST registration Jesse owns a mobile shoe-cleaning business. He used to work on his own and earned sales revenue of approximately $30,000 each year. He has now hired two more employees as business is booming. He expects that, with the additional employees, his sales revenue for the year will increase to approximately $90,000. Initially, Jesse is not required to register for GST purposes as his current and projected annual turnover ($30,000) is below the registration turnover threshold ($75,000). However, Jesse may choose to register for GST purposes depending on his circumstances. Once Jesse hires the two additional employees, he is required to register for GST as his projected annual turnover ($90,000) exceeds the registration turnover threshold.
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Taxable supply [25.90] Taxable supplies are central to the operation of GST as they create the obligation to pay (and therefore charge) GST. An entity makes a taxable supply under s 9-5 of GST Act if: • it makes a supply: see [25.100]; • the supply is for consideration: see [25.110]; • the supply is made in the course or furtherance of the entity’s enterprise: see [25.60] and [25.115]; • the supply is connected with the indirect tax zone: see [25.120]; and • the entity is registered or required to be registered for GST: see [25.50]. However, a supply is not a taxable supply to the extent that it is a GST-free supply (see [25.140]) or an input taxed supply: see [25.160].
Supply [25.100] Section 9-10 of GST Act defines “supply” as “any form of supply whatsoever” and specifically includes (but is not limited to) the following:
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• a supply of goods; • a supply of services; • a provision of advice or information; • a grant, assignment or surrender of real property; • a creation, grant, transfer, assignment or surrender of any right; • a financial supply: see [25.163]; and • an entry into, or release from, an obligation to do anything, to refrain from an act or to tolerate an act or situation.
Example 25.4: Making a supply Jesse has his own shoe-cleaning business. The cleaning of shoes is a supply as it is the provision of services.
This definition of “supply” is very broad, and many activities of an entity may constitute the making of a supply. In FCT v Reliance Carpet Co Pty Ltd (2008) 68 ATR 158, the High Court considered the meaning of “supply” in the context of the GST legislation. The Court’s decision supports a wide interpretation of “supply”.
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Case study 25.1: Meaning of supply In FCT v Reliance Carpet Co Pty Ltd (2008) 68 ATR 158, the taxpayer granted a purchaser an option to buy commercial property in Victoria. The purchaser exercised the option and the parties entered into a contract for the sale of the property for a price of A$2.975 million plus GST. The purchaser paid a deposit of A$297,500. The purchaser subsequently defaulted and, under the terms of the agreement, the deposit was forfeited to the taxpayer. The Commissioner assessed the taxpayer for GST on the forfeited deposit under s 99-10 of GST Act, which establishes the time of recognition for a forfeited deposit. The taxpayer argued that GST was not applicable on the forfeited deposit as there was no supply, a requirement for the application of s 99-10. The High Court found that the deposit was consideration for a supply, being the obligations undertaken by the vendor on entry into the contract. The High Court noted that “there was upon exchange of contracts the grant by the taxpayer to the purchaser of contractual rights exercisable over or in relation to land, in particular of the right to require in due course conveyance of the land to it upon completion of the sale”.
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872 [25.100] PRINCIPLES OF TAXATION LAW 2020 The wide interpretation of “supply” was affirmed by the High Court in FCT v Qantas Airways Ltd [2012] HCA 41.
Case study 25.2: Existence of a supply In FCT v Qantas Airways Ltd [2012] HCA 41, the taxpayer was the supplier of domestic and international air travel. GST is imposed on domestic travel and the question arose as to whether GST was payable where a passenger books and pays for a domestic flight but subsequently cancels the booking or does not turn up for the flight and does not receive a refund. The taxpayer argued that GST was not payable as there was no “supply” (ie, the provision of a flight). The Commissioner argued that the relevant supply when the passenger made a booking and paid for it was the booking itself. The AAT had found that there was a “supply” when the booking was made being the fact that the taxpayer was “holding itself ready” to carry the passenger at a future time.
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The Full Federal Court held that the relevant supply was the provision of travel, and it was inappropriate to artificially split the transaction into two separate components (ie, the booking and the travel). Here, the conditions of carriage were specifically linked with a particular flight, rather than the booking, which further supported the conclusion that the relevant supply was the provision of travel. The High Court, by 4-1 majority, found that the taxpayer was liable for GST in respect of bookings made by customers where the customer did not travel on the booked flights. The relevant supply by Qantas was “the promise to use best endeavours to carry the passenger and baggage, having regard to the circumstances of the business operations of the airline” (para 33).
The High Court’s decision in FCT v Qantas Airways Ltd suggests that it will generally be the case that there is a “supply” for GST purposes as most transactions involve the formation of a contract and the granting of rights under the contract will constitute a “supply”. A broad view of “supply” was also adopted by the High Court in FCT v MBI Properties Pty Ltd [2014] HCA 49. The Commissioner discusses the meaning of “supply” in Ruling GSTR 2006/9. The only exclusion to the definition of “supply” is the supply of money or digital currency, unless the money or digital currency is provided as consideration for a supply that is a supply of money or digital currency: s 9-10(4). For example, the provision of money on the acquisition of a table will not constitute a “supply”. However, the provision of money in a foreign exchange transaction will constitute a “supply”.
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Consideration [25.110] “Consideration” is defined in s 9-15 of GST Act as including any payment or any act or forbearance in connection with the supply. As such, consideration is not limited to the provision of money, but includes anything of value, such as the provision of services or goods. Note that the consideration does not have to be voluntary or even provided by the recipient of the supply: s 9-15(2). Example 25.5: Consideration Adam is an accountant. He recently assisted Jesse in completing his tax return for his shoe-cleaning business. Adam would normally charge $110 for his services, but in this case, he decided to accept Jesse’s offer of one year of free shoe-cleaning services, which would normally be worth at least $300. The free shoe-cleaning services would constitute consideration for Adam’s supply of accounting services. Further, the accounting services would constitute consideration for Jesse’s supply of shoe-cleaning services.
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In the course or furtherance of an enterprise [25.115] The meaning of “enterprise” is discussed at [25.60]. The expression “in the course or furtherance of” is not defined in the legislation. FCT v Reliance Carpet Co Pty Ltd (2008) 68 ATR 158 (see Case Study [25.1]) suggests that a wide approach is to be adopted and any supply that is connected to the enterprise will be made “in the course or furtherance of” that enterprise.
Connection to the indirect tax zone [25.120] Section 9-25 of GST Act details when a supply would be connected with the indirect tax zone. The “indirect tax zone” is defined in s 195-1 of the GST Act and in essence refers to Australia. The term “Australia” was replaced in the GST Act with “indirect tax zone” from 1 July 2015 to ensure consistency of terminology across the tax legislation. There was no change in policy with the change in terminology, and the term “Australia” is used here for readability. Examples of supplies connected to Australia include where: • the goods are delivered or made available to the recipient in Australia; • the supply involves goods being removed from Australia; • the supply is of Australian land; • the supply is done in Australia;
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874 [25.130] PRINCIPLES OF TAXATION LAW 2020 • the supply is made through an enterprise carried on in Australia; or • the recipient of the supply is an Australian consumer (see [25.297]). The Commissioner has published Rulings GSTR 2018/1 and GSTR 2018/2 on when supplies of real property and goods will be connected with Australia.
Consequences of making a taxable supply [25.130] An entity that makes a taxable supply is liable to pay GST on the taxable supply: s 9-40 of GST Act. It is therefore important to note that, although in practice it is often the recipient of a taxable supply who pays GST, the imposition of the liability to pay GST under the law is actually on the supplier. The amount of GST payable on the taxable supply is 10% of the value of the taxable supply: s 9-70. The value of a taxable supply is equal to ten-elevenths of the price of the supply: s 9-75. Generally, the price of a supply is equal to the consideration for the supply. Remember that consideration can be monetary or non-monetary in nature (see [25.110]), and the price is the sum of any monetary consideration and the GST-inclusive value of any non-monetary consideration: s 9-75(1).
Example 25.6: Consequences of making a taxable supply
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Jesse has his own shoe-cleaning business, which is registered for GST purposes. Jesse charges his customers $22 per cleaning. The cleaning of shoes is a taxable supply as it meets all of the requirements of a taxable supply in s 9-5. As a consequence of providing a taxable supply, Jesse must pay GST of 10% on the value of the taxable supply. The value of the taxable supply is ten-elevenths of the price of the supply. The price of the supply is equal to the consideration received, which in this case is $22. Therefore, GST payable by Jesse on the provision of shoe- cleaning services = 10% × (10/11 × $22) = $2.
GST-free supply [25.140] Certain goods and services are exempt from being a taxable supply if they are listed in Div 38 of GST Act as “GST-free supplies”. The list of items which are GST-free supplies is limited and generally relates to goods or services which are considered essential living expenses, necessary
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to maintain the international competitiveness of Australian businesses or charitable activities. The following items are listed in Div 38 as GST-free supplies: • food –subdiv 38-A: see [25.142]; • health –subdiv 38-B: see [25.144]; • education –subdiv 38-C: see [25.146]; • child care –subdiv 38-D: see [25.148]; • exports –subdiv 38-E: see [25.148]; • religious services –subdiv 38-F; • non-commercial activities of charitable institutions, etc –subdiv 38-G; • raffles and bingo conducted by charitable institutions, etc –subdiv 38-H; • water, sewerage and drainage –subdiv 38-I; • supplies of going concerns –subdiv 38-J: see [25.148]; • transport and related matters –subdiv 38-K; • precious metals –subdiv 38-L; • supplies through inward duty free shops –subdiv 38-M; • grants of land by governments –subdiv 38-N; • farm land –subdiv 38-O; • cars for use by disabled people –subdiv 38-P; • international mail –subdiv 38-Q: see [25.148]; • mobile global roaming services provided in Australia –subdiv 38-R; • eligible emissions units –subdiv 38-S; and • inbound intangible consumer supplies –subdiv 38-T: see [25.297]. Some of the more common categories of GST-free supplies are discussed in further detail below.
Food [25.142] Section 38-2 of GST Act stipulates that a supply of food is GST-free. Food is defined in s 38-4 as: • food and beverages for human consumption; • ingredients for food and beverages for human consumption; • goods to be mixed with or added to food for human consumption (including condiments, spices, seasonings, sweetening agents or flavourings); and • fats and oils marketed for culinary purposes. Under s 38-4, “food” does not include live animals (other than crustaceans or molluscs), unprocessed cow’s milk, grain, cereal or sugar cane that has not
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876 [25.144] PRINCIPLES OF TAXATION LAW 2020 been subject to any process or treatment, or plants under cultivation that can be consumed as food for human consumption without being subject to further process or treatment. The broad exemption from GST for food is narrowed by s 38-3, which specifies when food is not GST-free. Food is not GST-free where it is: • for consumption on the premises from which it is supplied (eg, restaurant food); • hot food for consumption away from those premises; and • food specified in Sch 1 of the GST Act as not being GST-free. A wide range of food is listed in the Schedule as not being GST-free. Food that is not GST-free includes: • prepared food (eg, quiches, sandwiches, pizzas, prepared meals but not including soup, burgers); • confectionary (eg, muesli bars, popcorn);
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• savoury snacks (eg, potato crisps, processed seeds or nuts); • bakery products (eg, cakes, pies, scones, bread with a sweet filling or coating); and • ice-cream food and biscuit goods. Despite the detailed list in Sch 1, the question as to whether a particular item of food is GST-free or not continues to arise in practice. In Lansell House Pty Ltd v FCT (2011) 79 ATR 22, the Full Federal Court considered whether “mini ciabatte” (Italian flat bread) is “bread”, which is GST-free, or a “cracker”, which is not GST-free. Based on the evidence presented (the appearance of the mini ciabatte, the ingredients and manufacturing process, as well as the treatment by stockists who sold it as a cracker or in the company of crackers), the Court concluded that “mini ciabatte” is a cracker and therefore not a GST-free supply. The High Court refused the taxpayer’s application for special leave to appeal. Beverages that are GST-free are listed in Sch 2 and include milk products; soy milk and rice milk; tea and coffee (but not in ready-to-drink form); fruit and vegetable juices; beverages for infants and invalids and natural, non- carbonated water without any additives. A broad rule of thumb is that only fresh, unprocessed food will be GST-free. Note that, under s 38-6, the packaging in which food is supplied is also GST- free if the supply of the food is GST-free.
Health [25.144] Under s 38-7 of GST Act, the supply of a medical service is GST- free. “Medical service” is defined in s 195-1 as a service for which a Medicare
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benefit is payable or any other service supplied by or on behalf of a medical practitioner or approved pathology practitioner that is generally accepted in the medical profession as being necessary for the appropriate treatment of the recipient of the supply. Under s 38-7(2), certain medical services, such as those provided for cosmetic reasons for which a Medicare benefit is not payable, are not GST-free. Any goods supplied in the course of supplying medical services are GST-free if the medical services are GST-free: s 38-7(3). Section 38- 10 extends GST- free treatment to the supply of other health services, such as acupuncture, chiropractic, dental, nursing, podiatry and so forth, where the requirements of the section are satisfied. Broadly, the service must be supplied by a person who is a recognised professional in services of that kind, and the service provided would be accepted in the profession as appropriate treatment for the patient.
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Under s 38-45, medical aids and appliances which are listed in Sch 3 of the GST Act are GST-free if the thing supplied is specifically designed for people with an illness or disability and is not widely used by people without an illness or disability. Examples of medical aids and appliances listed in Sch 3 include heart monitors, pacemakers, orthotics, nebulisers and prescription contact lenses. Section 38-50 specifies that drugs and medicines are GST-free if the supply is on prescription, and certain other conditions are specified. In addition, subdiv 38-B also lists other government-funded health services (s 38-15), hospital treatment (s 38-20), residential care (s 38-25), community care (s 38-30), flexible care (s 38-35), specialist disability services (s 38-40) and private health insurance (s 38-55) as being GST-free supplies where the necessary conditions are satisfied. Determination GSTD 2012/4 sets out the Commissioner’s views as to when the supply of hospital treatment will be GST- free under s 38-20.
Education [25.146] The supply of an education course and any administrative services directly related to the supply of such a course which are provided by the supplier of the course are GST-free supplies under s 38-85 of GST Act. “Education course” is defined in s 195-1 as being: • a pre-school course; • a primary course; • a secondary course; • a tertiary course; • a Masters or Doctoral course; • a special education course; • an adult and community education course;
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878 [25.148] PRINCIPLES OF TAXATION LAW 2020 • an English language course for overseas students; • a first aid or life saving course; and • a professional or trade course or a tertiary residential college course. Each of these courses is separately defined in s 195-1. In addition, excursions or field trips (s 38-90), course materials (s 38-95) and leases of curriculum-related goods (s 38-97) are also GST-free where they relate to an education course and satisfy the conditions specified in those sections. Accommodation at boarding schools may be GST-free under s 38-105, while certain services provided in recognising prior learning may be GST-free under s 38-110. Aside from course materials (s 38-95) and those items covered by s 38-97, a supply of any other goods related to an education course (eg, textbooks) and membership in a student organisation are not GST-free under s 38-100.
Other GST-free supplies [25.148] Other GST-free supplies that are worth noting are child care, exports, going concerns and international mail.
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Broadly, child care is GST- free when provided by a registered carer, an approved child care service or a carer eligible for Commonwealth funding for prescribed care: subdiv 38-D. Exports are generally GST-free under subdiv 38-E. A supply of goods will be GST-free if exported from Australia within 60 days after the earlier of the day the consideration is received or the day a tax invoice is provided by the supplier: s 38-185(1); Ruling GSTR 2002/6. The GST-free status will be lost if the goods are reimported into Australia: s 38-185(2). The supply of things, other than goods or real property, will be GST-free where the supply is connected with property outside Australia, made to a non-resident outside Australia or used or enjoyed outside Australia: s 38-190(1), Items 1-3. Where the supply is made in relation to rights, the supply will be GST-free where the rights are for use outside Australia or the supply is made to a non-resident of Australia who is outside Australia when the supply is made: s 38-190(1), Item 4. Repairs of goods from outside Australia will be GST-free if the final destination of the goods at the time the repairs are done is outside Australia: s 38-190(1), Item 5. The supply of a going concern is GST-free under subdiv 38-J. The supply must satisfy the requirements in s 38-325(1) to be GST-free. The requirements are that the supply must be for consideration; the recipient of the supply must be registered or required to be registered for GST; and the supplier and the recipient must have agreed in writing that the supply is of a going concern. In Midford v DFCT (2005) 60 ATR 1009, the Administrative Appeals Tribunal (AAT)
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stated that the last requirement meant that the agreement “when reasonably read, must identify the relevant supply and express a mutual understanding that it is a supply of a going concern”. A supply will be a supply of a going concern where the supplier supplies to the recipient all of the things that are necessary for the continued operation of an enterprise and the supplier carries on, or will carry on, the enterprise until the day of the supply: s 38-325(2). The question of when the supplier has provided “all things necessary” for the business to continue is a difficult issue in practice and will depend on the particular circumstances of the supply: see Ruling GSTR 2002/5. The supply of international mail (ie, mail posted overseas) is GST-free under s 38-540. It is therefore important when purchasing stamps to ensure that the correct stamps are purchased. Stamps for domestic mail include GST in their price, while stamps for international mail (marked “international”) do not include GST.
Consequences of making a GST-free supply [25.150] An entity that supplies GST-free supplies is not required to pay GST on the making of the supply: s 38-1 of GST Act. This is because GST-free supplies are excluded from the definition of “taxable supply” in s 9-5. Note that the making of a GST-free supply does not impact upon the entity’s entitlement to a refund of GST paid on any creditable acquisitions related to the making of the GST-free supply: see [25.190].
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Example 25.7: GST-free supplies Rob runs a fruit and vegetable stall in the local market. He is registered for GST purposes. Rob sells packs of five apples for $5 per pack. He pays $66 (inc GST) per week for rental of his stall. The supply of the apples for $5 per pack is a GST-free supply as it meets the requirements for the exemption on food in subdiv 38-A. As a result, Rob does not have to pay GST on the supply of the fruit. Rob may be entitled to a refund of GST paid on the stall rental if it is a “creditable acquisition”: see [25.190].
Input taxed supply [25.160] Another category of goods and services which are exempt from being taxable supplies are input taxed supplies. There are only a limited
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880 [25.163] PRINCIPLES OF TAXATION LAW 2020 number of goods and services which are input taxed supplies, and these are listed in Div 40 of GST Act as: • financial supplies: subdiv 40-A; • residential rent: subdiv 40-B; • residential premises: subdiv 40-C; • precious metals: subdiv 40-D; • school tuckshops and canteens: subdiv 40-E; • fund-raising events conducted by charitable institutions: subdiv 40-F; and • inbound intangible consumer supplies: subdiv 40-G (see [25.297]). Where a supply is both an input taxed supply and a GST-free supply (eg, financial supplies to an overseas customer), the GST- free characterisation prevails: s 9-30(3).
Financial supplies: subdiv 40-A
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[25.163] The term “financial supplies” is defined in s 40-5 of the GST Act by reference to the A New Tax System (Goods and Services Tax) Regulations 1999 (Cth) (GST Regulations). Regulation 40.5.09 of the GST Regulations specifies those supplies that are “financial supplies”. The broad categories of financial supplies include the provision, disposal or acquisition of an interest in or under a bank account; a loan arrangement; a superannuation fund; an insurance agreement; and shares or derivatives. Regulation 40.5.11, by reference to Sch 7 of the GST Regulations, provides a non-exhaustive list of examples of each of the categories of financial supplies in reg 40.5.09. These include opening, keeping, operating, maintaining and closing of cheque, debit card, deposit and savings accounts for account holders; cashing cheques and payment orders; electronic funds transfer; supply of credit cards; a mortgage over land, premises or chattel; various types of contracts of insurance; foreign currency, and so forth. Regulation 40.5.12 of the GST Regulations specifies the broad categories of supplies that are not financial supplies such as professional services in relation to a financial supply; a payment system; certain store value cards; broking services, and so forth. Regulation 40.5.13, by reference to Sch 8 of the GST Regulations, provides a non-exhaustive list of examples of supplies that are not financial supplies. These include advice by a legal practitioner or accountant in the course of professional practice; taxation or actuarial advice; health insurance, and so forth. Where an item is listed as both a financial supply and not a financial supply, it will not be a financial supply: Note 1 to reg 40.5.12. The Commissioner’s guidance on financial supplies is in Ruling GSTR 2002/2.
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Residential rent: subdiv 40-B [25.165] The supply of premises by way of lease, hire or licence (including renewals and extensions) is an input taxed supply where the premises are: • residential premises that are not commercial residential premises; or • commercial accommodation that would be subject to Div 87 of the GST Act but for a choice made by the supplier under s 87-25. “Residential premises” is defined in s 195-1 as land or a building that is occupied or intended to be occupied or capable of being occupied as a residence or for residential accommodation (including a floating home). The period of occupation or intended occupation is irrelevant. In Vidler v FCT (2009) 74 ATR 520, the Federal Court held that vacant land is not “residential premises” (affirmed by the Full Federal Court in Vidler v FCT (2010) 75 ATR 825). The taxpayer argued that the land is “capable of being occupied as a residence or for residential accommodation”. In South Steyne Hotel Pty Ltd v FCT (2009) 71 ATR 228, Stone J held that this meant that the premises must be capable of being occupied as such at the time and not merely have the potential to be developed to have that capacity. Residential premises must have the “element of shelter and basic living facilities such as provided by a bedroom and bathroom”. This view was affirmed by the Full Federal Court in South Steyne Hotel Pty Ltd v FCT (2009) 74 ATR 41. It is clear from Ruling GSTR 2012/5 that the Commissioner will focus on the physical characteristics of the premises to determine whether it is “residential premises”. Accommodation provided in an office building, private hospital, residential care facility or a shop will generally not be considered the supply of residential premises.
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“Commercial residential premises” is defined in s 195-1 as: • a hotel, motel, inn, hostel or boarding house; • premises used to provide accommodation in connection with a school; • a ship that is mainly let out on hire in the ordinary course of a business of letting ships out on hire; • a ship that is mainly used for entertainment or transport in the ordinary course of such a business; • a marina at which one or more of the berths are occupied or are to be occupied by ships used as a residence; or • a caravan park or camping ground. Premises that are similar to these will also be “commercial residential premises”, except for premises used to provide accommodation to students in connection with an education institution that is not a school. The Commissioner’s views on when premises will be considered “commercial residential premises” for GST purposes are set out in Ruling GSTR 2012/6.
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882 [25.167] PRINCIPLES OF TAXATION LAW 2020 “Commercial accommodation” is defined in s 87-15 as the right to occupy in whole or in part “commercial residential premises”, including the supply of cleaning and maintenance; electricity, gas, air-conditioning or heating; or telephone, television, radio or similar if provided. Division 87 applies to the supply of long- term (more than 28 days continuously) accommodation in commercial residential premises. Suppliers of long- term accommodation in commercial residential premises have the choice of treating the supply as a taxable supply subject to concessional GST rates in Div 87 (GST is charged but the supplier is entitled to input tax credits on acquisitions) or as an input taxed supply under Div 40 (no GST is charged but the supplier is not entitled to input tax credits on acquisitions). The Commissioner’s views on when “long-term accommodation” is provided in commercial residential premises are set out in Ruling GSTR 2012/7. The distinction between “residential” and “commercial residential premises” has been considered in several cases, including Sunchen Pty Ltd v FCT (2010) 78 ATR 197; South Steyne Hotel Pty Ltd v FCT (2009) 74 ATR 41; Meridien Marinas Horizon Shores Pty Ltd v FCT (2009) 74 ATR 787; and Toyama Pty Ltd v Landmark Building Developments Pty Ltd (2006) 62 ATR 73.
Residential premises: subdiv 40-C
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[25.167] The sale (s 40-65(1) of GST Act) and long-term lease (s 40-70(1)) of “residential premises” ([25.165]) is input taxed where it is to be used predominantly for residential accommodation (regardless of the term of occupation). However, the sale or long-term lease is not treated as input taxed if the premises are “commercial residential premises” (see [25.165]) or “new residential premises”: ss 40-65(2) and 40-70(2). “Long-term lease” is defined in s 195-1 as a lease, hire or licence for a period of at least 50 years. “New residential premises” is defined in s 40-75 as residential premises: • which have not previously been sold as residential premises and have not previously been the subject of a long-term lease; • have been created through substantial renovations of a building; or • have been built or contain a building that has been built to replace demolished premises on the same land. Premises will not be treated as “new residential premises” if: • they were used for residential accommodation before 2 December 1998, regardless of the term of occupation (s 40-65(2)); or • if they have only been used as residential rental premises for a period of at least five years since they first became residential premises; were last substantially renovated or were last built: s 40-75(2).
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The determination as to what constitutes “substantial renovations” can be difficult in practice, and the Commissioner provides some guidance on this issue in Ruling GSTR 2003/3.
Consequences of making an input taxed supply [25.170] An entity that makes input taxed supplies is not required to pay GST on the making of the supply: s 40-1 of GST Act. This is because input taxed supplies are excluded from the definition of “taxable supply” in s 9-5. A further consequence of making input taxed supplies is that the entity is not entitled to a refund of GST paid on any acquisitions related to the making of that supply as the acquisition would not satisfy the requirements of “creditable acquisition”: see [25.190] and [25.210]–[25.217]. Example 25.8: Input taxed supplies Guido owns eight houses which he rents out to students at the nearby university. He charges rental of $110 per week for each house. Guido recently paid $66 (inc GST) to a plumber for repairs in one of the houses. Guido is registered for GST purposes. The rental of the houses would constitute input taxed supplies as it is residential rent. Guido does not have to pay GST on the $110.
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Guido is not entitled to a refund of the GST paid to the plumber as the acquisition relates to the provision of an input taxed supply and would therefore not satisfy the requirements of creditable acquisition: see [25.190] and [25.210]–[25.217].
Mixed or composite supply [25.175] An entity may also make a supply that is partly a taxable supply and partly GST-free or input taxed. Such supplies fall into two categories –mixed supplies and composite supplies. A mixed supply is a supply that can be unbundled into separately identifiable parts, and each part is treated separately for GST purposes. A composite supply is one that is made up of a dominant part and something that is integral, ancillary or incidental to that part. A number of examples of mixed and composite supplies are discussed in Ruling GSTR 2001/8. In the case of a mixed supply, the value of the supply is to be apportioned between the taxable supply and the GST- free or input taxed supply: s 9-80. The Commissioner considers a number of different direct and indirect apportionment methods in Ruling GSTR 2001/8.
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884 [25.180] PRINCIPLES OF TAXATION LAW 2020
Example 25.9: Consequences of making a mixed supply Jill sells a property that consists of commercial and residential premises on a single title. Commercial premises are taxable supplies while residential premises are input taxed supplies. Therefore, the sale of the property is a mixed supply. Jill is registered for GST purposes. The property was sold for $200,000. Jill estimates that the commercial premises comprise 70% of the property area, while the residential premises comprise 30% of the property area. As a consequence of making a taxable supply, Jill must pay GST of 10% on the value of the taxable supply. The value of the taxable supply is apportioned to take into account the fact that the value also relates to an input taxed supply. Jill may calculate the value of the commercial premises as 70% × $200,000 = $140,000. Therefore, GST payable by Jill on the sale of the commercial premises = 10% × (10/11 × $140,0000) = $12,727.
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Note that property area is only one example of a method Jill could use to determine the proportionate value of the commercial premises. She could also determine the value using other bases, such as the rentals received on each premises or a professional valuation. In FCT v Luxottica Retail Australia Pty Ltd [2011] FCAFC 20, the Full Federal Court held that taxpayers can choose to only discount the taxable component of a mixed supply and not the GST-free or input-taxed component (ie, a discount does not have to be apportioned across both supplies). In FCT v Luxottica, the taxpayer had offered its customers a discount on spectacle frames (which are taxable supplies) if they purchased full-price lenses (which are GST-free supplies). The Court rejected the ATO’s argument that the discount had to be applied to the whole package and accepted the taxpayer’s treatment of the transaction. Composite supplies are treated as a single supply, and it is necessary to ascertain which is the dominant part of the supply to determine the GST consequences of the supply. It is not always easy to distinguish the dominant part of a supply from that part of a supply that is integral, ancillary or incidental to the dominant part. The Commissioner discusses a number of ways in which this determination can be made in Ruling GSTR 2001/8.
Supply summary [25.180] Table 25.1 provides a summary of the GST consequences for an entity of the three different categories of supplies:
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TABLE 25.1 GST consequences of making a supply GST payable on supply? Taxable supply
✓
GST-free supply
✗
Input taxed supply
✗
Where the supply comprises a combination of taxable and GST-free or input taxed supplies, it is necessary to determine whether the supply is a mixed or composite supply. The GST consequences are determined accordingly. As mentioned earlier, the basic rules regarding taxable supplies, GST-free supplies and input taxed supplies are generally quite straightforward. However, it should be noted that there are a large number of special rules that may alter the treatment of a supply. These special rules include: • supplies to associates: Div 72; • margin scheme for sale of real property: Div 75; • insurance claims or settlements: Div 78; • offshore supplies other than goods or real property: Div 84; • vouchers: Div 100; • supplies in satisfaction of debts: Div 105; and • agents: Div 153. Discussion of these special rules is beyond the scope of this book.
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Creditable acquisition [25.190] So far in this chapter we have looked at the consequences, for an entity that is registered for GST, of making a supply. The second key concept in GST is “creditable acquisition”, which governs an entity’s entitlement to “input tax credits” (refund of GST paid on acquisitions). Under s 11-5 of GST Act, an entity makes a creditable acquisition if: • the entity makes an acquisition: see [25.200]; • the acquisition was solely or partly for a creditable purpose: see [25.210]–[25.220]; • the supply to the entity was a taxable supply: see [25.225]; • the entity provided or was liable to provide consideration for the supply: see [25.110]; and • the entity is registered or required to be registered for GST purposes: see [25.50].
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Acquisition [25.200] Similar to the definition of “supply” (see [25.100]), “acquisition” is defined very broadly in s 11-10 of GST Act as “any form of acquisition whatsoever” and includes: • an acquisition of goods; • an acquisition of services; • a receipt of advice or information;
• • • •
an acceptance of a grant, assignment or surrender of real property; an acceptance of a grant, transfer, assignment or surrender of any right; an acquisition of something the supply of which is a financial supply; and an acquisition of a right to require another person to do anything or to refrain from an act or to tolerate an act or situation.
Example 25.10: Meaning of “acquisition” Jesse bought shoe polish from the local supermarket for his shoe cleaning business. Jesse paid his accountant $110 for preparing his tax return for the year. The purchase of the shoe polish is an acquisition as Jesse has acquired goods.
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The payment for the preparation of the tax return is an acquisition as Jesse has acquired services.
Creditable purpose [25.210] Establishing that an acquisition is for a creditable purpose is generally the key issue in satisfying the requirements of “creditable acquisition”. Creditable purpose is defined in s 11-15 of GST Act; see also the Commissioner’s guidance in Ruling GSTR 2008/1. An acquisition would be for a creditable purpose where the acquisition relates to the carrying on of the entity’s enterprise. Generally, an acquisition would be for a creditable purpose where it is made for a business purpose. Section 11-15(2)(b) expressly states that an acquisition will not be for a creditable purpose if it is private or domestic in nature. However, acquisitions which relate to the provision of fringe benefits that are for an employee’s private use are taken to be for a creditable purpose: see Ruling GSTR 2001/3. Example 25.11: Acquisition for a creditable purpose Jesse has his own shoe cleaning business. He recently purchased shoe polish for the business. While he was at the store, he also purchased
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various cleaning products for use in his home and a digital camera to provide as a gift to his employee. The provision of the digital camera constitutes the provision of a fringe benefit. The acquisition of the shoe polish is for a creditable purpose as Jesse purchased the shoe polish for use in his business. The acquisition of the cleaning products is not for a creditable purpose as they were purchased for use in his home and were therefore not related to the carrying on of his enterprise. Further, they are specifically excluded under s 11-15(2)(b) of GST Act as they are private or domestic in nature. The acquisition of the digital camera is for a creditable purpose as it relates to the provision of a fringe benefit. It does not matter that the employee may use the digital camera for private purposes.
Acquisitions related to input taxed supplies
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[25.214] As mentioned at [25.170], acquisitions related to the making of input taxed supplies are not creditable acquisitions. This is because of s 11-15(2)(a) of the GST Act, which states that an acquisition is not for a creditable purpose where it relates to the making of input taxed supplies. In Rio Tinto Services Pty Ltd v FCT [2015] FCAFC 117, the Full Federal Court held that acquisitions were not for a creditable purpose because they are related to the provision of input taxed supplies (residential accommodation), notwithstanding that the input taxed supplies were provided as part of a broader enterprise which made taxable supplies.
Example 25.12: Acquisition for a creditable purpose and input taxed supplies Guido owns various investment properties which he rents out to students at a nearby university. Guido recently paid $66 (inc GST) to a plumber for repairs in one of the houses. Guido is registered for GST purposes. The acquisition of plumbing services is not for a creditable purpose as it relates to the provision of residential rental premises, which is an input taxed supply.
[25.217] Financial supplies. Where the input taxed supplies are financial supplies, the supplier may nonetheless be entitled to input tax credits on acquisitions related to the making of those supplies in certain circumstances.
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888 [25.220] PRINCIPLES OF TAXATION LAW 2020 Under s 70-5 of the GST Act, suppliers may be entitled to a partial input tax credit (75%: reg 70-5.03) for certain acquisitions listed in regs 70-5.02 and 70-5.02A. Examples include acquisitions related to cheque clearing services, loan services, debt collection services and transaction processing services. The reduced input tax credit was introduced to address the bias between financial suppliers performing certain functions in-house or outsourcing those services. The operation of the reduced input tax credit (including examples) is discussed in Ruling GSTR 2004/1. Under s 11-15(4), any acquisitions related to the making of financial supplies are treated as being for a creditable purpose where the entity does not exceed the “financial acquisitions threshold”. Generally, an entity will not exceed the financial acquisitions threshold where the amount of its input tax credits on acquisitions related to the making of financial supplies does not exceed $150,000 (since 1 July 2012; $50,000 prior to that date), and its input tax credits on acquisitions related to the making of financial supplies is less than 10% of its input tax credits on all acquisitions: ss 189-5 and 189-10. The test requires a determination of current and future acquisitions –that is the preceding and following 11 months. The Commissioner’s guidance on the financial acquisitions threshold is contained in Ruling GSTR 2003/9.
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Example 25.13: Acquisition for a creditable purpose and the financial acquisitions threshold J Pty Ltd runs a furniture manufacturing business. During the year, it provided customers with various loan arrangements to finance the purchase of furniture. Its expenses relating to the loan arrangements totalled $33,000 (inc GST), while its total expenses were $2 million (inc GST). J Pty Ltd is registered for GST purposes. Although some of J Pty Ltd’s acquisitions relate to the provision of input taxed supplies (loans are financial supplies), the acquisitions are for a creditable purpose because the input taxed supplies are financial supplies, and the amount of J Pty Ltd’s input tax credits on these acquisitions for the year would be $3,000, which is below the financial acquisitions threshold of $150,000. Further, its input tax credits on those acquisitions are less than 10% of its input tax credits on all acquisitions.
Solely or partly [25.220] The expression “solely or partly” for a creditable purpose in s 11-5 of GST Act ensures that an acquisition will still be treated as being for a creditable purpose even though the entity may have had a non-business purpose as well as a business purpose in making the acquisition. The Commissioner’s guidance
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on determining the extent of creditable purpose is in Rulings GSTR 2006/3 (for providers of financial supplies) and GSTR 2006/4 (for providers of supplies other than financial supplies). Example 25.14: Partial creditable purpose Jesse has his own shoe cleaning business. He purchased shoe polish which he uses for the business as well as to clean his own shoes at home. The acquisition of the shoe polish is for a creditable purpose even though Jesse also had a non-business purpose (home use) for the shoe polish at the time of acquisition. Although the acquisition is still a creditable acquisition, the consequences will differ where it is partly for a creditable purpose: see [25.230].
Supply to the entity was a taxable supply
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[25.225] This element ensures that input tax credits are only available where GST was in fact paid on the acquisition. Where the information provided states that the amount paid for an acquisition includes GST, this is clearly the acquisition of a taxable supply by the entity. However, where it is not clear that the amount paid includes GST, it will be necessary to go through the analysis at [25.90] from the supplier’s perspective to determine whether the supplier has or should have charged GST on the supply. This includes deliberation as to whether the supplier is or should be registered for GST purposes and whether the supply is a GST-free or input taxed supply. Example 25.15: Acquisition was a taxable supply Jesse runs his own shoe cleaning business. He recently purchased shoe polish for $22 (including GST). He also purchased a shoe polishing machine for $5,500 from the manufacturer, Big Machines Pty Ltd, which is located in Perth. Big Machines Pty Ltd is one of the largest manufacturers of shoe polishing machines in the world and has an annual turnover of $2 million. The acquisition of the shoe polish is clearly the acquisition of a taxable supply as the information states that the price paid includes GST. The acquisition of the shoe polish will be a creditable acquisition if all of the other elements are satisfied. To determine whether Jesse’s acquisition of the machine is the acquisition of a taxable supply, it is necessary to consider whether the supply of the machine is a taxable supply from Big Machines’ perspective.
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Big Machines is clearly carrying on an enterprise and, with an annual turnover of $2 million, is required to be registered for GST. Big Machines is located in Perth, and therefore the supply is connected to Australia. The supply is made for consideration. The machine is not a GST-free or input taxed supply. Therefore, the supply of the machine to Jesse is a taxable supply, and the $5,500 includes GST. The acquisition of the machine by Jesse will be a creditable acquisition if all of the other elements are satisfied.
Consequences of making a creditable acquisition [25.230] An entity that makes a creditable acquisition is entitled to input tax credits on the acquisition: s 11-20 of GST Act. The amount of input tax credits on a creditable acquisition is the amount equal to the GST payable on the supply of the thing acquired: s 11-25. As discussed at [25.130], the amount of GST payable on a taxable supply is 10% of the value of the taxable supply: s 9-70. The value of a taxable supply is equal to ten- elevenths of the price of the supply: s 9-75. Generally, the price of a supply is equal to the consideration for the supply. Example 25.16: Consequences of making a creditable acquisition
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Jesse has his own shoe cleaning business, which is registered for GST purposes. Jesse purchased a bottle of shoe polish for $22 for use in the business. The acquisition of the shoe polish is a creditable acquisition as it satisfies all of the requirements in s 11-5 of GST Act. As a consequence of having a creditable acquisition, Jesse is entitled to input tax credits in relation to the acquisition. The amount of the input tax credits is equal to the GST payable on the taxable supply. The GST payable on the supply is calculated as follows: • The value of the taxable supply is ten-elevenths of the price of the supply. • The price of the supply is equal to the consideration received, which in this case is $22. • The GST payable on the supply is 10% × (10/11 × $22) = $2. Therefore, Jesse is entitled to input tax credits of $2 on the acquisition of the shoe polish.
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Where the acquisition was only partly for a creditable purpose, the amount of input tax credits on the acquisition is limited to the extent that the acquisition was for a creditable purpose: s 11-30. Example 25.17: Consequences of making an acquisition partly for a creditable purpose Following on from Example 25.16, assume that Jesse expects to use the shoe polish 80% for business purposes and 20% for private use on cleaning his own shoes. We established that Jesse is entitled to input tax credits of $2 on the acquisition of the shoe polish. The amount of input tax credits on the acquisition where Jesse only has a partly creditable purpose is calculated by multiplying the amount of the input tax credits on the acquisition by the creditable purpose percentage (ie, the extent to which the acquisition is for a creditable purpose). In this case, the amount of Jesse’s input tax credits on the acquisition would be $2 × 80% = $1.60.
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Special rules [25.235] As with taxable supplies, the entitlement to input tax credits for creditable acquisitions may be varied under the operation of various special rules in the GST Act. These rules include: • Div 60 in relation to pre-establishment costs; • Div 137 relating to stock on hand when an entity becomes registered; and • Div 153 in relation to agents. A particularly important override to the general creditable acquisition rules is Div 69, relating to non-deductible expenses.
Non-deductible expenses [25.240] Even where all of the elements of “creditable acquisition” are satisfied, an acquisition will not be a creditable acquisition if it is a non- deductible expense: s 69-5 of GST Act. A “non-deductible expense” refers to an expense which is not deductible for income tax purposes. However, for GST purposes, only the following non-deductible expenses are treated as not being creditable acquisitions under s 69-5: • penalties: s 26-5 of Income Tax Assessment Act 1997 (Cth) (ITAA 1997); • relative’s travel expenses: s 26-30 of ITAA 1997;
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• • • • • •
family maintenance expenses: s 26-40 of ITAA 1997; recreational club expenses: s 26-45 of ITAA 1997; expenses for a leisure facility or boat: s 26-50 of ITAA 1997; entertainment expenses: Div 32 of ITAA 1997; non-compulsory uniforms: Div 34 of ITAA 1997; and agreements for the provision of non- deductible non- cash business benefits: s 51AK of ITAA 1936. Note that some of these expenses (eg, entertainment expenses) may be deductible for income tax purposes where they relate to the provision of a fringe benefit: see [12.220]–[12.230]. Where a non- deductible expense is deductible for income tax purposes because it relates to the provision of a fringe benefit, the restriction in s 69-5 of GST Act does not apply, and the acquisition will be treated as a “creditable acquisition” if all the elements of “creditable acquisition” are satisfied. Example 25.18: Input tax credits on entertainment expenses
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Jesse took his two employees out to dinner to celebrate the end of a successful year. The dinner cost $110 (inc GST). Assume that Jesse chooses to treat the meal as a meal entertainment fringe benefit and uses the 50/ 50 split method to calculate the taxable value (see [7.230]–[7.240]). Also assume that all of the elements of “creditable acquisition” are satisfied. By choosing the 50/50 split method, Jesse only pays fringe benefits tax on half of the cost of the fringe benefit. As such, Jesse is entitled to a deduction for income tax purposes for that half of the meal expense ($55): s 32-20 of ITAA 1997 and s 51AEA of ITAA 1936. The other half of the meal entertainment expense is a “non-deductible expense” and does not give rise to a creditable acquisition: s 69-5(3A) of GST Act. Therefore, Jesse is only entitled to input tax credits of $5 for the half of the expense that is deductible. Note that Jesse’s deduction will be reduced from $55 to $50 because of the $5 of input tax credits: s 27-5 of ITAA 1997 (see [25.320]). Further, as mentioned at [14.125], the amount of input tax credits in relation to a car is generally limited to 1/11 of the “car limit”: s 69-10. The “car limit” is $57,581 for the 2019–2020 income year: “Car cost limit for depreciation” on ATO website.
Importation [25.250] The rules regarding importations are covered in Div 13 of GST Act and are different to the general rules regarding GST as they:
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• apply regardless of whether an entity is registered for GST purposes; • only apply to the importation of goods and not other types of importations; and • impose the liability to pay GST on the importer of goods, not the supplier. These special rules are necessary because, in the case of an importation, the supplier is located outside Australia, and it would be administratively difficult to collect GST from an entity located outside Australia. The rules also ensure that goods consumed in Australia are subject to GST regardless of whether they are acquired in or out of Australia, thereby maintaining the competitiveness of Australian businesses. The general rules regarding importations in Div 13 is supplemented by the special rules in Div 84 which imposes GST on certain offshore supplies not covered by Div 13: see [25.295].
Taxable importation [25.260] Liability for GST is imposed on an entity which makes a taxable importation. Under s 13- 5 of GST Act, an entity makes a taxable importation where:
• goods (excluding the importation of money: s 13-5(4)) are imported; and
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• the goods are entered for home consumption. “Entered for home consumption” is an expression used in customs law and essentially means that goods are brought into Australia for consumption or use in Australia (ie, the goods are not in Australia in transit). An entity does not have to be carrying on an enterprise or be registered for GST purposes to make a taxable importation. Similarly, a taxable importation will exist regardless of whether the goods are being imported for business or private purposes. However, an importation is not a taxable importation to the extent that it is a non-taxable importation. The following are non-taxable importations: • goods that would have been GST-free or input taxed supplies if they were supplies (ie, supplied in Australia) (s 13-10(b)); • goods exported from Australia and returned to Australia unchanged (s 42-10); and • goods that qualify for certain customs duty concessions (s 42-5). A wide range of goods qualify for customs duty concessions and would therefore be non- taxable importations. The most relevant category in this range is low-value goods, which are goods that have a customs value of less
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894 [25.270] PRINCIPLES OF TAXATION LAW 2020 than $1,000. However, from 1 July 2018, importations of low-value goods are subject to GST under different provisions: see [25.299]. Example 25.19: Non-taxable importations Paul moved to Australia from New Zealand. He purchases fresh kiwifruit and New Zealand chocolates online directly from a New Zealand supplier. The chocolates and kiwifruit are delivered to him in Australia by the seller’s representative. He purchases the items for himself as he misses the taste of New Zealand and cannot get the same quality items in Australian shops. The customs value of the chocolates is $1,200, and the customs value of the kiwifruit is $3,000. The purchase of the chocolates from New Zealand and brought into Australia will be a taxable importation (as confectionary, chocolates are not GST-free food: Sch 1 of GST Act). The chocolates are not low-value goods as they have a customs value in excess of $1,000. The purchase of the fresh kiwifruit will not be a taxable importation as it would have been a GST-free supply had it been a supply (ie, purchased in Australia).
Consequences of making a taxable importation
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[25.270] GST is payable on the making of a taxable importation by the person making the taxable importation: ss 13-1 and 13-15 of GST Act. The amount of GST payable on the making of a taxable importation is 10% of the value of the taxable importation: s 13-20(1). The value of a taxable importation is the customs value of the goods plus any costs incurred in transporting and insuring the goods to bring them into Australia: s 13-20(2). Generally, the customs value of goods is the cost of the goods in Australian dollars.
Example 25.20: Consequences of making a taxable importation Jimmy purchased a new mobile phone from the US as he could not wait for it to be sold in Australia. The phone cost him approximately A$1,500 plus A$100 in postage and insurance costs. The purchase of the mobile phone is a taxable importation as goods are being imported into Australia for home consumption. The mobile phone would not fall into any of the categories of non-taxable importations. The value of the taxable importation is the customs value of the mobile phone ($1,500) plus the freight and insurance costs ($100), which is $1,600.
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Therefore, GST payable by Jimmy on the importation of the mobile phone is 10% × $1,600 = $160. If Jimmy brings the phone into Australia personally after travelling to the US, he is required to declare the taxable importation and pay tax at the airport when he enters into Australia. If the phone is shipped to him by post or courier, the post office or courier company will collect the GST from Jimmy and remit it to the ATO on his behalf.
Creditable importation [25.280] The making of a taxable importation gives rise to a liability to pay GST, whereas the making of a creditable importation gives rise to an entitlement to input tax credits. Under s 15-5 of GST Act, a creditable importation exists where: • an entity imports goods solely or partly for a creditable purpose: see [25.210]–[25.220]; • the importation is a taxable importation: see [25.260]; and
• the entity is registered or required to be registered for GST purposes: see [25.50].
These elements of “creditable importation” preserve the general rule that GST is imposed on final, private consumers. Entities will be entitled to input tax credits on importations that are for a business purpose, provided that the entity is registered for GST purposes.
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Even where all of the elements of “creditable importation” are satisfied, an importation will not be a creditable importation if it is a non-deductible expense: s 69-5. See [25.240] for a list of non-deductible expenses.
Consequences of making a creditable importation [25.290] An entity that makes a creditable importation is entitled to input tax credits on the importation: ss 15-1 and 15-15 of GST Act. The amount of input tax credits on a creditable importation is the amount equal to the GST payable on the importation: s 15-20. As discussed at [25.270], the amount of GST payable on a taxable importation is 10% of the value of the taxable importation. Example 25.21: Consequences of making a creditable importation Following on from Example 25.20, assume that Jimmy purchased the new mobile phone from the US for business purposes only. Jimmy is registered for GST purposes.
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As established in Example 25.20, the purchase of the mobile phone is a taxable importation, and Jimmy is liable to pay GST of $160 on the importation. As the mobile phone was purchased for a creditable purpose (for Jimmy’s business) and Jimmy is registered for GST purposes, the importation of the phone is also a creditable importation and Jimmy is entitled to input tax credits of $160 on the importation. In practice, the two amounts would generally arise in the same GST period (see below) and Jimmy would be able to net-off the two amounts, so that there is no amount payable or receivable in relation to the importation.
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Offshore supplies [25.295] The general importation rules in Div 13 are supplemented by the special rules in Div 84 which extend the imposition of GST on importations to the importation of intangible supplies and to the importation of low value goods. A detailed examination of the special rules is beyond the scope of this book, and only a brief outline is provided here. The consequence of the different sets of rules is that the liability for GST on the importation of non-low value goods (taxable importations) is imposed on the importer of such goods, while the liability for GST on importations of intangible supplies and low value goods is generally imposed on the overseas supplier. Further, the rules regarding offshore inbound intangible supplies and the importation of low value goods refer to supplies made to Australian consumers. As such, supplies made to Australian businesses (B2B transactions) generally fall outside the scope of these measures. Under subdiv 84-A, where the offshore supply of intangibles or low value goods is made to a recipient carrying on an enterprise in Australia but the acquisition was not solely for a “creditable purpose” (see [25.210]), or the supplier reasonably believed that the recipient was not a consumer, the supplies are treated as taxable supplies and a “reverse charge” applies (GST on the supply is payable by the recipient of the supply, not the supplier). A “reverse charge” can also apply to taxable supplies made by non-residents where the recipient agrees to such an arrangement: Div 83.
Intangible supplies [25.297] From 1 July 2017, offshore inbound intangible supplies, such as the provision of services (eg, consultancy or professional services) or digital products (eg, movie streaming or downloading services, music, apps, games, ebooks), are treated as being connected to Australia for GST purposes if the recipient of the supply is an Australian consumer: s 9-25(5)(d). An “Australian consumer” is an Australian- resident entity (refer to the residency tests in Chapter 4) that is not registered for GST in Australia or, if GST-registered, the
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supply is acquired for a non-business purpose: s 9-25(7). Under s 84-100, an entity may treat a supply as not being made to an Australian consumer (and not subject to GST) if the entity took reasonable steps to obtain information as to whether the recipient of the supply was an Australian consumer, or, had business systems and processes which provide a reasonable basis for identifying if the recipient in an Australian consumer, and, having taken such steps or had such processes, reasonably believed that the recipient was not an Australian consumer. Where this is later found not to be the case, a “reverse charge” may apply, as discussed at [25.295], and the Australian consumer may be subject to administrative penalties if they have made false or misleading statements. Ruling GSTR 2017/1 provides guidance on how overseas suppliers can determine whether a recipient of a supply is an “Australian consumer”. Where the supplies are to be used or enjoyed outside Australia, the supplies will continue to be GST-free supplies under s 38-190.
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Unlike the general rules regarding importations, which impose the liability for GST on the importer (see [25.260]), the liability for GST on the importation of intangible supplies is placed on the offshore supplier of such supplies. Broadly, a non-resident supplier is required to register for GST (and pay GST on the supply) if it is carrying on an enterprise and the “registration turnover threshold” (see [25.70]) is met. However, in determining whether the “registration turnover threshold” is satisfied, any supplies that are not connected with Australia are disregarded: ss 188-15(3) and 188-20(3). Where an inbound intangible consumer supply is made through an “electronic distribution platform” (EDP) (eg, an app store), the operator of the EDP is treated as the supplier and required to comply with the GST obligations (register for GST if it meets the “registration turnover threshold” and pay GST on the supply): s 84-55.
Low value goods [25.299] As mentioned at [25.260], GST also applies to offshore supplies of low value goods from 1 July 2018. Low value goods are goods with a customs value of $1,000 or less and the goods are not tobacco, tobacco products or alcoholic beverages: s 84-79(3). An offshore supply of low value goods is treated as being connected to Australia if the recipient of the supply is a consumer of the supply and the goods are brought into Australia: ss 84-75 and 84-77. Broadly, a non-resident supplier is required to register for GST (and pay GST on the supply) if it is carrying on an enterprise and the “registration turnover threshold” (see [25.70]) is met. However, in determining whether the “registration turnover threshold” is satisfied, any supplies that are not connected with Australia are disregarded: ss 188-15(3) and 188-20(3). Where low value goods are supplied through an EDP or a redeliverer, the operator of the EDP or the redeliverer may be treated as the supplier and required to comply with the GST obligations (register for GST if it meets the “registration turnover threshold” and pay GST on the supply): s 84-81.
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898 [25.300] PRINCIPLES OF TAXATION LAW 2020
Administration [25.300] GST is administered by the ATO. Entities that are registered or required to be registered for GST are required to complete and lodge a GST return (known as a “Business Activity Statement” or BAS) on a quarterly basis: ss 27-5, 31-5 and 31-8 of GST Act. However, entities with an annual turnover in excess of $20 million, entities that will be carrying on business in Australia for less than three months, or entities that have a bad history of compliance must complete the BAS on a monthly basis: ss 27-15, 31-5 and 31-10. Other entities have the option of choosing to report on a monthly basis (s 27-10) and may return to quarterly reporting whenever they wish as long as they do not have to report on a monthly basis: s 27-10. Entities must report the amount of any GST payable (ie, GST on taxable supplies or taxable importations) and GST refundable (ie, input tax credits on creditable acquisitions or creditable importations) for the period on the BAS. The two amounts are netted off, and the entity is either in a net GST payable or refundable position (known as the “net amount”) for the period: s 17-5(1). Taxpayers who have made an error in working out their net GST amount in a particular period may correct that error in a later period where the circumstances set out in GST Errors Determination 2013 are satisfied. Anti- avoidance provisions similar to Pt IVA of ITAA 1936 (see [23.180]–[23.260]) are contained in Div 165.
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Timing [25.304] Entities are generally required to report their GST obligations on an accruals basis unless they choose to account for GST on a cash basis. Section 29-40 specifies that entities may choose to account for GST on a cash basis in certain specified circumstances (eg, the entity is a “small business entity”): see also Ruling GSTR 2000/13. In this context, a “small business entity” is a sole trader, partnership, company or trust that operates a business for all or part of the income year and has an aggregated turnover of less than $10 million. Broadly, “aggregated turnover” is the entity’s turnover plus the annual turnover of any business that is connected or affiliated to the entity. For entities that account for GST on an accruals basis, GST payable is attributed to the tax period when any consideration is received or an invoice is issued in relation to the supply: s 29-5. Entities that account for GST on a cash basis account for GST payable in proportion to the cash received. For example, if an entity invoices a customer for a supply on 20 June but only receives payment on 5 July, the entity will be required to include the GST amount in its GST
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payable for the period ending 30 June if it accounts for GST on an accruals basis. However, if it accounts for GST on a cash basis, it will only include the GST amount in its GST payable for the next period, once the amount is actually received. Where the GST payable relates to a taxable importation, GST is payable when the customs duty is payable, regardless of whether the entity accounts for GST on a cash or accruals basis: s 33-15(1)(a). In relation to acquisitions, s 29-10 provides that, for accruals basis entities, input tax credits are attributable to the period when the entity provides any consideration or an invoice is issued in relation to the acquisition. Entities that account for GST on a cash basis are entitled to input tax credits in proportion to the consideration provided: s 29-10(2). The Commissioner’s guidance on the attribution rules for GST payable, input tax credits and adjustments is contained in Ruling GSTR 2000/29. Input tax credits due to creditable importations are attributable to the tax period when the entity actually pays GST on the importation, regardless of whether the entity accounts for GST on a cash or accruals basis: s 29-15(1).
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In response to a recommendation by the Board of Taxation in its report into the Review of the Legal Framework for the Administration of GST, the government has introduced a four-year limitation period, subject to certain exceptions, to claim input tax credits: s 93-5. The four-year period commences from the day on which a taxpayer is required to give the Commissioner a return for the tax period to which a credit would be attributable under the basic attribution rules in s 29-10.
Tax invoice [25.306] For both cash and accruals taxpayers, the entity must have a tax invoice to be entitled to input tax credits: s 29-10(3) and (4). Where the entity does not possess a tax invoice, the input tax credits are attributable to the period in which the entity holds a tax invoice. Section 29-70 sets out the requirements that must be satisfied for a document to be a “tax invoice”. These requirements were amended with effect from 1 July 2010 by replacing the existing requirements with equivalent but flexible principles. A document will be a tax invoice if it: • is issued by a supplier or a recipient in the case of a recipient created tax invoice; • is in the approved form; • contains the required information;
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900 [25.310] PRINCIPLES OF TAXATION LAW 2020 • was intended to be a tax invoice, which must be clearly ascertained from the document; and • contains any other matters specified by the GST Regulations. The required information that must be contained in the document includes the supplier’s identity and ABN, the recipient’s identity or ABN if the consideration for the supply is $1,000 or more, the thing supplied including the quantity and price of the thing, the extent to which the supply is taxable, and the date the document is issued. Under these requirements, a collection of documents can constitute a tax invoice. The Commissioner has published Ruling GSTR 2013/1 which sets out the minimum information requirements for a tax invoice under s 29-70(1). Under s 29- 80(1), tax invoices are not required for low- value transactions (currently transactions with a value of less than $75 (excluding GST): reg 29-80.01).
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Adjustments [25.310] The net amount calculated under s 17-5 of GST Act is increased or decreased for any adjustments: s 17-5(2). An entity can make an adjustment to its GST obligations on supplies or acquisitions under Div 19: see also Ruling GSTR 2000/19. An adjustment may arise because the supply or acquisition is cancelled, there is a change to the consideration for a supply or acquisition, or the supply or acquisition becomes or stops being a taxable supply or creditable acquisition: s 19-10. Adjustments relating to a change in the extent of creditable purpose are dealt with in Div 129, while adjustments relating to goods applied solely to private or domestic use are dealt with in Div 130. Adjustments for bad debts are dealt with in Divs 21 and 136: see also Ruling GSTR 2000/2. Where an adjustment is necessary, the entity must compare its obligations following the adjustment with its previously reported GST obligations and include an adjustment to increase or decrease its GST liability on its BAS. The adjustment is attributable to the tax period when the entity becomes aware of the adjustment: s 29-20(1). However, adjustments for entities which account for GST on a cash basis are attributable in accordance with consideration paid or received: s 29-20(2). Similar to the requirement that entities must possess a tax invoice to be entitled to input tax credits, entities making a decreasing adjustment must have an adjustment note when making the adjustment, otherwise the adjustment is attributable to the first period when the entity has an adjustment note: s 29-20(3). The requirements of an adjustment note (essentially an amended tax invoice) are set out in s 29-75. The Commissioner has published Ruling GSTR 2013/ 2 which sets out the requirements for adjustment notes under Div 29. An adjustment note is not required for decreasing adjustments of $75 or less: s 29-80(2), reg 29.80.02.
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25: GooDs anD serVices tax [25.313] 901
Example 25.22: Adjustments Dino purchased a table for his office on 1 June for $330 (inc GST). Dino accounts for GST on an accruals basis. The acquisition of the table was a creditable acquisition, and Dino included his entitlement to $30 input tax credits in his June quarter BAS as he possessed a valid tax invoice at the time. The table was delivered to Dino on 16 July, but it was not in the colour he had ordered. The supplier offered Dino a 20% discount on the price if Dino would accept the delivered table. Dino accepted the discount as the colour of the table did not make any difference to him. Dino must make an adjustment as there has been a change in the consideration of a creditable acquisition. He has received a 20% discount on the price, which means that the new consideration is $264 (inc GST). Dino originally claimed input tax credits of $30, but he is now only entitled to input tax credits of $24 and therefore he has an increasing adjustment of $6. The adjustment is attributable to the September quarter as that is when Dino became aware of the adjustment.
Non-residents
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[25.313] Non-residents which are required to register for GST can choose to be a limited registration entity under Div 146. In the absence of such an election, a non-resident will be a standard registration entity. Table 25.2 outlines the differences between the two systems:
TABLE 25.2 Standard GST-registration and Limited GST-registration Standard GST-registration
Limited GST-registration
Entity uses an Australian Business Number (ABN). Process for non-residents to obtain an ABN may take some time and requires additional documentation and proof of identity.
Entity uses an ATO Reference Number (ARN). Process for non-residents to obtain an ARN should be quicker and less onerous than obtaining an ABN.
Entity can claim input tax credits.
Entity cannot claim input tax credits.
Entity can account and report for GST on monthly or quarterly basis.
Entity must lodge GST returns and pay GST quarterly.
Entity not required to issue tax invoices or adjustment notes on inbound intangible consumer supplies and offshore supplies of low value goods: ss 84-50, 84-87.
Entity cannot issue tax invoices or adjustment notes.
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902 [25.315] PRINCIPLES OF TAXATION LAW 2020
GST groups [25.315] Generally, transactions between companies which are part of the same corporate group will be subject to GST in accordance with the rules discussed in this chapter. In other words, a company making a “taxable supply” is required to pay GST on that supply, and a company making a “creditable acquisition” is entitled to input tax credits on that acquisition. This is the case even where the companies may have formed a tax consolidated group for income tax purposes: see [21.650]. To reduce GST compliance costs, companies are permitted to form a GST group under Div 48 of the GST Act if they satisfy the membership requirements. Broadly, the effect of forming a GST group is that the group is treated as a single entity for GST purposes, and most transactions between group members are disregarded for GST purposes. One member of the group is nominated as the responsible member and deals with the group’s GST obligations on transactions with non-group members and lodging the group’s GST return.
Interaction with other taxes
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Income tax [25.320] Entities include the GST-exclusive amount of their supplies in their assessable income: s 17-5 of ITAA 1997. The amount to be included as a deduction will depend on the entity’s entitlement to input tax credits on the acquisition. Where the entity is entitled to input tax credits, the deduction amount will be the GST-exclusive amount: s 27-5 of ITAA 1997. On the other hand, if the entity is not entitled to input tax credits, the deduction amount will be the GST-inclusive amount. Example 25.23: GST and income tax Jesse has a shoe cleaning business. Last year he earned $220,000 (inc GST) from providing shoe cleaning services and spent $110,000 (inc GST) on shoe polish and special cloths for the business. Jesse is registered for GST purposes. Jesse will include $200,000 in his assessable income for the year as it is income from business. The GST component of Jesse’s sales revenue is 10% × 10/11 × $220,000 = $20,000. Jesse will include $100,000 in his deductions for the year as they are ordinary business expenses. The GST component of Jesse’s expenses is 10% × 10/11 × $110,000 = $10,000.
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25: GooDs anD serVices tax [25.340] 903
Fringe benefits tax [25.330] Where an entity’s acquisition relates to the provision of a fringe benefit, the entity’s fringe benefits tax (FBT) liability in relation to the provision of the fringe benefit will depend on the entity’s entitlement to input tax credits. This is because the gross-up factor to be used in calculating the fringe benefits taxable amount depends on whether the entity is entitled to input tax credits on the acquisition: see [7.400]. Note that reimbursements of an employee’s expenses (ie, an expense payment fringe benefit) are taken to have been made by the employer for GST purposes under s 111-5 of GST Act. This ensures that the employer is entitled to any input tax credits in relation to the acquisition as long as the elements of “creditable acquisition” are satisfied: see Ruling GSTR 2001/3.
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Questions [25.340] 25.1 Advise whether the following would be considered “taxable supplies”, “GST-free supplies” or “input tax supplies” (you may assume that the supplies are made by an entity located in Australia and registered for GST purposes and that the supplies are made for consideration in the furtherance of an enterprise): a) Sale of t-shirts by a retailer. b) Sale of a new residential house by a property developer. c) Loan set-up fees charged by a bank. d) Sale of fresh fruit by a grocer. e) Airline ticket from Adelaide to Perth. f) Painting a house. g) Sale of herbal tea by a café. h) Home-delivered pizza with separate charges for the pizza and the delivery. i) Airline ticket from Melbourne to London (return). j) Sale of an existing residential house owned as an investment property. k) Interest on a loan to buy shares. l) Sale of shares in an ASX listed company. m) Sale of Australian souvenirs to purchasers located overseas. 25.2 Audrey is a talented artist. Her paintings of Australian scenery sell for $50,000 to $100,000 each. She sells at least one painting a month to
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904 [25.340] PRINCIPLES OF TAXATION LAW 2020 buyers in Australia and overseas. Her paintings are highly sought after and she uses only premium paints and canvasses for her paintings. She purchases these items at a large local retailer. Advise Audrey as to her GST consequences arising out of the above information. 25.3 BP Pty Ltd is a large company incorporated in Australia. BP is registered for GST purposes. The company sells tractors for $55,000 each (inc GST). It purchases the tractors from China for $45,000 each, and the tractors are shipped to BP at an additional cost of $2,000 each. BP also sells tractors to companies in Singapore and Malaysia for $70,000 each. In this case, it does not take delivery of the tractors, but directs the Chinese seller to ship them directly to the Singaporean or Malaysian buyer. Last year, there was a problem with one of the tractors which BP sold to a local Australian company and BP had to provide the buyer with a full refund six months after the purchase. BP also incurred a penalty of $550 (inc GST) as it failed to comply with certain regulatory requirements imposed under Australian law. Advise BP of its GST consequences arising from the above information.
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25.4 Big Bank Ltd operates nationally with more than 50 branches, a 10- storey head office and numerous call centres. It is registered for GST purposes. Big Bank has for many years provided loans and deposit facilities to customers in Australia. Last year it launched a new product, Big Bank home and contents insurance policies. It was a significant step for Big Bank and required it to change some of its computerised accounting systems due to the fact that GST needed to be charged on the new product. Big Bank budgeted to spend $1,650,000 (including GST) on advertising campaigns last year. Of that sum, $550,000 was allocated to a television advertising campaign specifically promoting Big Bank home and contents insurance policies. The other $1,100,000 was allocated to a general advertising campaign, including television, radio and print media advertisements promoting Big Bank to the public as the bank that is “Here for You”. When Big Bank Ltd launched Big Bank home and contents insurance policies, it forecast that its home and contents insurance business would constitute 2% of its entire enterprise. Big Bank has been proved correct in its forecasts. The other 98% of its enterprise is made up of its traditional loans and deposit facilities businesses. Last month, the advertising consultants issued their tax invoice for $1,650,000. Discuss Big Bank’s ability to claim input tax credits with respect to its advertising expenditure of $1,650,000.
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25: GooDs anD serVices tax [25.340] 905
25.5 New Developments Pty Ltd (New Developments) is a property investment and development company. Recently, New Developments purchased an old warehouse which it is converting into apartments for sale. New Developments also owns an established apartment building, which it rents out to tenants. In the course of its activities, New Developments negotiates many contracts. It engages a busy independent lawyer, Rumpole Richardson, to assist in drafting and negotiating these contracts. Rumpole Richardson has a number of clients and turns over $250,000 per year in his legal advisory business. New Developments offered to allow Rumpole Richardson to live in one of its apartments rent-free in exchange for his legal work. Rumpole Richardson agreed to this arrangement. Normally, the rent payable on the apartment would be $22,000 per annum. Advise New Developments and Rumpole Richardson of their GST obligations and any input tax credit entitlements they may have. Assume that New Developments is registered for GST purposes. 25.6 Following on from Question 25.4, New Developments sold one of the apartments in the newly converted warehouse for $550,000. It also sold one of the apartments in the established apartment building for $500,000. Advise New Developments of its GST obligations arising from the sale of the apartments. 25.7 Krafty Kitchens Ltd is a large kitchen manufacturer that is registered for GST purposes. It accounts for GST on an accruals basis and submits its BASs monthly. Krafty Kitchens Ltd organises and pays for the golf club membership of its Head of Sales, Samuel. This is treated as a fringe benefit for fringe benefits tax purposes. On 16 April, Krafty Kitchens Ltd received a tax invoice from Samuel’s golf club, Greenvale Golf Club, for the payment of Samuel’s membership fees of $220 (including GST). Krafty Kitchens did not pay the membership fee for Samuel until 2 July, due to an oversight by the company’s accounts clerk. Greenvale Golf Club accounts for GST on a cash basis and submits its BASs quarterly. Discuss whether Krafty Kitchens can claim an input tax credit with respect to the golf club fees. If it can claim an input tax credit, when would it do so? When would Greenvale Golf Club report the GST payable with respect to Samuel’s membership fees on its BASs? 25.8 Gemma is a university student. She recently purchased a new computer from a retailer in Singapore as the computer was not yet available in Australia. The computer is for her personal use. The computer cost AUD $3,000 and was shipped directly to Gemma’s home. Gemma also purchased a book from Amazon US for $50. What are the GST consequences arising from the above information?
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26 State taxes Key points.................................................................................................... [26.00] Introduction................................................................................................ [26.10] Stamp duty.................................................................................................. [26.20] Duty tax base........................................................................................ [26.40] Transfer (conveyance) duty................................................................. [26.60] Dutiable property................................................................................. [26.70]
Location of dutiable property and apportionment................................. [26.80]
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Dutiable transactions........................................................................... [26.90] Dutiable value..................................................................................... [26.110]
Related parties....................................................................................... [26.115] Aggregation............................................................................................ [26.120] Calculating the duty payable............................................................. [26.130] Foreign purchasers of residential property.......................................... [26.135] Failing to lodge documents for stamping............................................. [26.140] Duty concessions and exemptions................................................... [26.150] Concessions........................................................................................... [26.152] Exemptions............................................................................................. [26.154] Landholder duty................................................................................. [26.160] Landholding entities........................................................................... [26.170] Constructive ownership......................................................................... [26.180] Relevant acquisition........................................................................... [26.190] Acquisition.............................................................................................. [26.192] Significant interest................................................................................. [26.194] Other duties........................................................................................ [26.200] Land tax..................................................................................................... [26.210] Landholder......................................................................................... [26.220] Taxable value of land......................................................................... [26.230] Aggregation of landholdings............................................................. [26.240] Grouping............................................................................................. [26.250] Joint ownership.................................................................................. [26.260] Surcharge rates.................................................................................. [26.270] Ownership of land by trusts in Victoria................................................. [26.270]
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908 [26.00] PRINCIPLES OF TAXATION LAW 2020 Absentee/foreign owners...................................................................... [26.275] Vacant residential land tax in Victoria................................................... [26.278] Exemptions......................................................................................... [26.280] Principal place of residence................................................................... [26.282] Primary production exemption.............................................................. [26.284] Other exemptions................................................................................... [26.286] Calculation of land tax liability........................................................... [26.290] Payroll tax................................................................................................. [26.300] Taxable wages................................................................................... [26.320] Rates and thresholds......................................................................... [26.330] Rebates............................................................................................... [26.340] Grouping............................................................................................. [26.350] Employee versus independent contractor........................................ [26.360] Control.................................................................................................... [26.362] Contractual relationship......................................................................... [26.364] Risk ........................................................................................................ [26.366] Tools and equipment............................................................................. [26.368] Other indicia........................................................................................... [26.369] Relevant contracts.............................................................................. [26.370] Exemptions............................................................................................. [26.380] Exempt organisations........................................................................ [26.390] Questions................................................................................................... [26.400]
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Key points [26.00] • Australian taxes comprise Commonwealth taxes, state taxes and municipal taxes. • For state taxes, the specific rules, regulations and tax rates of each tax vary in each jurisdiction. • Stamp duty was traditionally a tax on instruments but now operates as a duty on various transactions. It applies to transfers of various types of property and is often now referred to as “transfer duty”. Other types of duties include motor vehicle duty and insurance duty. • Most jurisdictions have re-written their stamp duty laws (the re-write jurisdictions), the exceptions being South Australia and the Northern Territory. • Transfer duty arises in the re- write jurisdictions when a “dutiable transaction” occurs in respect of “dutiable property”. What constitutes a “dutiable transaction” or “dutiable property” varies in each jurisdiction. • All jurisdictions have a “landholder duty”. Acquiring a “relevant interest” in a particular “landholder” may trigger a liability to transfer duty.
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26: State taxes [26.10] 909
• Land tax is an annual tax imposed on persons or entities holding land, either solely or jointly, in a particular jurisdiction where the site value is above a certain threshold. • Land tax is assessed on the aggregated taxable value of land holdings in a particular jurisdiction. Various land tax exemptions exist in each jurisdiction, the primary one being for a principal place of residence (PPR). • Payroll tax is assessed on employers based on “taxable wages” paid to employees. • Contractors may be deemed to be employees and their payments deemed as “taxable wages” when they engage in principal/independent contractor relationships and principally provide labour services. • Employers may be grouped to ensure they do not structure their businesses to avoid or minimise their payroll tax obligations.
Introduction
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[26.10] We saw in Chapter 3 that the Australian Constitution distributes taxing rights between the Commonwealth and State Governments. The six states make laws under their own State Constitutions in areas that are not under the control of the Commonwealth. The two territories do not have constitutions but possess a limited right of “self-government” that has been granted to them by the Commonwealth. This right allows the territories to handle certain governmental matters under a locally elected parliament. The powers conferred on the states and territories results in these jurisdictions being responsible for areas they administer. These areas include: education, health, public transport, infrastructure and justice. To fund this expenditure, the jurisdictions require a source of revenue, which comes from two main forms. The first form of revenue is Commonwealth Government grants and appropriations, but the states and territories often face budgetary pressures that exceed the quantum of funding provided to them by the Commonwealth. Consequently, the second source of revenue is the imposition of their own taxes. For 2017–2018, the total taxation revenue collected by the jurisdictions amounted to $84,261 million: 5506 –Taxation Revenue, Australian Bureau of Statistics. As noted at [3.20], the states’ and territories’ powers to tax is limited by the Australian Constitution and no state or territory has imposed income tax since 1942, resulting in the taxes imposed often having a relatively narrow tax base. Consequently, to ensure sufficient levels of revenue, these jurisdictions have imposed up to 25 different taxes. This chapter provides an overview of the three key state taxes regimes: stamp duty, land tax and payroll tax. Broadly, stamp duty is imposed on various transactions, the most common being the transfer of certain types of property
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910 [26.20] PRINCIPLES OF TAXATION LAW 2020 (eg, land and certain business assets). Land tax is imposed on the site value of landholdings at a particular date, and payroll tax is charged on various payments to employees and certain independent contractors. Each jurisdiction has its own powers to impose these taxes. As such, the specific rules and the administration of each tax in each jurisdiction vary. The scope of this chapter is to provide a broad framework for the operation of these three types of state taxes and to highlight common issues. It is therefore necessary to analyse the jurisdiction-specific legislation, revenue rulings and tax consequences in respect of any given transaction.
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The administration of these taxes is also under the power of each jurisdiction- specific Revenue Commissioner, operating their own revenue office (equivalent to the Australian Taxation Office for Commonwealth taxes). The revenue authorities administer state and territory tax legislation pursuant to their own tax administration legislation. The revenue authorities for each jurisdiction are: Jurisdiction
Revenue authority
Australian Capital Territory
ACT Revenue Office
New South Wales
Revenue NSW
Northern Territory
Territory Revenue Office
Queensland
Office of State Revenue (Qld)
South Australia
Revenue SA
Tasmania
State Revenue Office (Tas)
Victoria
State Revenue Office (Vic)
Western Australia
Office of State Revenue (WA)
Stamp duty [26.20] Stamp duty (or “duty”) was historically a tax imposed on various instruments (paper documents evidencing certain transactions) since the 1800s. Over time the tax base upon which duty is imposed has broadened to include a wider range of transactions, whether or not recorded on paper. The tax base and triggers for the imposition of duties are governed by the respective laws of each state and territory: Jurisdiction
Legislation
Australian Capital Territory
Duties Act 1999 (ACT)
New South Wales
Duties Act 1997 (NSW)
Northern Territory
Stamp Duty Act 1978 (NT)
Queensland
Duties Act 2001 (Qld)
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26: State taxes [26.40] 911
South Australia
Stamp Duties Act 1923 (SA)
Tasmania
Duties Act 2001 (Tas)
Victoria
Duties Act 2000 (Vic)
Western Australia
Duties Act 2008 (WA)
[26.30] There have previously been attempts to harmonise the stamp duty legislation to create a uniform regime among the jurisdictions. The broad aim was to create a more consistent approach to the treatment of transactions across Australia. To date, the Australian Capital Territory, New South Wales, Queensland, Tasmania, Victoria and Western Australia have participated in harmonisation by re-enacting their stamp duty laws and these jurisdictions are referred to as the “re-write jurisdictions”. South Australia and the Northern Territory have retained their historic stamp duty laws. However, South Australia commenced a consultation process in mid- 2019 aimed at rewriting the stamp duty and the intention is to get a final bill to the Parliament in early 2020. While the re-write jurisdictions have in principle harmonised, significant differences still remain. These differences include different: types of duties; dutiable property; rates and thresholds; apportionment methodologies for multi- jurisdictional transactions/ assets; and lodgement requirements.
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Duty tax base [26.40] A common misconception is that stamp duty only applies to the acquisition of land, however the tax base is broader. Duty may also apply to other transactions, for example, on the transfer of certain business assets, registration of vehicles and issuing of insurance policies. In 1999, an Intergovernmental Agreement on the Reform of Commonwealth- State Financial Relations (the Agreement) was signed by the Commonwealth and the Premiers of each jurisdiction. The purpose of the agreement was to create a more efficient tax system by abolishing various inefficient and narrow- based state taxes. In principle, a compensatory return of the forgone state taxes revenue was to be appropriated to the states and territories from the revenue collected from the broad-based Goods and Services Tax (GST) system, which commenced on 1 July 2000: see [25.10]. In line with the Agreement, the states and territories have progressively abolished certain taxes and duties such as, for example, the Financial Institutions Duty and Debits Tax. The abolition of various state taxes has occurred in a largely ad hoc manner. Some duties scheduled for abolition have been postponed as many of the jurisdictions consider the GST revenue appropriated to them is insufficient for their outlays.
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912 [26.50] PRINCIPLES OF TAXATION LAW 2020 [26.50] While the state tax base is narrowing by the elimination of inefficient and narrow-based taxes, as part of the stamp duty harmonisation and legislative re-write process, jurisdictions have widened their tax base with respect to transactions that effectively change the economic ownership of property. Consequently, the focus of the stamp duty part of this chapter is on the two main duties which relate to property, being transfer duty and landholder duty. Other types of duties are also imposed, for example, motor vehicle duty and insurance duty. Some of these duties are outlined in [26.200]. Figure 26.1: Overview of key issues
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Transfer (conveyance) duty [26.60] Transfer duty, known as conveyance or ad valorem duty in the non-re- write jurisdictions, is a tax charged on the transfer of certain types of property. A liability to transfer (conveyance) duty falls on the purchaser and may be determined by applying the following steps:
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26: State taxes [26.70] 913
Dutiable property [26.70] Dutiable property is initially based on the legal concept of “property”. Property takes many forms and may include tangible property (eg, land) and intangible property (eg, goodwill and intellectual property). Although business goodwill is intangible, it is recognised as a separate, indivisible item of property: Federal Commissioner of Taxation v Murry (1998) 193 CLR 605. The range of the specific property subject to transfer duty varies in each jurisdiction so a jurisdiction-by-jurisdiction analysis is required to determine if, in a particular case, the property is dutiable. To undertake this analysis, in the re-write jurisdictions and the Northern Territory, the starting point is to refer to the “dutiable property” provisions. In South Australia, the starting point is Div 6 of the Stamp Duties Act 1923 (SA). Duty on property other than land was abolished in South Australia from 1 July 2016 and, since 1 July 2018, is only payable on transfers of residential and primary production land. The main categories of dutiable property are usually land and business assets. Examples of various types of dutiable property, together with their legislative references (as at time of writing) are outlined in Table 26.1. TABLE 26.1 Examples of types of dutiable property by jurisdiction NSW s 11
Vic s 10
Qld s 10
SA Div 6
WA s 15
ACT s 10
Tas s9
NT s4
Land and buildings
Y
Y
Y
Y
Y
Y
Y
Y
Goods sold with land
Y*
Y*
Y*
N
Y*
Y*
Y*
Y*
N
N
Y
N
Y
N
N
Y
Type of property
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Goodwill Trade debtors Plant and equipment
N
N
Y
N
N
N
N
N
Y#
Y#
Y#
N
Y#
Y#
Y#
Y#
Y dutiable N not dutiable * certain goods are not considered to be dutiable property, for example, trading stock. # if transferred with another type of dutiable property, for example, land.
As shown in Table 26.1, different jurisdictions characterise different types of property as dutiable in different situations. For example, in many jurisdictions, the transfer of plant and equipment (a type of goods) will only be subject to duty if transferred together with another type of dutiable property (eg, land). In this example, the underlying rationale is that the purchase of the goods form part of substantially one transaction with the purchase of the land. As the jurisdictions continue with the abolition of some state taxes, it is possible that the “scope” of what constitutes dutiable property may change over time.
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914 [26.80] PRINCIPLES OF TAXATION LAW 2020 For example, New South Wales abolished duty on business assets (other than land and certain goods when transferred together with other dutiable property (eg, land)) on 1 July 2016. South Australia abolished duty on non-residential, non-primary production real property from 1 July 2018. Example 26.1: Sale of business Fred owns and runs two bakeries. The first is located in Victoria and the second in Queensland. Fred wishes to retire and sell both his businesses by selling his business assets. The types of assets involved in both businesses comprise: goodwill, trading stock, plant and equipment and premises. For Fred’s business in Victoria, the types of assets that will constitute dutiable property will be the premises and the plant and equipment, as the latter is being sold with the premises. In Queensland, all assets will constitute dutiable property.
Location of dutiable property and apportionment
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[26.80] The location of the dutiable property determines which state or territory jurisdiction has the right to impose duty. For tangible assets, the jurisdictional nexus is the physical location of the asset itself. For intangible assets, jurisdictional nexus is determined by legal rules and specific duty laws in each jurisdiction. For example, a trade debt is taken to be located where the debtor resides. For other intangibles, such as goodwill, an apportionment exercise may need to be performed based on a jurisdiction’s specific rules. For example, in Queensland, goodwill is broadly taken to be proportionally located in that state to the extent that goods are supplied or services provided in Queensland to customers, as a proportion of total gross sales amounts, over the preceding three completed financial years: ss 26 and 27 of the Duties Act 2001 (Qld). Example 26.2: Jurisdictional nexus of trade receivables Daniel carries on a trading business based in Victoria and makes sales to customers throughout Australia. Daniel has decided to sell his business by way of asset sale. The sale includes the assignment of trade receivables to the purchaser. Some customers of the business who are trade debtors reside in Queensland and others reside in Victoria. To the extent that the trade debtors: • are located in Queensland, the value of those Queensland trade receivables will constitute Queensland dutiable property (ss 10(1) (d) and 35(1)(f) of the Duties Act 2001 (Qld)); • are located in Victoria, the value of those Victorian trade receivables will not constitute Victorian dutiable property.
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Dutiable transactions [26.90] A transfer of dutiable property will prima facie constitute a dutiable transaction. A “dutiable transaction” is often broadly drafted to capture a wide array of circumstances that could lead to the change in the legal or beneficial ownership of the dutiable property. The common types of dutiable transactions include: • a transfer of dutiable property; • an agreement for the sale or transfer of dutiable property; • a declaration of trust over dutiable property; and • a surrender of dutiable property.
Example 26.3: Declaration of trust over dutiable property
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Bob is the registered owner of a property located in Sydney. Bob establishes a discretionary trust with himself as trustee and Jessica and Jimmy, being his children as the beneficiaries (students can revise trust law concepts at [20.20]). Bob subsequently declares that he holds the property in Sydney on trust pursuant to the discretionary trust deed, for the benefit of his two children. This declaration of trust by Bob over the property will trigger a liability to transfer duty in New South Wales, at transfer duty rates based on the dutiable value of the property at the time of the trust declaration: see [26.110]. The specific types of “dutiable transactions” vary in each jurisdiction and can be more expansive than the types outlined above. The legislative provisions defining a “dutiable transaction” where such definition exists are outlined in Table 26.2. For South Australia, the starting point is to review the duty imposition provisions (ie, Sch 2 of the Stamp Duties Act 1923 (SA)). TABLE 26.2 Dutiable transaction provisions Dutiable transaction
NSW
Vic
Qld
WA
ACT
Tas
NT
s8
s7
s9
s 11
s7
s6
s4
[26.100] A “dutiable transaction” may occur in any form and includes written agreements, oral agreements or electronic transactions. This overcomes the historic issue when stamp duty was only charged on paper instruments and taxpayers avoided duty by not evidencing transactions in writing. In some jurisdictions, if the dutiable transaction is not in writing, a written statement on the revenue authority’s approved form must be provided.
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916 [26.110] PRINCIPLES OF TAXATION LAW 2020
Dutiable value [26.110] Having triggered a liability to transfer duty, the next step is to ascertain the dutiable value upon which duty will be assessed. The general rule is that dutiable value is the greater of any consideration and the unencumbered market value of the dutiable property. Example 26.4: Sale of land subject to mortgage for less than market value Ellison owns a property in Manly, New South Wales. She purchased the property six years ago for $1.2 million and currently owes $750,000 to the bank. The current market value of the property is $1.8 million. The bank has a registered mortgage over the title of the property. Ellison is in great need to sell the property and sells the property to the first willing buyer for $1 million as the buyer offered a quick settlement. The dutiable value of the property will be $1.8 million, as the market value of the property is higher than the consideration.
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Related parties [26.115] Where a transaction occurs between related parties and the consideration (if any) is less than the market value, the dutiable value will be based on the market value. The substantiation requirements to evidence market value differ in each jurisdiction. For example, for a transfer of real property (eg, land) and goods between related parties in Victoria, a valuation from a suitably qualified person such as a certified practicing valuer may be required when the total value of the assets exceeds $1 million: Revenue Ruling DA 029, SRO (Victoria).
Aggregation [26.120] The transfer duty tax rates in most jurisdictions are progressive, meaning the duty tax rate increases as the dutiable value increases: see Appendix for examples of transfer duty rates. It would therefore be beneficial to taxpayers to split essentially one transaction into parts to obtain the benefit of a lower duty tax rate. To deter this duty minimisation conduct, the aggregation provisions may treat two or more separate transactions as one single transaction where they are substantially one arrangement: for example, see s 25 of the Duties Act 1997 (NSW).
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The specific aggregation “triggers” which will cause transactions to be aggregated vary across jurisdictions. For example, in New South Wales, the aggregation “triggers” include where there is a substantially one transaction, for example, transferring a block of land in subdivided parts, and the dutiable transactions: • occur within 12 months; • have the same transferor (seller/ vendor), or the transferors are associated persons; and • have the same transferee (purchaser), or the transferees are associated persons.
Example 26.5: Aggregation of substantially one arrangement
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Charlie purchased a block of land in New South Wales on 1 January 2019 for $500,000. On 1 August of the same year, he purchased an adjacent block of land from the same vendor for $550,000. The transactions are substantially one arrangement.
When Charlie purchased the first parcel of land on 1 January 2019, he was assessed on the dutiable value of $500,000 and paid duty of $17,990 ($8,990 + $4.50 for every $100, or part, that the value exceeds $300,000): see [26.130]. When Charlie subsequently purchased the second parcel of land on 1 August in the same year, this acquisition was treated as substantially one arrangement together with the prior acquisition of 1 January. The aggregate dutiable value of the “one” transaction is $1,050,000 and duty was assessed at $43,052 ($41,017 + $5.50 for every $100, or part, that the value exceeds $1,013,000). Charlie will receive a credit for the duty paid on the first acquisition, resulting in a duty balance of $25,062 ($43,052 − $17,990). If the transactions were not aggregated, Charlie would have paid $20,182 on the second acquisition, resulting in a total duty of $38,172 ($17,990 + $20,182).
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918 [26.130] PRINCIPLES OF TAXATION LAW 2020
Calculating the duty payable [26.130] The liability to pay transfer duty ordinarily rests on the transferee/ purchaser. The transfer (or conveyance) duty payable is based on the following formula:
The transfer (or conveyance) duty rates (and thresholds) are different in each jurisdiction, and concessional rates may apply in certain circumstances (see [26.150]). The transfer duty rates for New South Wales are in Table 26.3. In some circumstances, premium rates of duty apply, such as for residential land in New South Wales where the dutiable value exceeds $3 million: s 32A of the Duties Act 1997 (NSW). The Australian Capital Territory split its residential (non-commercial) and commercial transfer rates from 7 June 2017, and from 6 June 2018, there is a nil rate where the value of the commercial property is under $1.5 million whereas the non-commercial rates are progressive up to a value of $1.455 million. The rates for the eastern seaboard jurisdictions are in the Appendix.
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TABLE 26.3 General transfer duty rates for New South Wales (s 32 of the Duties Act 1997 (NSW)) and premium transfer duty rates for residential NSW land (s 32A) Dutiable value
Rate
$0–$14,000
$1.25 for every $100 or part of the value
$14,001–$30,000
$175 + $1.50 for every $100 or part, that the value exceeds $14,000
$30,001–$81,000
$415 + $1.75 for every $100 or part, that the value exceeds $30,000
$81,001–$304,000
$1,307 + $3.50 for every $100 or part, that the value exceeds $81,000
$304,001–$1,013,000
$9,112 + $4.50 for every $100 or part, that the value exceeds $304,000
Over $1,013,000
$41,017 + $5.50 for every $100 or part, that the value exceeds $1,013,000
Premium Property Duty: over $3,040,000
$152,502 + $7.00 for every $100 or part, that the value exceeds $3,040,000
Duty must be paid within a certain timeframe of a dutiable transaction occurring. For example, in Victoria, the timeframe is 30 days, and in New South Wales, the timeframe is 90 days. Under the ACT’s “Barrier Free” rules,
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liability for duty arises on registration of the property transfer and must be paid within 14 days.
Foreign purchasers of residential property [26.135] Foreign purchasers of land acquiring residential property in Victoria, New South Wales, Queensland, South Australia, Tasmania and Western Australia are subject to additional duty or surcharge. The additional duty rates are 8% of the dutiable value of the property being transferred in Victoria from 1 July 2019, 8% from 1 July 2017 in New South Wales, 7% in Queensland from 1 July 2018, 7% in South Australia from 1 January 2018 and 3% in Tasmania from 1 July 2018. However, New South Wales has since removed the surcharge in relation to Australian-based developers that are foreign persons in relation to land used for the construction and sale of new homes or sold for new home construction: s 104ZJA of the Duties Act 1997 (NSW). Western Australia introduced an additional duty of 7% for foreign purchasers from 1 January 2019, with an exemption similar to that in New South Wales for residential developments. For these purposes, a foreign purchaser will often include foreign natural persons, foreign companies and foreign trusts, as defined under the relevant legislation.
Failing to lodge documents for stamping
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[26.140] If documents have not been lodged for stamping and consequently duty is unpaid, the consequences include: • interest and penalty tax may apply to the late lodgement; • the document that effects a dutiable transaction may not be presented as evidence in civil court proceedings (exceptions apply); and • the registration of ownership of the dutiable property is prohibited. The process for lodging and stamping documents is changing with the move to electronic lodgement systems. For example, in Victoria, a Digital Duties Form became compulsory for all transactions from 1 October 2018. Example 26.6: Failing to stamp documents Jacqueline purchased a home in Victoria on 1 March 2018. On settlement one month later, she handed over moneys to the seller (the vendor) for the purchase price and in return, the seller provided Jacqueline with a signed “Transfer of Land” form (the Form). The Form constitutes a dutiable transaction upon which duty is payable. Jacqueline takes the Form to the
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920 [26.150] PRINCIPLES OF TAXATION LAW 2020
Land Victoria Office to register her name as the registered proprietor of the home on the property Title. The Land Victoria Office is unable to register Jacqueline’s interests in the home as the Form is unstamped. Jacqueline will need to first lodge the Form with the Victorian State Revenue Office to have the Form assessed and to pay the transfer duty, and second, lodge the Form at the Land Victoria Office to have her name registered as the new proprietor of the home.
Duty concessions and exemptions [26.150] Each jurisdiction provides duty concessions and exemptions aimed to subsidise certain taxpayers, activities or assets.
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Concessions [26.152] Some of the common duty concessions include: • PPR: Concessional rates of duty may apply on the acquisition/ownership of a home which is used as a PPR. The availability of the concession is based on the value of the PPR not exceeding a certain threshold. • First home purchase: To assist with affordability for first home buyers, a reduction in duty is available in most jurisdictions when certain criteria are met (eg, home is used as a PPR). An example is the first home purchase in New South Wales where the purchase of a new or existing home valued up to $650,000 is exempt from transfer duty, and duty concessions exist for a home valued between $650,000 and $800,000. Victoria has similar measures, where a transfer duty exemption is available for a home valued up to $600,000, and duty concessions for a home between $600,001 and $750,000. • Regional land: Victoria has introduced a new concession from 1 July 2019 for purchases of land and land use entitlements used for commercial, industrial or extractive industries, where the land is located in one of the listed regional council areas or in one of the alpine resort areas. The concession is a 10% reduction in the duty payable for the 2019–2020 year and will be phased in to reach 50% for contracts entered into on or after 1 July 2023.
Exemptions [26.154] An exemption from duty results in no duty being applied in respect of a dutiable transaction. The documents evidencing an exempt transaction are still required to be assessed and stamped “exempt”. The Australian Capital Territory has abolished stamp duty in relation to commercial property valued
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at $1.5 million or less from 6 June 2018. Certain categories of landowners are usually exempt from duty, such as charities and public hospitals and primary producers. Other common exemptions include: • Spouses: Transfers of certain dutiable property between spouses and domestic partners are exempt from duty. For example, in Victoria from 1 July 2017, a transfer of a PPR is exempt from duty, subject to the transfer being for no consideration and at least one spouse must live in the PPR continuously for 12 months commencing within 12 months from the date of the transfer. Transfers of non-PPR property between spouses and domestic partners are no longer exempt in Victoria (from 1 July 2017). • Deceased estates: A transfer of dutiable property from an executor or legal personal representative to a beneficiary to satisfy any entitlements arising pursuant to a will of a deceased or in an intestacy may be exempt from duty or subject to only a concessional duty ($50 in New South Wales). • Corporate reconstructions: Transfers of dutiable property between eligible members of a corporate group are exempt from duty when certain conditions are met.
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Landholder duty [26.160] Prior to landholder duty, the jurisdictions had land-rich duty which was introduced as an anti-avoidance mechanism. Taxpayers could gain control of land by acquiring the shares in a company that owned land or acquiring the units in a unit trust that owned land. As the ownership of the land itself remained unchanged, there was effectively no trigger of the conveyance rates of duty. Instead, taxpayers would have been liable only to the now former marketable securities duty (also formerly known as share transfer duty) which attracted a significantly lower tax rate (eg, in New South Wales, marketable securities duty was at a rate of 0.6% when it was abolished on 1 July 2016).
In response to the duty avoidance, jurisdictions enacted the land- rich provisions where the purpose was to capture persons or entities undertaking such arrangements. Triggering the land-rich provisions resulted in a liability to transfer (conveyance) rates of duty. Over time, all jurisdictions have replaced
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922 [26.170] PRINCIPLES OF TAXATION LAW 2020 the “land-rich” provisions with “landholder” provisions, with the latter regime widening the tax base. The landholder provisions will trigger a liability to transfer (conveyance) duty when:
Landholding entities [26.170] Under the landholder regime, a landholder is broadly an entity that has interests (ownership or entitlement) in land which have a total value at or above a particular threshold amount in a particular jurisdiction. The landholder thresholds are detailed in Table 26.4.
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TABLE 26.4 Landholding thresholds and land-rich test Jurisdiction
Landholding threshold
Australian Capital Territory
Any interest in ACT land.
New South Wales
$2 million or more of NSW land.
Northern Territory
$500,000 or more of NT land.
Queensland
$2 million or more of Qld land.
South Australia
Any interest in residential or primary production SA land.
Tasmania
$500,000 or more of Tas land.
Victoria
$1 million or more of Vic land.
Western Australia
$2 million or more of WA land.
“Land” takes a broad definition and includes and is not limited to: buildings; fixtures to the land; and an easement (a right to use land without owning it). Jurisdictions also have a statutory definition of “landholder” which can include holding rights that enhance the value of land: for example, see s 167 of the Duties Act 2001 (Qld).
The entities subject to the landholder regime encompass many different types of entities, including private companies and private unit trusts. This differs to the treatment of land owned by a partnership, where the transfer of a partner’s interest in the partnership is at law the transfer of an equitable chose in action and not a transfer of any interests in the land held by the partnership (and therefore not dutiable): Commr of State Revenue (Vic) v Danvest Pty Ltd [2017] VSCA 382. However, the effect of this decision has been overridden by recent amendments so that each partner is, for duty purposes, considered to hold a beneficial interest
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in each item of partnership property that corresponds to the partner’s partnership interest: new s 3H of the Duties Act 2000 (Vic). This issue may also be dealt with by treating an interest in a partnership that is holding dutiable property as itself dutiable property: see s 11(1)(i) of the Duties Act 1997 (NSW). The appropriate method for valuing land, other assets and goodwill in order to determine if a company is a landholder was recently considered by the High Court in Commissioner of State Revenue (WA) v Placer Dome Inc [2018] HCA 59. Under the relevant legislation, a listed company would be a land-holder corporation, where the value of land in Western Australia was not less than $1 million and 60% or more of value of all property of the company is land wherever located.
Constructive ownership [26.180] The value of land owned by a landholder comprises direct interests (eg, a company owning land directly) and indirect interests (eg, a company owning shares in another company that owns land). For the latter, each jurisdiction has tracing (or “look through”) provisions where indirect interests are essentially deemed landholdings of the landholder.
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Indirect interests in land may be counted when an entity is associated with another entity, sometimes referred to as a “linked entity”. In most jurisdictions, for a company or unit trust to be “linked” to another entity, the company or unit trust must have a certain entitlement to the unencumbered value of the property held by the “linked entity”. For example, the minimum percentage entitlement of a private company in Victoria is 20% and in New South Wales, Tasmania and the Northern Territory, 50%. An illustration of the operation of the tracing provisions in Victoria is in Example 26.7. Example 26.7: Tracing provisions
Entity A would be entitled to $1 million of Victorian land and consequently be a “landholder”, traced as follows: • 100% of Victorian land held by Entity B = $900,000; • 20% of Victorian land held by Entity C = $100,000.
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Relevant acquisition [26.190] When a taxpayer has made a “relevant acquisition”, a liability to duty at the transfer (or conveyance) rates will arise. There are two components to a “relevant acquisition”:
The person or entity making the “relevant acquisition” is liable to pay the duty.
Acquisition [26.192] The most common acquisition is a purchase, for example, of shares or units in a landholding entity. For landholder duty, the statutory definition is significantly broader as it includes any increase in a person’s interest in a landholder, regardless of how it is obtained or increased. Acquisitions could therefore arise out of, for example, issuing or cancelling shares or units, gifting shares or units and altering rights attached to share capital.
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Example 26.8: Acquisition by cancellation of shares Tran Pty Ltd (“Tran”) has two shareholders, Rosemary and Michael. Each shareholder owns five ordinary shares. At a general meeting, Tran passes a resolution to cancel Michael’s shares. The cancellation means that Rosemary is effectively the sole shareholder of Tran and is therefore taken to have acquired a further 50% interest in the company.
Significant interest [26.194] A “significant interest” is defined in each jurisdiction as a 50% or greater interest in a private company or a 50% or greater interest in a private unit trust (20% in Victoria). When an acquisition amounts to a “significant interest”, a “relevant acquisition” occurs, which triggers duty. An acquisition of a “significant interest” may occur in the following two ways: • the acquisition itself is amounts to a significant interest (eg, a purchase of 50% of the share capital in a private company); or
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• the acquisition when aggregated with existing interests or with the interests held by “associated persons” (eg, related persons such as relatives being children, brothers, parents) amounts to a significant interest.
Example 26.9: Acquisition of significant interest by aggregation Juliet owns 30% of the units in a private unit trust, which owns $5,000,000 of land located in New South Wales. The private unit trust is therefore a landholder in New South Wales. Juliet purchased a further 10% of the units in the unit trust and, at the same time, Juliet’s son Matthew purchased 10% of the units in the same trust. Juliet would be deemed to have acquired a “significant interest” in the trust of 50% by aggregating her original interest of 30% with her purchase of 10% and her son’s interest of 10% (her son being an associated person). A relevant acquisition could also be triggered when a person or entity that already holds a “significant interest”, acquires a “further interest” in the landholder entity. The value of the “further interest” acquired would be subject to duty.
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Concessions and exemptions are available in limited circumstances in relation to an acquisition of a significant interest or a further interest. For example, if the acquisition of the land itself could have been exempt from duty, then the acquisition of the significant interest may similarly be exempt.
Other duties [26.200] This chapter has focused on the two duties that relate to transfers of dutiable property. The jurisdictions impose other forms of duties on different types of transactions and assets. Examples of other types of stamp duties are outlined below, although with the exception of motor vehicle duty, they do not all still apply in all jurisdictions. • Motor vehicle duty. Such duty is imposed upon the first registration of a motor vehicle, upon the transfer of registration of a motor vehicle to another person, and upon certain imported second-hand vehicles in certain jurisdictions. The motor vehicle duty rates and thresholds vary between jurisdictions. As with transfer duty, exemptions and concessions may be available. • Lease duty. Such duty, as payable upon the “rent” of a lease, has been abolished in all jurisdictions. Officially while not “lease duty”, some jurisdictions (eg, New South Wales, Northern Territory and the Australian Capital Territory) continue to impose duty upon transactions
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926 [26.210] PRINCIPLES OF TAXATION LAW 2020 involving leasing arrangements. In these circumstances, a liability to duty at transfer (or conveyance) rates occurs when the lease, in particular, involves a lease premium: see [9.170].
Land tax [26.210] The jurisdictions (excluding the Northern Territory) impose land tax, an annual tax on the ownership of land. Land tax is simple to administer for two reasons. First, the property upon which the tax is imposed is immoveable such that the location of the land itself determines which jurisdiction has the taxing right. Second, the registered proprietor of the land is on record with the respective Land Titles Office. Land tax legislation for each jurisdiction is stated in the table below, and Figure 26.2 outlines the main issues discussed in this section. Jurisdiction
Legislation
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Australian Capital Territory Land Tax Act 2004 (ACT) New South Wales
Land Tax Act 1956 (NSW) Land Tax Management Act 1956 (NSW)
Queensland
Land Tax Act 2010 (Qld)
South Australia
Land Tax Act 1936 (SA)
Tasmania
Land Tax Act 2000 (Tas) Land Tax Rating Act 2000 (Tas)
Victoria
Land Tax Act 2005 (Vic)
Western Australia
Land Tax Act 2002 (WA) Land Tax Assessment Act 2002 (WA) Metropolitan Region Improvement Tax Act 1959 (WA)
Figure 26.2: Overview of key issues
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Landholder [26.220] The liability to land tax is ordinarily imposed annually on the “owner” of land. The owner is ordinarily the registered proprietor on the title of the property. Each jurisdiction has their own statutory definition of what constitutes an “owner”. The statutory definition widens the tax base, as it may include: persons entitled to possess the land, whether jointly or severally; a person who is entitled to receive rents and profits from the land; or certain beneficiaries of trusts. Possession of land also extends to “de facto possession” which occurs when a purchaser of land has physical control of the land while not yet having a legal right to possess the land due to the contract of sale being uncompleted: Kameel Pty Ltd v Commissioner of State Revenue (Vic) [2016] VSCA 83. The “owner” of land may include persons entitled to land under a Crown lease (s 10 of the Land Tax Act 2005 (Vic)). In the case of Living & Leisure Aus Ltd v Commissioner of State Revenue (Vic) [2018] VSCA 237, the Court of Appeal held that rights granted under the Alpine Resorts Act 1983 (Vic) were sufficient for these purposes even though the leases included public access provisions.
Taxable value of land
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[26.230] The “owner” of the land is charged land tax based on the “taxable value” of their landholdings, when the landholdings at a particular point in time exceed a jurisdiction-specific threshold. Some jurisdictions use different names for “taxable value” such as “land value” in Tasmania, however the concept remains the same. The “taxable value” is based on the value of the land, which is usually the site value/unimproved capital value (ie, excludes capital improvements such as the value of any building on the land). This value is provided by the respective state valuation offices (such as the Valuer General) or municipal councils. It is not the market value of the property (ie, the amount the property would sell at arm’s length). If a landholder is dissatisfied with the valuation, they must lodge their objection with the valuer. Table 26.5 lists the relevant point in time in which landholdings are counted for the impost of land tax and the “tax-free” thresholds for some jurisdictions as available at time of writing. Each jurisdiction has its own method to calculate “taxable value”. For example, Victoria uses the site value: s 19 of the Land Tax Act 2005 (Vic). New South Wales uses the average land value from the current tax year and the previous two tax years: ss 9 and 9AA of the Land Tax Management Act 1956 (NSW). The “taxable value” is assessed by the respective revenue authorities and not by the landholder itself. If landholders are dissatisfied with the “taxable value” provided, they are able to raise an objection within the time limits specified in each jurisdiction.
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928 [26.240] PRINCIPLES OF TAXATION LAW 2020 TABLE 26.5 Point in time land value is measured and general “tax- free thresholds” Jurisdiction
Date and time
“Tax-free threshold”
New South Wales
1 July
$692,000 for 2019 calendar year
Queensland
Midnight on 30 June
$599,999 for individual residents; $349,999 for companies, trustees and absentees (people who do not usually live in Australia) for 2019–2020 financial year
South Australia
Midnight on 30 June
$391,000 for 2019–2020 financial year ($450,000 from 1 July 2020)
Tasmania
1 July
$24,999 for 2019–2020 financial year
Victoria
Midnight on 31 December
$249,999 ($24,999 for trusts: see [26.270]) for 2019 calendar year
Western Australia
Midnight on 30 June
$300,000 for 2019–2020 financial year
The land tax liability is levied on the “owner” for the forthcoming calendar or financial year, depending on the jurisdiction. For example, in Victoria, the “owner” of a parcel of taxable land as at midnight on 31 December 2018 will be levied with land tax for the 2019 calendar year. Similarly, in Queensland, the “owner” of a parcel of taxable land as at midnight on 30 June will be liable for land tax for that financial year.
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Aggregation of landholdings [26.240] The land tax rates are progressive in every land tax jurisdiction: see Appendix for some land tax rates. Land tax is assessed upon the total (ie, aggregate) land holdings of a taxpayer in a particular jurisdiction. Where an “owner” of a parcel of land holds more than one parcel (whether solely or jointly), the total taxable value of all landholdings of that owner in respect of the same jurisdiction will be aggregated. This ensures taxpayers do not obtain the benefit of lower tax rates by holding multiple lower value properties. Example 26.10: Aggregation Diane owns three parcels of land. The first two parcels are in Victoria and the third is in New South Wales. The taxable values of the land are $350,000, $200,000 and $700,000, respectively. The taxable value of Diane’s Victorian landholdings is $550,000 and of New South Wales landholdings is $700,000. Land tax liabilities will be calculated on these values in Victoria and New South Wales, respectively.
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Grouping [26.250] A similar concept to aggregation is the grouping provisions which exist in some jurisdictions (eg, Victoria, New South Wales and Tasmania). These provisions apply to corporations and essentially treat related corporations as a single “owner” of land. Corporations may be grouped when they are “related corporations”. Depending on the jurisdiction, the definition of a “subsidiary” in s 46 of the Corporations Act 2001 (Cth) may be used as a basis for when a corporation may be related to another corporation. The common situations in which a corporation may be related to another corporation include: • if it owns more than 50% of the share capital in another corporation; • if it controls of the composition of the board of directors; • if it is able to control the casting of more than 50% of the maximum number of votes that may be cast at a general meeting of another corporation; or • if a person has, or the same people together have, a controlling interest in both corporations.
Example 26.11: Grouping of corporations by ownership of share capital
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A Pty Ltd (“A”) owns 70% of the issued share capital of B Pty Ltd (“B”) and 100% of the issued share capital of C Pty Ltd (“C”), as shown below.
A is related to B and C as A owns more than 50% of the issued share capital in each corporation. Consequently, B and C are also related as A is the common corporation of B and C. As a result, A, B and C will be grouped and taken to be a single landholder.
Joint ownership [26.260] When a parcel of land is owned by more than one owner, each owner is only assessed on their share of the landholding. This share is then added to the value of other landholdings for each owner, upon which land tax will be assessed. Each jurisdiction uses a specific formula or process in which they
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930 [26.270] PRINCIPLES OF TAXATION LAW 2020 calculate the land tax liability of owners that hold joint land. For example, Victoria also assesses each combination of joint owners as if they were one person.
Surcharge rates Ownership of land by trusts in Victoria [26.270] We have considered the aggregation of landholdings and the grouping of related corporations. The common purpose of these provisions is to ensure that taxpayers are assessed on all their landholdings at the jurisdiction-specific progressive tax rates. In 2006, Victoria introduced special rules that apply to trusts. These rules, contained in Div 2A of Pt 3 of the Land Tax Act 2005 (Vic) were enacted because landholders achieved the benefit of the lower progressive tax rates by owning land in multiple trusts, albeit the trusts were related (eg, use of the same trustee). There are no provisions to group related trusts, unlike in the case of corporations. In response, the rules have two consequences: 1. Trustees (as the legal owners) of certain types of trusts that own Victorian land are assessed at surcharge land tax rates. This is effectively 0.375% higher than the general rates when landholdings are valued between $25,000 and $1.8 million. A phase out of the Victorian surcharge rate applies for landholdings valued between $1.8 million and $3 million, so that over $3 million the surcharge rate is the same as the general rate.
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2. The impost of land tax starts when the taxable value of landholdings is $25,000 or greater. This is a deviation from the general land tax-free threshold in Victoria of $250,000. The surcharge rates are not imposed when a trust is an “administration trust” (eg, deceased estate but only for up to three years), “excluded trust” (eg, charitable trust) or the land is held in a discretionary trust and used as a PPR by a beneficiary.
Absentee/foreign owners [26.275] In Victoria and Queensland, a land tax surcharge applies to taxable land owned by “absentee owners”. For the surcharge of 1.5% to apply in Victoria, there is a further threshold requirement that the taxable value of the absentee’s land is $250,000 or greater. For the 2% surcharge to apply in Queensland, the threshold is $350,000. The definition of an “absentee owners” varies in each jurisdiction. However, broadly, an individual will be an “absentee owner” if they were away from Australia for more than six months in the preceding land tax year unless they are a citizen, permanent visa holder or ordinarily reside in Australia. A surcharge of 0.75% applies in the Australian Capital Territory to foreign owners of residential land from 1 July 2018 (unless the land is the foreign
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26: State taxes [26.282] 931
owner’s PPR). New South Wales has a similar surcharge land tax that is applied to foreign persons who own residential New South Wales land. The surcharge is 2% from the 2018 land tax year onwards. A special PPR exemption operates in relation to the surcharge and has separate requirements, including that the owner uses and occupies the home as a PPR for a continuous period of at least 200 days in the land tax year. From 1 July 2019, the exemption also requires that the person holds a permanent visa, is a New Zealand citizen with a special visa category, or holds a partner or retirement visa of a specified class.
Vacant residential land tax in Victoria [26.278] From 1 January 2018, residential dwellings in certain areas of Melbourne that are unoccupied for more than six months in the preceding calendar year are subject to a vacant residential land tax of 1% of the capital improved value of the land (so the value of the land and buildings). There are exemptions from the vacant residential land tax, for example, when the property is used as a holiday home and occupied by the owner for at least four weeks in the preceding calendar year, provided that the owner has a different PPR in Australia.
Exemptions
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[26.280] Each jurisdiction has land tax exemptions and concessions in their respective land tax legislation. When satisfied, the taxable value of the land may be wholly or partly reduced. The common exemptions are the PPR exemption and primary production exemption. In the Australian Capital Territory, from 1 July 2018, land tax is only imposed on residential land that is not used as a PPT of one of the owners (s 9 of the Land Tax Act 2004 (ACT)).
Principal place of residence [26.282] The general rule is that land used as an individual’s PPR is exempt from land tax regardless of the value or size of the land. To be eligible for this exemption, in most jurisdictions, the PPR must have the characteristics of residential property (eg, a home); be owned by natural person(s) and those persons must reside in the PPR for a particular minimum length of time. Ordinarily, only one PPR can be exempted, but the exemption may be extended for other reasons. For example, two homes may be exempted when the landholder is in the process of changing their PPR. Where land is used partly as a PPR and partly for business activities, the full exemption may be reduced to a partial exemption. For example, in South Australia, when business activities comprise between 25% and 75% of the total floor area of all buildings on the PPR, a partial exemption is applied: s 5 of the Land Tax Act 1936 (SA).
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932 [26.284] PRINCIPLES OF TAXATION LAW 2020
Example 26.12: Principal Place of Residence –Partial Exemption Joseph is the registered owner of his private home in South Australia. The building on the land in which Joe resides has the characteristics of a residential home. Joseph uses 30% of the total floor space of his home for his private architectural consulting business. In such circumstances, Joseph will be entitled to receive a partial PPR land tax exemption. The taxable value of his land will be reduced by 70%.
Primary production exemption [26.284] Land used for primary production (eg, agriculture, poultry and dairy farming) is generally exempt from land tax. The specific definition of “primary production” for land tax purposes varies as the landscape of each jurisdiction differs. In South Australia, the land that is in a “defined rural area” (within the greater metropolitan area of Adelaide or land within Mt Gambia) must be at least 0.8 hectares and used for a primary production business. New South Wales has similar rules that extend the exemption to non-rural areas, where the land is used for primary production and the use has a substantial commercial purpose. An example of a qualifying use is when the dominant use of the land is for “cultivation, for the purpose of selling the produce of the cultivation”: s 10AA of the Land Tax Management Act 1956 (NSW); Chief Commissioner of State Revenue v Metricon Qld Pty Ltd [2017] NSWCA 11; Leppington Pastoral Co Pty Ltd v Chief Commissioner of State Revenue [2017] NSWSC 9.
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Other exemptions [26.286] Jurisdictions have other exemptions available when land is used for certain purposes, such as land used primarily as a boarding house or other low cost accommodation and land use for aged care or a retirement village. Some other examples of exemptions include when land is used by: • charitable organisations (eg, public benevolent institutions); • educational institutions; and • religious organisations.
Calculation of land tax liability [26.290] The following formula determines an owner’s liability to land tax: for example, see s 7 of the Land Tax Management Act 1956 (NSW):
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The above formula excludes any land which is exempt land: see [26.280]. The general land tax rates differ in each jurisdiction and some jurisdictions have multiple rates which apply in certain circumstances. The land tax rates for the eastern seaboard states are listed in the Appendix. For example, Table 26.6 lists the rates in Queensland when an individual is the landowner: Sch 1 of the Land Tax Act 2010 (Qld). TABLE 26.6 Land tax rates for an individual owner of land in Queensland Dutiable value
Rate
$25,000–$130,000
$350 + 2.4% of that part of the dutiable value that exceeds $25,000
> $130,000–$960,000
$2,870 + 6% of that part of the dutiable value that exceeds $130,000
More than $960,000
5.5% of the dutiable value
s 28 of Duties Act 2000 (Vic).
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956 PRINCIPLES OF TAXATION LAW 2020 Queensland –General land transfer duty rates Dutiable value
Rate
Up to $5,000
Nil
$5,001–$75,000
$1.50 for each $100, or part of $100, by which the dutiable value is more than $5,000
$75,001–$540,000
$1,050 + $3.50 for each $100, or part of $100, by which the dutiable value is more than $75,000
$540,001–$1,000,000
$17,325 + $4.50 for each $100, or part of $100, by which the dutiable value is more than $540,000
More than $1,000,000
$38,025 + $5.75 for each $100, or part of $100, by which the dutiable value is more than $1,000,000
Sch 3 of Duties Act 2001 (Qld).
25. Land tax rates for eastern border states
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Victoria: General land tax rates for 2009–present Landholding taxable value
Rate
< $250,000
Nil
$250,000 to < $600,000
$275 plus 0.2% of the taxable value that exceeds $250,000
$600,000 to < $1,000,000
$975 plus 0.5% of the taxable value that exceeds $600,000
$1,000,000 to < $1,800,000
$2,975 plus 0.8% of the taxable value that exceeds $1,000,000
$1,800,000 to < $3,000,000
$9,375 plus 1.3% of the taxable value that exceeds $1,800,000
$3,000,000 and over
$24,975 plus 2.25% of the taxable value that exceeds $3,000,000
Sch 1, Table 1.4, of Land Tax Act 2005 (Vic).
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APPENDIX 957
New South Wales: General land tax rates Landholding taxable value
Rate
> $692,000–$4,231,000
$100 + 1.6% of the amount by which the taxable value exceeds the tax threshold of $692,000 up to the premium threshold of $4,231,000
> $4,231,000 and over (premium threshold)
$56,724 for the first $4,231,000 then 2% of the amount by which the taxable value exceeds the premium rate threshold of $4,231,000
s 3AL and Sch 13 of Land Tax Act 1956 (NSW) and ss 62TBA and 62TBC of Land Tax Management Act 1956 (NSW).
Queensland: Land tax rates for an individual owner (other than companies, absentees and trustees for which different rates will apply) Landholding taxable value
Rate
< $600,000
Nil
$600,000–$999,999
$500 + 1.0c for each $1 more than $600,000
$1,000,000–$2,999,999
$4,500 + 1.65c for each $1 more than $1,000,000
$3,000,000–$4,999,999
$37,500 + 1.25c for each $1 more than $3,000,000
$5,000,000–$9,999,999
$62,500 + 1.75c for each $1 more than $5,000,000
$10,000,000 or more
$150,000 + 2.25c for each $1 more than $10,000,000
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s 32 and Sch 1 of Land Tax Act 2010 (Qld).
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INDEX
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A ABC Lumber Pty Ltd mills .................... [24.700] Absentee owners land tax surcharge .............................. [26.275] Absolute liability ................................... [24.203] Access to corporate board advice papers ......................................... [24.595] Access to information accountants’ papers ........................... [24.590] Commissioner’s powers ...... [24.510], [24.540] full and free access ............................. [24.530] legal professional privilege ................ [24.560] ATO access manual ......................... [24.580] Ombudsman .................................... [24.660] substantiation of claims ................... [24.570] third party communications ............ [24.570] notice requiring production ............... [24.540] validity .............................................. [24.550] Ombudsman ....................................... [24.660] safety deposit box .............................. [24.550] secrecy ................................................ [24.620] statutory privilege ............................... [24.600] taxpayers’ rights ................................. [24.630] conditionally exempt documents .... [24.640] freedom of information .................... [24.640] Accounting, financial advice ...................................................... [1.50] tax advice, distinction .......................... [1.50] entity relationships ............................... [1.130] expenses ............................................... [1.110] financial reporting standards ................. [1.30] gross income ............................. [1.90], [1.100] policy considerations ........................... [1.120] problem solving ...................................... [1.60] recognition of receipts ........................... [1.80] tax law distinguished ......[1.20], [1.70], [1.140] timing rules ........................................... [1.140] Accounting, tax — see Tax accounting Accruals based accounting — see Tax accounting Accruals taxation regime background ........................................... [22.50] components of regime ....................... [22.160] controlled foreign company (CFC) ..... [22.160] active income test ............................ [22.200] application of regime ....................... [22.170] attributable income .......................... [22.210] attributable taxpayers ...................... [22.190] attribution percentage ..................... [22.190] listed countries ................................. [22.200]
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tainted income ................................. [22.200] tests to determine ............................ [22.180] components of regime ....................... [22.160] foreign investment fund (FIF) ............ [22.160], [22.240] overview ................................. [22.70], [22.160] purpose of regime .............................. [22.160] review of provisions ........................... [22.160] Ad valorem duty — see Transfer duty Administrative Appeals Tribunal decisions ............................................. [24.270] reasons for decision ........................... [24.270] review by ............................................. [24.260] Small Business Taxation Division ...... [24.260] Small Taxation Claims Tribunal ......... [24.280] Administrative Decisions (Judicial Review) Act 1977 ....................... [24.650] Administrative penalties ...................... [24.201] false or misleading statement penalties in Division 284 ............ [24.201] Age limits superannuation contributions ............ [18.125] Agricultural schemes carrying on a business ....................... [23.330] mass-marketed schemes ................... [23.330] non-recourse loans ............................. [23.330] round-robin finance ............................ [23.330] sham transactions .............................. [23.330] tax avoidance ...................................... [23.330] Alcohol, tax on .......................................... [3.10] Allowable deductions — see Deductions Amendment determinations .................. [14.90] Anti-avoidance provisions — see Tax avoidance schemes Appeal or review Administrative Appeals Tribunal ........ [24.260] decisions .......................................... [24.270] reasons for decision ........................ [24.270] administrative review ......................... [24.650] appealable objection decision ........... [24.250] application for ..................................... [24.240] choice for proceedings ....................... [24.260] Federal Court ....................... [24.260], [24.270] overview ............................... [24.210], [24.250] procedure ............................................ [24.210] reviewable objection decision ........... [24.250] Small Taxation Claims Tribunal ......... [24.280] test case litigation program ................ [24.290] Assessable income — see also Ordinary income; Statutory income business income — see Business income
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960 PRINCIPLES OF TAXATION LAW 2020
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Assessable income — cont capital gains — see Capital gains tax compensation or damages — see Compensation or damages definition .................................. [1.160], [3.140] development of concept ...................... [1.100] dividends — see Dividends foreign residents ........................ [4.30], [4.230] hobbies ................................................... [8.50] income tax formula ............................... [3.120] interest — see Interest lease premiums .................................... [9.170] overview ....................................... [1.90], [6.10] partners ................................................. [19.60] personal exertion income — see Personal exertion/services income rental income ........................................ [9.160] royalties ................................................. [9.190] source .................................................... [4.230] taxable income determination ............. [3.130] taxable income formula ........... [3.120], [3.130] trading stock — see Trading stock Assessment amendment ......................................... [24.140] rulings and ........................................ [24.400] appeal — see Appeal or review assets betterment statement .............. [24.100] challenging .......................................... [24.225] onus of proof .................................... [24.225] deemed assessments ........................... [24.70] default assessments ............................. [24.90] proof that excessive ........................... [24.90] definition .................................. [24.40], [24.50] notice of ................................................ [24.50] evidence of assessment .................. [24.130] service .............................................. [24.110] technical shortcomings ................... [24.120] objections — see Objections overview ................................... [24.10], [24.50] presumption of validity ...................... [24.130] risk assessment by ATO ..................... [24.300] self-assessment system ........ [24.40], [24.300] tax returns ................................ [24.10], [24.20] tentative assessments .......................... [24.80] validity .................................. [24.120], [24.130] what constitutes .................................... [24.50] Assets betterment statement .............. [24.100] Assignments — see Study skills Associates Everett assignments ........................... [19.150] excessive payments to ....................... [23.120] fringe benefits provided by .................... [7.50] fringe benefits provided to ..................... [7.60] Australian Business Number (ABN) GST registration ..................... [24.340], [25.50] overview .............................................. [24.340] partnership ............................................ [19.40]
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Australian Government general government receipts Table ................................................. [3.1] Australian tax regime annual return ......................................... [24.10] Commonwealth Government expenditure, projected ......................................... [3.10] Government revenue, projected ......................................... [3.10] power to tax ......................................... [3.20] composition .......................................... [26.00] government functions ............................ [3.10] income tax .............................................. [3.30] overview ....................................... [3.10], [3.30] revenue from taxes ...................... [3.10], [3.30] Australian Taxation Office — see also Commissioner of Taxation access to information — see Access to information audits and reviews .............................. [24.510] accountants’ papers ......................... [24.590] Black Economy, and ........................... [24.300] business line ....................................... [24.310] compliance model .............................. [24.360] data-matching ..................................... [24.330] decision impact statements ............... [24.500] disallowable legislative instrument ................................... [24.305] division of taxpayers .......................... [24.310] freedom of information ...................... [24.640] GST administration ............................. [25.300] adjustments ...................................... [25.310] GST groups ...................................... [25.315] non-residents ................................... [25.313] tax invoice ........................................ [25.306] timing ................................................ [25.304] Inspector General of Taxation (IGT) .............. [24.660], [24.670] overview .............................................. [24.300] policy documents ............................... [24.500] powers of access and investigation ............................... [24.510] Project Refresh ..................... [24.300], [24.410] publications .......................... [24.320], [24.370] role of .................................................. [24.300] rulings — see Rulings secrecy ................................................ [24.620] tax administration ................................. [24.10] risk assessment ................... [24.50], [24.300] tax and superannuation systems ....................................... [24.320] Taxpayer Alerts ................................... [24.500] taxpayer support ................................ [24.370] non-ruling guidance ......................... [24.500] rulings — see Rulings Taxpayer’s Charter ............................. [24.350] test case litigation program ................ [24.290] third party reporting ........................... [24.330]
06-Dec-19 14:02:18
INDEX 961
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B Backpacker tax ........................... [3.200], [4.155] Bad debts deduction .............................................. [13.80] companies .......................................... [13.80] money-lending business ................... [13.85] timing ................................................ [16.220] determination of ................................... [13.83] overview ................................................ [13.80] provisions for ...................................... [16.220] Banks TFN, failure to give to ......................... [24.330] thin capitalisation — see Thin capitalisation BAS — see Business activity statements (BAS) Beneficiaries capital gains distributed to ................. [20.130] discretionary trusts ............................... [20.40] default beneficiary provision ........... [20.150] splitting income between .................. [20.40] dividends ............................................. [20.130] foreign resident ................................... [20.170] income distributed to, character preserved .................................... [20.130] legal disability ..................................... [20.140] minors .................................... [20.40], [20.160] tax rates ............................................ [20.160] overview ................................................ [1.160] presently entitled ................................ [20.110] legal disability, under ....................... [20.140] meaning ............................................ [20.110] no knowledge of distribution .......... [20.110] not under legal disability ................. [20.110] statutory present entitlement .......... [20.120] taxation of trust income ...... [20.70], [20.140] share in trust income, meaning ........... [20.90] taxation ................................................. [20.10] default beneficiary provision ........... [20.150] foreign resident beneficiaries .......... [20.170] presently entitled, not under legal disability ...................................... [20.110] presently entitled, under legal disability ...................................... [20.140] Black hole expenses business-related costs ........................ [14.200] overview .............................................. [14.180] project pools ....................................... [14.190] start up expenses ............................... [14.215] Board of Taxation ................................. [24.680] Bonuses ..................................................... [6.40] Buildings CGT asset ............................................ [11.170] separate CGT assets ........................... [11.200] Burden of tax ........................................... [3.110] Business black hole expenditure — see Black hole expenses
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carrying on — see Carrying on a business cessation of breach of contract ............................ [10.190] expenses after .................................. [16.150] commencement of ............................... [8.110] definition ................................................. [8.20] Business activity statement (BAS) intersection with GST ............ [1.260], [25.300] overview .............................................. [24.160] service providers ................................ [24.690] taxpayers ............................................... [24.35] Business continuity test (BCT) ........... [21.320], [21.330], [21.330] Business income — see also Personal exertion/services income bounties and subsidies ......................... [8.280] carrying on a business — see Carrying on a business commencement of business ................ [8.110] compensation or damages — see Compensation or damages extraordinary transactions ......[8.170]; [8.265] capital gains tax ................................. [8.270] categories of ....................................... [8.170] FCT v Myer Emporium case study .... [8.210] ordinary income under first strand of Myer ................. [8.220]–[8.250] ordinary income under second strand of Myer .............................. [8.260] transaction forms business in itself ...... [8.190] isolated transactions ................[8.170]; [8.265] capital gains tax ................................. [8.270] categories of ....................................... [8.170] definition ............................................. [8.170] ordinary income, calculation ............. [8.200] ordinary income under first strand of Myer ................. [8.220]–[8.250] ordinary income under second strand of Myer .............................. [8.260] transaction forms business in itself .... [8.180] nature of business ................. [8.140], [10.150] broad definition .................................. [8.140] narrow approach ................................ [8.140] nexus of receipt with business ............ [8.150] non-cash business benefits .................. [8.160] normal proceeds of business ........................... [8.130], [8.170] ordinary income ...................................... [8.10] under first strand of Myer ............................. [8.220]–[8.250] under second strand of Myer .......................................... [8.260] overview ......................[8.10], [8.265], [10.150] preliminary expenses, deductibility .................................. [8.120] profit-making undertaking or plan ........................................... [8.290] sale of asset acquired for resale ........ [8.300] receipt, treatment of ............................. [8.265]
06-Dec-19 14:02:19
962 PRINCIPLES OF TAXATION LAW 2020 Business losses carrying on a business — see Carrying on a business compensation or damages ........................ [10.10], [10.150] anticipated profits ............................ [10.170] breach of contract ............. [10.170]–[10.190] GST consequences .......................... [10.150] insurance proceeds ......................... [10.230] loss of capital asset .......................... [10.210] loss of depreciable assets ............... [10.200] loss of trading stock ......................... [10.220] types of compensation .................... [10.160]
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C Capital allowances — see also Depreciating assets black hole expenses business-related costs ..................... [14.200] overview ........................................... [14.180] project pools .................................... [14.190] capital works deductions .................... [14.170] categories of expenditure .................... [14.10] depreciation — see Depreciating assets overview ................................... [1.110], [14.10] Capital assets CGT events — see CGT events compensation for loss of .................... [10.210] sale of — see Disposal of assets Capital gains or losses amount of ............................................ [11.440] beneficiaries, distributed to ................ [20.130] calculation ........................................... [11.460] capital gain, what is ............................ [11.450] capital loss, what is ............................. [11.450] capital proceeds .................................. [11.470] apportionment rule .......................... [11.470] assumption of liability rule .............. [11.470] market value substitution rule ......... [11.470] non-receipt rule ................................ [11.470] repaid rule ........................................ [11.470] carry forward losses ............ [11.530], [21.230] CGT events — see CGT events cost base ............................................. [11.480] GST and ............................................ [11.480] indexation .......................... [11.490], [11.540] modification rules ............................ [11.490] reduced cost base ............................ [10.500] determining ........................................... [11.30] discount capital gains ......................... [11.540] meaning .............................................. [11.450] net capital gain ..................... [11.510], [11.560] calculation ......................... [11.520]–[11.560] CGT discount .................................... [11.540] prior year losses ............................... [11.530] reducing gains by losses ........................... [11.520], [11.530]
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small business concessions ............ [11.550] net capital loss ..................... [11.510], [11.570] overview ................................................ [1.110] return of capital ..................................... [21.60] trading stock ....................................... [11.275] trust distributions ................................ [20.130] Capital gains tax buildings and land .............................. [11.200] capital allowances .............................. [14.118] capital proceeds .................................. [11.470] CGT assets .......................................... [11.170] definition ........................................... [11.170] examples .......................................... [11.170] partnerships ..................................... [19.130] separate assets ................................ [11.200] time of acquisition ........................... [11.210] CGT discount ...................................... [11.540] beneficiary ........................................ [20.130] temporary residents not entitled ........................... [4.150], [22.330] CGT events — see CGT events CGT small business entity .................. [11.330] collectables .......................... [11.170], [11.180] definition ........................................... [11.180] exemption ..........[11.180], [11.220], [11.240] sets ................................................... [11.180] compensation ........................ [10.20], [11.290] breach of contract ............................ [10.190] composite claims .............. [10.240], [10.250] discrimination ................... [10.120], [10.125], [11.290] financial institutions ......................... [10.130] loss of physical abilities ................... [10.100] medical expenses ............................ [10.110] pain or suffering ............................... [10.110] trustee, received by ......................... [10.100] undissected lump sums ................... [10.250] determining application .......... [11.20], [11.30] exemptions ......................................... [11.220] anti-overlap provisions .................... [11.310] cars ................................................... [11.230] collectables ...................... [11.180], [11.220], [11.240] compensation .................................. [11.290] death ................................................. [11.425] depreciating assets ............. [11.270], [14.30] exempt assets ................... [11.230]–[11.270] exempt income-producing assets .......................................... [11.250] exempt transactions ......... [11.280]–[11.300] gambling .......................................... [11.300] main residence .................. [11.380]–[11.420] PDF shares ....................................... [11.260] personal use assets ........................ [11.190], [11.220], [11.240] prize competitions ........................... [11.300] start-up companies .......................... [11.265] trading stock ..................................... [11.310] valour decorations ........................... [11.230] foreign residents ................................. [22.320]
06-Dec-19 14:02:19
INDEX 963
Copyright © 2019. Thomson Reuters. All rights reserved.
Capital gains tax — cont taxable Australian property ............ [22.330], [22.335] history of ............................................... [1.230] improvements ..................................... [11.200] threshold .......................................... [11.200] income tax, part of .................................. [3.30] legislation .............................................. [1.230] main residence exemption ................. [11.380] absence from dwelling .................... [11.400] basic case .......................... [11.380], [11.390] conditions for exemption ................ [11.390] extension of exemption ................... [11.400] limitation of exemption .................... [11.410] more than one dwelling ................... [11.410] partial exemptions ........................... [11.420] tax shelters ......................................... [23.90] ordinary income, and .............. [5.40], [11.310] overview ................................................ [11.10] partnerships ........................................ [19.130] assignment of interests ................... [19.150] disposal of CGT assets .................... [19.130] new partner ...................................... [19.130] personal use assets ............. [11.170], [11.190] definition ........................................... [11.190] exemption ........................ [11.190], [11.220], [11.240] roll-over relief ....................... [11.430], [14.120] royalties ................................................. [9.190] separate CGT assets ........................... [11.200] small business concessions .............. [11.320], [11.550] basic conditions ............................... [11.330] 15-year exemption ........................... [11.340] 50% reduction .................................. [11.350] retirement concession ..................... [11.360] roll-over relief ................................... [11.370] turnover test ..................................... [11.330] statutory income, and ......................... [11.310] tax avoidance ........................................ [23.80] discretionary trusts ............................ [23.80] wash sales ........................................ [23.340] tax liability affected by .......................... [11.10] trusts ................................................... [20.130] CGT events .......................... [11.90], [20.180] discretionary trusts ............................ [23.80] Capital or income characteristics of income — see Ordinary income converting income to capital ................ [23.70] flow concept .............................. [5.100], [9.10] relevance of distinction .......................... [5.40] restrictive covenants .............. [6.160]– [6.170] trusts .........................[1.160], [1.160], [20.130] Capital or revenue expenses ................. [1.110] Capital works deductions .................... [14.170] Car CGT exemption ................................... [11.230]
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definition ............................................. [11.230] depreciating asset — see also Depreciating assets cost of car, limit ................................ [14.125] expenses — see Travel expenses fringe benefits — see Car fringe benefits Car expenses — see Travel expenses Car fringe benefits exempt benefits .................................... [7.110] overview ................................................ [7.100] private use ............................... [7.100], [7.110] taxable value ......................................... [7.120] cost basis method .............................. [7.140] statutory formula method .................. [7.130] Carried forward offsets .......................... [15.60] Carry forward losses capital losses ....................................... [11.530] companies ............................ [21.230], [21.310] continuity of ownership test ............ [21.330] realised losses .................................. [21.320] same business test .......................... [21.340] similar business test (SiBT) ............. [21.340] unrealised losses ............................. [21.350] franking offsets, and ........................... [21.230] Carrying on a business agricultural schemes .......................... [23.330] commencement of business ................ [8.110] deductibility of preliminary expenses ....................................... [8.120] commercial purpose ............................... [8.50] factors in determining ............................ [8.20] gambling ...................................... [8.60]–[8.70] hobbies distinguished ............................ [8.50] indicators of ................................. [8.30]–[8.50] investment activities ............................... [8.90] land sales .............................................. [8.100] losses or outgoings — see Losses or outgoings overview .................................................. [8.20] partnerships .......................................... [19.40] share trading ........................................... [8.90] sportspeople ........................................... [8.80] termination of business ........................ [8.110] CGT events bringing asset into existence ............... [11.80] cancellation or surrender of asset ....... [11.70] capital gain or loss ............... [11.450], [11.460] capital proceeds ..................... [11.50], [11.470] categories of .......................... [11.40], [11.150] cessation of residency ........................ [11.130] consolidated groups ........................... [11.160] cost base ................................ [11.50], [11.480] indexation ......................................... [11.495] reduced cost base ............................ [11.500] disposal of asset .................... [11.50], [11.450] end of an asset ...................................... [11.70] exceptions ........................................... [11.220] forfeited deposits ................................ [11.120]
06-Dec-19 14:02:19
964 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
CGT events — cont leases .................................................. [11.100] liquidation ............................ [11.110], [21.140] loss or destruction of asset .................. [11.70] MEC groups ........................................ [11.160] options ..................................... [11.70], [11.80] overview ................................... [11.20], [11.40] roll-overs ............................................. [11.140] shares .................................................. [11.110] special capital receipts ....................... [11.120] trading stock ........................ [17.250], [17.260] trusts ...................................... [11.90], [20.180] use and enjoyment of asset ................. [11.60] Child care deductibility of expenses ................... [12.370] GST-free supply .................................. [25.148] Clothing expenses capital in nature .................................. [12.800] conventional clothing ......................... [12.750] abnormal expenditure ..................... [12.760] working conditions .......................... [12.780] deductibility ........................................ [12.740] occupation-specific clothing .............. [12.790] protective clothing .............................. [12.790] uniforms .............................................. [12.790] Collectables CGT ....................................... [11.170], [11.180] exemption ..........[11.180], [11.220], [11.240] definition ............................................. [11.180] losses from ......................................... [11.180] sets ...................................................... [11.180] Collection of tax departure prohibition orders .............. [24.190] due for payment ................................. [24.150] general interest charge (GIC) ............. [24.150] late payment ....................................... [24.150] Mareva orders ..................................... [24.180] methods of collection ......................... [24.160] overview .............................................. [24.150] PAYG instalments ............................... [24.160] PAYG withholding .............................. [24.160] person receiving/controlling foreign resident’s money, from .............. [24.175] shortfall interest charge (SIC) ............. [24.150] third parties, from ............................... [24.170] Commissioner of Taxation access to information .......... [24.510], [24.540] accountants’ papers ......................... [24.590] full and free access .......................... [24.530] legal professional privilege ....................... [24.560]–[24.580] notice requiring production ............. [24.540] offshore information notices ........... [24.610] record-keeping requirements .......... [24.520] remedial amendment power ........... [24.305] statutory privilege ............................ [24.600] validity of notices ............................. [24.550]
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access to premises ............................. [24.510] full and free access .......................... [24.530] investigative powers ........................... [24.510] overview .............................................. [24.510] rulings, and ........................................... [1.280] Commissions assessable income ................................. [6.40] Commonwealth Department of Public Prosecutions (CDPP) .................. [24.203] Commonwealth power to tax ................. [3.20] Companies — see also Consolidated groups central management and control test ................................................. [4.190] board of directors .............................. [4.200] determination, criteria ....................... [4.200] examples ............................................ [4.200] question of fact .................................. [4.190] test of residency ................................. [4.200] corporate limited partnerships taxed as .......................... [19.190], [21.20] corporate tax entities taxed as ......................................... [21.20] corporate unit trusts taxed as ............................ [20.30], [21.20] definition ............................................... [21.20] dividends — see Dividends dual residency ....................................... [4.220] flat or proportional tax .......................... [3.210] landholders ......................................... [26.250] liquidation — see Liquidation listed companies ................................. [21.120] losses anti-avoidance provisions ................... [21.310]– [21.340] carry back ......................................... [21.320] carry forward .................... [11.530], [21.230], [21.310] continuity of ownership test ............ [21.330] loss trafficking .................................. [21.310] multiplication of ............................... [21.360] overview ........................................... [21.310] pre-consolidation losses .................. [21.440] realised ............................................. [21.320] same business test .......................... [21.340] similar business test (SiBT) ............. [21.340] unrealised ......................................... [21.350] non-profit-making club taxed as ......................................... [21.20] overview ................................................ [21.10] passive investment companies ............ [3.210] PAYG instalments ............................... [24.160] private ................................................. [21.120] public ................................................... [21.120] public officer ......................................... [21.30] public trading trusts, taxed as ............................ [20.30], [21.20] residency .......................[4.10], [4.170], [22.40] central management and control test ....................... [4.190], [4.200]
06-Dec-19 14:02:19
INDEX 965
Copyright © 2019. Thomson Reuters. All rights reserved.
Companies — cont controlling shareholders .................... [4.210] dual residency .................................... [4.220] incorporation test ............................... [4.180] voting power test ............................... [4.210] share capital account ............................ [21.70] start-up, investments in ...................... [11.265] tax losses — see Tax losses tax rate .................................................. [3.210] Compensation or damages — see also Reimbursement of expenses breach of contract ............................... [10.170] fundamental structure of business .... [10.190] ordinary trading contract ................ [10.170], [10.180] business losses ...................... [10.10], [10.150] anticipated profits ............................ [10.170] breach of contract ............. [10.170]–[10.190] capital assets .................................... [10.210] depreciable assets ........................... [10.200] GST consequences .......................... [10.150] insurance proceeds ......................... [10.230] trading stock ..................................... [10.220] types of compensation .................... [10.160] categories of compensation ................. [10.50] CGT exemption ................................... [11.290] character of receipts ............................. [10.20] composite claims ................. [10.240], [10.250] apportionment ................................. [10.240] lump sum payment .......................... [10.250] defamation .......................................... [10.210] discrimination claims ........... [10.120], [11.290] examples of awards ......................... [10.125] earning capacity, loss of ....................... [10.80] explanatory flowchart ........................... [10.30] financial institutions, paid by .............. [10.130] income replacement ............................. [10.20] individuals .............................. [10.40]–[10.140] insurance proceeds business ........................................... [10.230] individual ............................... [10.60], [10.90] interest .................................................... [9.80] capital gains tax ................................. [9.120] damages for personal injury ................................ [9.100], [9.110] damages for property .......................... [9.90] medical expenses ............................... [10.110] ordinary income .................................... [5.140] overview ................................... [10.10], [10.30] pain and suffering ............................... [10.110] personal exertion income .................... [10.40] physical abilities, loss of ..................... [10.100] replacement principle .............. [10.20], [10.30] salary or wages, loss of ........... [6.230], [10.60] insurance or indemnity ......... [10.60], [10.90] loss of earning capacity ..................... [10.80] lump sum ........................................... [10.70] payment to employer ........................ [10.70] replacement principle ........................ [10.60]
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structured settlements ........................ [10.140] trustee, received by ............................ [10.100] undissected lump sum ....................... [10.250] unlawful dismissal ............... [10.125], [11.290] Compliance Approach .......................... [24.310] Consolidated groups available fraction rule ......................... [21.440] CGT events .......................................... [11.160] entry and exit history rules ................ [21.420] intra-group transactions ...................................... [21.410] transfers of assets ............................ [21.450] liability to tax ....................................... [21.430] membership requirements ................. [21.390] multiple entry consolidated (MEC) groups ......................................... [21.400] overview .............................................. [21.370] policy objectives ................................. [21.380] pre-consolidation losses .................... [21.440] single entity rule ................................. [21.410] tax cost setting rules .......................... [21.450] tax sharing agreement ........................ [21.430] Continuity of ownership test (COT) .................... [21.320], [21.330] Controlled foreign company (CFC) accruals taxation regime .................... [22.160] exemption from ............................... [22.200] active income test ............................... [22.200] application of regime .......................... [22.170] assumed control test .......................... [22.180] attributable income ............................. [22.210] attributable taxpayers ......................... [22.190] attribution percentage ........................ [22.190] de facto control test ............................ [22.180] listed countries ................................... [22.200] overview .............................................. [22.160] strict control test ................................. [22.180] tainted income .................................... [22.200] tests to determine ............................... [22.180] Conveyance duty — see Transfer duty Corporate Plan for 2018–19 ................. [24.300] Cost base apportionment rule ............................. [11.490] assumption of liability rule ................. [11.490] elements .............................................. [11.480] excluded amounts .............................. [11.480] indexation ........................... [11.490], [11.540], [11.580] market value substitution rule ............ [11.490] merged assets ..................................... [11.490] modification rules ............................... [11.490] overview .............................................. [11.480] reduced cost base .............................. [11.500] split assets ........................................... [11.490] Country-by-country reporting ...................... [22.375], [24.330] Crisis Couriers ....................................... [26.360]
06-Dec-19 14:02:19
966 PRINCIPLES OF TAXATION LAW 2020 Crowdfunding activities contributions ......................................... [8.107] income tax impact ................................ [8.107] initiator (recipient) ................................. [8.107] intermediary .......................................... [8.107] raising funds ......................................... [8.107] tax implications ..................................... [8.107]
Copyright © 2019. Thomson Reuters. All rights reserved.
D Damages — see Compensation or damages Death benefit superannuation fund .......................... [18.220] binding death benefit nomination ... [18.225] entitlement ....................................... [18.225] taxation ............................................. [18.230] taxation case study .......................... [18.230] termination payment, taxation of ......... [6.380] Debt bad debts — see Bad debts collection ............................................. [24.620] recoverable, accounting for ................. [16.40] Debt waiver fringe benefits overview ................................................ [7.150] taxable value ......................................... [7.160] Deductions — see also Losses or outgoings allowable, overview .............................. [12.20] amount of ............................................ [12.290] actual or reasonable expense ......... [12.300] purpose of incurring expense ......... [12.310] apportionment .................................... [12.270] bad debts — see Bad debts black hole expenses — see Black hole expenses business-related expenses ................. [14.200] business taxpayers ............................. [12.350] capital works ....................................... [14.170] car expenses — see Travel expenses carrying on a business future expense reduction . [12.100], [16.160] future income .................... [12.130], [16.170] past income ....................... [12.140], [12.150] categories of ......................................... [3.180] charitable donations ........................... [13.160] clothing expenses — see Clothing expenses depreciation — see Depreciating assets dual purpose expenses ...................... [12.270] expenses not deductible ..... [12.160]–[12.260] assistance to students ..................... [12.240] capital or capital in nature ............... [12.170] denied deductions ........................... [12.240] entertainment expenses .................. [12.250] form and substance ......................... [12.200] gaining exempt or non-assessable non-exempt income ................... [12.230] gifts or donations ............................. [12.240] judicial tests ...................................... [12.180]
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non-compliant payments for work and services ................................ [12.240] private or domestic .......................... [12.220] rebatable benefits ............................ [12.240] reimbursed expenditure .................. [12.260] relatives travel expenses ................. [12.240] explanatory flowchart ........................... [12.20] exploration/prospecting for minerals ........................................ [14.40] future expenses .................................. [12.100] insurance companies ........ [16.230]–[16.240] provisions for leave .......... [16.190]–[16.210] reduction of ...................................... [16.160] timing of ............................ [16.190]–[16.240] future income ....................... [12.130], [16.170] gearing ................................................ [12.825] general deductions ................. [12.20], [12.30], [16.120] explanatory flowchart ........................ [12.50] losses or outgoings ........................... [12.40] negative limbs ................... [12.160]–[12.260] positive limbs ...................... [12.40]–[12.150] requirements ...................................... [12.20] gifts ....................................... [13.130], [13.160] limitations ......................................... [13.140] political contributions ...................... [13.150] home office expenses — see Home office expenses immediate ............................................. [14.40] insurance companies ......................... [16.230] estimates of claims .......................... [16.240] interest expenses ................................ [12.810] capital ............................................... [12.830] penalty interest payments, deductibility of ............................ [12.810] involuntary losses or outgoings ......... [12.110] laundry expenses ............................... [12.320] legal expenses ..................... [12.840], [12.850] loss or outgoing — see Losses and outgoings membership fees ................................ [13.100] overview .................................. [3.180], [12.10], [12.20], [13.10] partnership losses ................................ [19.70] past income ......................... [12.140], [12.150] personal services income .................. [23.180] political contributions ......................... [13.150] prepaid expenditure ............ [16.180], [16.182] prior year losses .................. [13.180], [16.140] companies, and ................................ [13.190] limitations ......................................... [13.200] provisions for leave actual payment .................. [16.190], [16.200] timing ................................. [16.190]–[16.210] year of payment ............................... [16.210] repairs — see Repairs self-education expenses — see Self-education expenses specific deductions ............................... [13.10] examples .......................................... [13.210]
06-Dec-19 14:02:19
INDEX 967
Copyright © 2019. Thomson Reuters. All rights reserved.
Deductions — cont start up expenses ............................... [14.215] substantiation ...................... [12.320], [24.520] tax accounting .................................... [16.120] bad debts .......................................... [16.220] future expenses .............................. [16.160], [16.190]–[16.210], [16.230]–[16.240] future income ................................... [16.170] incurred, meaning ............. [16.120], [16.130] insurance companies ........ [16.230]–[16.240] post-cessation of business .............. [16.150] prepaid expenses .............. [16.180], [16.182] previous years’ expenses ...................... [16.140], [16.150] provisions for leave .......... [16.190]–[16.210] tax agent fees ........................................ [13.20] tax losses — see Tax losses tax-related expenses ............................ [13.20] preparation of objections ................ [24.220] trading stock ............................ [17.60], [17.70] non-arm’s length transactions ........... [17.70] travel expenses — see Travel expenses value of .................................................. [3.180] work expenses .................................... [12.320] wrongdoing by taxpayer ...................... [12.80] Deemed dividends — see Dividends Definitions acquisition ........................................... [25.200] adjusted taxable income .................... [15.150] assessable income .......[1.90], [1.160], [3.140] assessment .............................. [24.40], [24.50] Australian resident ................... [4.40], [22.250] benefit ..................................................... [7.30] business .................................................. [8.20] business income ................................... [8.170] capital proceeds .................................. [11.470] car ...................................................... [11.230] CGT asset ............................................ [11.170] collectable ........................................... [11.180] company ............................................... [21.20] consideration ...................................... [25.110] depreciating asset ................................. [14.30] derive .................................................... [16.20] distribution .......................................... [21.160] dividend ................................... [9.150], [21.60] employee ................................................ [7.60] employer ................................................. [7.50] enterprise .............................................. [25.60] foreign resident ..................................... [4.160] foreign service ...................................... [22.80] franking entity ..................................... [21.160] fringe benefit ................................ [7.20], [7.80] income .................................................... [5.20] income from personal exertion ............ [10.40] income from property ............................ [9.10] net income of partnership .................... [19.60] non-share dividends ............................. [21.80] ordinary income ......................... [3.150], [6.20]
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paid ........................................................ [21.90] partnership ............................... [19.20], [19.30] partnership loss .................................... [19.70] personal use asset .............................. [11.190] primary production business ............... [17.20] private company ................................. [21.120] profits .................................................. [21.100] public company .................................. [21.120] qualifying security .................................. [9.60] resident ...........................[4.40], [4.50], [4.170] resides ..................................................... [4.60] royalty .................................... [9.190], [22.310] scheme ................................................ [23.280] share capital account ............................ [21.70] shareholder ........................................... [21.50] statutory income ..................................... [5.10] superannuation ..................................... [18.10] supply .................................................. [25.100] tax benefit ........................................... [23.290] taxable income ..................................... [1.160] trading stock ......................................... [17.20] traditional security .................................. [9.60] trust ....................................................... [20.20] Departure prohibition orders ............... [24.190] Dependant tax offset ............................ [15.150] Depreciating assets amount of deduction ............................ [14.40] balancing adjustment on disposal of ................................... [14.110] reduction where non-income producing purpose ..................... [14.120] black hole expenses — see Black hole expenses capital works ....................................... [14.170] cars ...................................................... [14.125] CGT exemption ...................... [11.270], [14.30] CGT rules and ........................ [14.30], [14.118] compensation for loss of .................... [10.200] composite items ................................... [14.35] conditions for deduction ...................... [14.40] cost of asset .......................................... [14.90] car limit ............................................... [14.90] GST ..................................................... [14.90] less than $300 .................................... [14.40] non-arm’s length acquisitions ......... [23.120] decline in value ..................................... [14.70] base value of asset ............................ [14.90] calculation methods .............. [14.70]–[14.90] cost of asset ....................................... [14.90] diminishing value method ........................... [14.80], [14.110] effective life ........................................ [14.90] examples .......................................... [14.190] low value pools ................................ [14.150] prime cost method ............... [14.70]–[14.90], [14.110] residential rental premises ................ [14.20] start time ............................................ [14.70] deduction, claiming .............................. [14.40]
06-Dec-19 14:02:20
968 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Depreciating assets — cont definition ............................................... [14.30] diminishing value method ...... [14.70]–[14.90], [14.110] disposal of ........................................... [14.110] balancing adjustment on ................ [14.110], [14.120] effective life ........................................... [14.90] excluded assets .................................... [14.30] buildings ............................................. [14.35] intangible assets ................................ [14.30] land ..................................................... [14.30] holder of asset ...................................... [14.50] immediate deductions ........... [14.40], [14.140] jointly held assets ................................. [14.60] low-value pool .................................... [14.140] balancing adjustment events .......... [14.155] decline in value ................................ [14.150] taxable purpose ............................... [14.145] medium sized businesses .................. [14.165] overview ................................................ [14.20] partnerships .......................................... [14.60] changes in composition .................. [19.180] pooling of assets ................................. [14.130] low-value pool ................... [14.140]–[14.155] software development pool ............ [14.160] prime cost method ................. [14.70]–[14.90], [14.110] roll-over relief ....................... [11.430], [14.120] small business entity concessions ..... [14.165] taxable purpose .................................. [14.100] Derivation of income cash or accruals accounting ................. [16.40] deferring, tax avoidance ....................... [23.50] derive, definition ................................... [16.20] disputed amounts ............................... [16.110] dividend income ................................. [16.100] earnings method ................................... [16.40] explanatory flowchart ........................... [16.20] lay-by sales ........................................... [16.95] overview ................................... [1.140], [16.20] prepayments ............................ [16.90], [23.50] receipts method .................................... [16.40] timing of derivation .............................. [16.30] Director Penalty Notice regime ........... [24.160] Director Penalty Notices ...................... [24.202] Discretionary trusts — see also Trusts appointor ............................................... [20.40] beneficiaries .......................................... [20.40] default beneficiary provision ........... [20.150] present entitlement ........... [20.110], [20.120] splitting income between .................. [20.40] trust property administered on behalf of ........................................ [20.40] deed of settlement ................................ [20.40] dividend imputation ........................... [21.250] minor beneficiaries ............................... [20.40] overview ................................... [20.20], [20.40]
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reasons for use ........................ [20.10], [20.40] settlor .................................................... [20.40] share in trust income ............................ [20.90] tax minimisation ................................... [23.80] trustee obligations .......................................... [20.40] ownership of trust property .............. [20.40] Discrimination compensation or damages ................ [10.120] examples of awards ......................... [10.125] Disposal of assets capital gain or loss .............................. [11.450] CGT event .............................. [11.50], [11.450] depreciating assets ............................. [14.110] trading stock ......................................... [17.80] explanatory flowchart ........................ [17.10] non-arm’s length dealings .... [17.70], [23.120] ordinary course of business ............ [17.900] outside ordinary business ............... [17.110] Diverted Profits Tax proposed introduction ........................ [22.517] Dividend imputation anti-avoidance provisions benchmark rule ................................ [21.270] qualified person ............................... [21.290] benchmark rule ................................... [21.270] carry forward losses and .................... [21.230] corporate tax entity ............................ [21.160] current year losses and ...................... [21.240] disqualifying accounts ........................ [21.160] distribution, meaning ......................... [21.160] frankable distributions ........................ [21.160] franked distributions non-resident shareholders .............. [21.160] franking account ................................. [21.180] franking credits .................... [21.170], [21.180] franking debits .................................... [21.180] franking deficit tax ............... [21.170], [21.190] franking entity ..................................... [21.160] New Zealand exception ................... [21.160] gross up and tax offset ........ [21.200], [21.260] overview ................................................ [21.10] partnerships ........................................ [21.250] purpose ............................................... [21.150] qualified person, 45-day holding period rule .............. [21.290] related payment rule ........................ [21.300] shareholders non-resident ...................... [21.160], [21.260] obligations ........................................ [21.200] resident corporate ............................ [21.220] carry forward losses ...................... [21.230] current year loss ............................ [21.240] resident individual ............................ [21.210] resident partnerships ....................... [21.250] trusts ................................................. [21.250] tax offsets — see Dividend tax offsets trusts ................................................... [21.250] unfrankable distributions .................... [21.160]
06-Dec-19 14:02:20
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INDEX 969 Dividend tax offsets ................... [15.70], [15.80] gross up and tax offset ........ [21.200], [21.260] non-resident shareholders ................. [21.260] overview ................................................ [15.80] refundable ............................................. [15.80] resident corporate shareholders ........ [21.220] resident individual shareholders ........ [21.210] resident partnerships .......................... [21.250] shareholders, for ................................... [15.70] trusts ................................................... [21.250] Dividends assessability ................[4.280], [21.40], [21.60] capital gains and ................... [21.60], [21.140], [21.350] debt/equity rules ...................... [21.50], [9.150] deemed anti-avoidance provisions ............... [21.110] distributable surplus ........................ [21.130] forgiven debts to shareholders ....... [21.130] liquidator’s distributions .................. [21.140] loans to shareholders ...................... [21.130] meaning ............................................ [21.130] payments to shareholders ............... [21.130] private company tax avoidance ..... [21.110], [23.140] definition .................................. [9.150], [21.60] return of capital exception ...... [21.60], [21.70] derivation of income ........................... [16.100] foreign, exemption for .......................... [22.90] franking — see Dividend imputation imputation system — see Dividend imputation interim dividends ................................ [21.140] liquidator’s distributions ..................... [21.140] meaning of paid .................................... [21.90] non-assessable ...................... [21.60], [21.260] non-share dividends ............................. [21.80] partnerships ........................................ [19.120] private company deemed dividends ........... [21.110]– [21.130] definition ........................................... [21.120] profits .................................................. [21.100] deemed dividends ........................... [21.130] meaning ............................................ [21.100] paid out of ......................... [21.100], [21.140] share capital account definition ........... [21.70] shareholders definition ............................................. [21.50] equity interest holders as .................. [21.50] forgiven debts .................................. [21.130] loans to ............................................. [21.130] non-resident ...................... [21.160], [21.260] obligations ........................................ [21.200] partnerships ..................................... [21.250] payments to ..................................... [21.130] registration ......................................... [21.50] resident assessable income ............ [4.280], [9.150], [21.40] definition .......................................... [21.50]
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paid or credited to ............. [21.60], [21.70], [21.130] resident corporate ............................ [21.220] carry forward losses ...................... [21.230] current year loss ............................ [21.240] resident individual ............................ [21.210] trusts ................................................. [21.250] shares, from .......................................... [4.280] source of income .................................. [4.280] tax offsets — see Dividend tax offsets taxation of, overview ............................ [21.40] trusts .................................... [20.130], [21.250] withholding tax — see Dividend withholding tax Doctrine of precedent — see Precedent Double tax agreements annuities and pensions ....................... [22.490] business profits ................................... [22.460] dependent services ............................ [22.490] dual resident companies ...................... [4.220] employer, meaning ............................ [22.490] entertainers ......................................... [22.490] individuals ........................................... [22.490] list of agreements ............................... [22.440] negotiation .......................................... [22.450] overview ................................. [22.20], [22.440] passive income ................................... [22.470] primary function ................................. [22.450] real property ....................................... [22.480] sportspersons ..................................... [22.490] Tax Information Exchange Agreements ................................ [22.450] Duties — see also Stamp duty; Transfer duty additional, for foreign purchasers ...... [26.135] aggregation ......................................... [26.120] substantially one location, of ........... [26.120] calculation of duty payable ............... [26.130], [26.135] concessions ........................................ [26.152] dutiable property .................................. [26.70] apportionment ................................... [26.80] location ............................................... [26.80] trade receivables, jurisdictional nexus ............................................. [26.80] types ................................................... [26.70] dutiable property, declaration of trust over .................................. [26.90] dutiable transactions ............................ [26.90] form .................................................. [26.100] provisions ........................................... [26.90] related parties .................................. [26.115] types ................................................... [26.90] dutiable value ...................................... [26.110] exemptions ......................................... [26.154] foreign purchasers of residential property ...................................... [26.135] land — see also Landholder lease duty ............................................ [26.200] motor vehicle duty .............................. [26.200]
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970 PRINCIPLES OF TAXATION LAW 2020 Duties — cont overview ................................................ [26.00] payable, calculation ............. [26.130], [26.135] related parties ..................................... [26.115] share transfer duty .............................. [26.160] tax base .................................... [26.40], [26.50]
Copyright © 2019. Thomson Reuters. All rights reserved.
E Education GST-free supplies ............................... [25.146] Higher Education Contribution Scheme (HECS) .............................. [3.90] HELP debt repayment rates ................... [3.90] persons living overseas ....................... [3.90] Electronic delivery ................................ [24.110] Electronic distribution platform (EDP) ........................................... [25.297] Employment — see also Payroll tax expenses related to — see Deductions income from — see Personal exertion/services income Employment termination payments (ETPs) ............................................ [6.260] Entertainment expenses deductibility .......................................... [7.430] fringe benefits ....................................... [7.430] Entities — see Companies; Partnerships; Trusts Exams — see Study skills Exempt income categories of ......................................... [3.170] foreign source income ............ [4.260], [22.70] employment income .......................... [22.80] foreign service, definition .................. [22.80] list of provisions ................................... [3.170] not subject to tax .................................. [3.170] overview ......................[1.120], [3.140], [3.170] Expense payment fringe benefits exempt benefits .................................... [7.210] external benefits ................................... [7.220] otherwise deductible rule .................. [7.390] in-house benefits ..................... [7.220], [7.370] no-private-use declaration ................... [7.210] overview ................................................ [7.200] taxable value ......................................... [7.220] otherwise deductible rule .................. [7.390] reduction ............................... [7.370], [7.390] Exports GST-free supply .................................. [25.148]
F FCT v Myer Emporium case study ............................................. [8.210]
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ordinary income under first strand ............................... [8.220]–[8.250] ordinary income under second strand ............................... [8.260] Federal Court appeal to .............................. [24.260], [24.270] choice of proceedings in .................... [24.260] Fees or commissions assessable income ................................. [6.40] Finance leasing sale and leaseback .............................. [23.320] tax avoidance schemes ...................... [23.320] Financial accounting — see Accounting Financial arrangements — see also Options TOFA rules .............................................. [9.70] Financial reporting standards interpretation .......................................... [1.30] Fixed trusts — see Trusts Food GST-free supply .................................. [25.142] Foreign branch income ......................... [22.100] Foreign companies — see also Controlled foreign companies dividends, exemption for ..................... [22.90] tax rates ............................................... [22.270] Foreign income tax offset calculating ........................................... [22.140] example ............................................ [22.150] double taxation relief .......................... [22.130] foreign income tax, definition ............ [22.130] foreign tax credit replaced by ............ [22.110] maximum amount .............................. [22.130] overview ................[15.100], [22.120], [22.130] Foreign investment fund (FIF) accruals taxation regime .................... [22.160] application of rules ............................. [22.240] overview ............................... [22.160], [22.240] Foreign losses offset against domestic income ......... [22.240] overview .............................................. [22.240] quarantining ........................................ [22.240] Foreign persons land ownership by .............................. [26.275] Foreign residents assessable income .................... [4.30], [4.230] assessment ......................................... [22.270] Australian sourced income ........ [4.10], [4.30], [22.30], [22.260] tax avoidance ..................................... [23.40] beneficiaries ........................................ [20.170] capital gains tax .................................. [22.320] non-final withholding tax applied to capital gains on Australian property ...................................... [22.335] taxable Australian property ............. [22.330]
06-Dec-19 14:02:20
INDEX 971
Copyright © 2019. Thomson Reuters. All rights reserved.
Foreign residents — cont definition ............................................... [4.160] dividends imputation ......................... [21.160], [21.260] timing of derivation .......................... [22.290] withholding tax — see Dividend withholding tax interest withholding tax ....... [22.280], [22.300] Medicare levy exemption ........... [3.40], [4.30], [22.270] non-residents ...................................... [25.313] overview .......[4.160], [22.10], [22.30], [22.250] personal exertion income .................. [22.340] residence according to ordinary concepts .......................................... [4.90] residency tests ......................... [4.90], [22.250] domicile test ....................................... [4.120] royalty withholding tax ........ [22.280], [22.310] source of income ........[4.10], [4.230], [22.250] natural resources ............................... [23.40] tax avoidance ..................................... [23.40] tax-free threshold ............................... [22.270] tax rates .......................[3.200], [4.30], [22.270] withholding tax ................................ [22.280] taxation ............[4.10], [4.30], [22.30], [22.260] Foreign source income — see also Accruals taxation regime; Foreign tax credits Australia’s jurisdiction to tax ................ [22.30] double taxation, preventing ................. [22.50] employment income ............................ [22.80] exempt income ........................ [4.260], [22.70] explanatory flowchart ........................... [22.60] foreign branch income ....................... [22.100] foreign dividends .................................. [22.90] foreign service, definition ..................... [22.80] overview ......................[22.10], [22.30], [22.50] tax avoidance schemes ...................... [23.310] taxation .................................... [22.30], [22.60] temporary residents ............................. [4.150] Foreign tax credits abolition .............................................. [22.110] foreign income tax offset ................... [22.120] prior to 1 July 2008 ............................. [22.110] Forfeited deposits CGT event ........................................... [11.120] Franking of distributions — see Dividend imputation Fraud amendment of assessment ................ [24.140] ATO risk-assessment measures ........... [24.50] Freedom of information overview .............................................. [24.640] unavailable documents ...................... [24.640] Freezing orders ..................................... [24.180] Frequent flyer schemes assessability .......................................... [6.130]
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Fringe benefits — see also Fringe benefits tax benefit, definition .................................... [7.30] benefits in kind ........................................ [6.70] categories of ........................................... [7.90] deduction for cost of providing ........... [7.430] definition ................................................. [7.20] employment, in respect of .................... [6.20], [7.70], [7.75] exclusions ............................................... [7.80] non-assessable non-exempt income of employee .................................. [7.440] reporting on Payment Summary ......... [7.440] tax on — see Fringe benefits tax Fringe benefits tax (FBT) ........................ [24.10] associate benefit provided by .............................. [7.55] benefit provided to .............................. [7.65] types of ................................................. [7.55] car fringe benefits ................................. [7.100] cost basis method .............................. [7.140] exempt benefits ................................. [7.110] private use ............................. [7.100], [7.110] statutory formula method .................. [7.130] taxable value ......................... [7.120]–[7.140] categories of benefits ............................. [7.90] debt waiver benefits ............................. [7.150] taxable value ...................................... [7.160] employee benefit provided to ........ [6.70], [7.50]–[7.60] definition ............................................... [7.60] former ................................................... [7.60] future .................................................... [7.60] interaction with income tax ............... [7.440] employer benefit provided by .............................. [7.50] definition ............................................... [7.50] former ................................................... [7.50] future .................................................... [7.50] imposed on .......................................... [7.10] interaction with income tax ............... [7.430] employment relationship ....................... [7.70] exempt benefits ....................... [7.310], [7.430] membership fees ............................... [7.340] minor benefits ....................... [7.320], [7.430] single-trip tax travel ........................... [7.350] subscriptions ...................................... [7.340] work-related items ............................. [7.330] expense payment benefits ................... [7.200] exempt benefits ................................. [7.210] external benefits .................... [7.220], [7.390] in-house benefits .................. [7.220], [7.370] otherwise deductible rule .................. [7.390] taxable value ............[7.220], [7.370], [7.390] FBT rate ................................................. [7.420] grossing-up ........................................... [7.410] GST and ....................[7.410], [7.450], [25.330] historical background ................ [1.240], [7.10] imposition of tax .......................... [7.10], [7.40] income tax and employees .......................................... [7.440]
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972 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Fringe benefits tax (FBT) — cont employers .......................................... [7.430] separate tax ............................... [3.30], [7.10] legislation .............................................. [1.240] liability ................................................... [7.420] loan fringe benefits ............................... [7.170] exempt benefits ................................. [7.180] otherwise deductible rule .................. [7.390] taxable value ......................... [7.190], [7.390] meal entertainment benefits ................ [7.230] taxable value ......................... [7.240], [7.320] otherwise deductible rule ..................... [7.390] overview .................................................. [7.10] portable electronic devices .................. [7.330] property benefits .................................. [7.250] exempt benefits ................................. [7.260] external benefits ................................. [7.270] in-house benefits .................. [7.270], [7.370] taxable value ......................... [7.270], [7.370] provision of benefit ...................... [7.40], [7.50] associate, by ........................................ [7.55] associate, to ......................................... [7.65] employee, to ........................................ [7.60] employer .............................................. [7.50] former ................................................... [7.50] future .................................................... [7.50] in respect of employment ........ [7.70], [7.75] third party arranger .............................. [7.58] recipient’s contribution ........................ [7.380] reductions in taxable value .................. [7.360] in-house benefits ............................... [7.370] otherwise deductible rule .................. [7.390] recipient’s contribution ...................... [7.380] residual benefits ................................... [7.280] exempt benefits ................................. [7.290] external benefits ................................. [7.300] in-house benefits .....[7.300], [7.370], [7.380] recipient’s contribution ...................... [7.380] taxable value ............[7.300], [7.370], [7.380] tax liability ............................................. [7.420] tax year ......................................... [7.10], [7.40] benefits provided during ..................... [7.40] taxable amount ..................................... [7.410] third party arranger providing benefit ............................................. [7.58] type of benefits ..................................... [7.400]
G Gambling business or hobby .................................. [8.60] CGT exemption ................................... [11.300] General interest charge .......... [24.30], [24.140], [24.150] Gifts assessability ............................................ [6.90] deductions ........................... [13.140], [13.160]
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incurred in producing assessable income ........................................ [13.160] parliamentarians, to constituents ....... [13.160] personal gifts .......................................... [6.90] political contributions ......................... [13.150] voluntary payments ................................ [6.90] Going concerns GST-free supply .................................. [25.148] Goods and services tax (GST) ............... [24.10] administration ..................................... [25.300] adjustments ...................................... [25.310] GST groups ...................................... [25.315] non-residents ................................... [25.313] tax invoice ........................................ [25.306] timing ................................................ [25.304] agents .................................................. [25.235] application ............................................. [25.20] Australian Business Number .......................... [24.340], [25.50] Business Activity Statement ....................... [1.260], [25.300] carrying on an enterprise ..................... [25.50] enterprise, definition .......................... [25.60] excluded activities ............................. [25.60] composite supplies ............................ [25.175] consumption tax ................................... [25.10] creditable acquisition ......................... [25.190] acquisition, definition ....................... [25.200] consequences of making ................. [25.230] creditable purpose ............ [25.210], [25.220] financial supplies, related to ............ [25.217] input taxed supplies, related to ..................................... [25.214] non-deductible expenses ................ [25.240] partly creditable purpose ................. [25.220] solely creditable purpose ................ [25.220] special rules ..................................... [25.235] taxable supply .................................. [25.225] creditable importations ...................... [25.280] consequences of making ................. [25.290] explanatory flowchart ........................... [25.40] financial supplies ................................ [25.163] acquisitions related to ...................... [25.217] input taxed supplies ......................... [25.163] fringe benefits tax and ......................... [7.410], [7.450], [25.330] GST-free supplies ................ [25.140], [25.180] child care .......................................... [25.148] consequences of making ................. [25.150] education .......................................... [25.146] examples .......................................... [25.140] exports .............................................. [25.148] food .................................................. [25.142] going concerns ................................ [25.148] health ................................................ [25.144] international mail ............................. [25.148] GST groups ......................................... [25.315] importations ........................................ [25.250] creditable importations ..... [25.280], [25.290]
06-Dec-19 14:02:21
INDEX 973
Copyright © 2019. Thomson Reuters. All rights reserved.
Goods and services tax (GST) — cont digital products and low value goods .......................................... [25.295] digital supplies ................................. [22.255] low value .......................................... [25.260] non-taxable importations ................ [25.260] services ............................................ [22.255] taxable importations ......... [25.260], [25.270] income tax and ......................... [1.260], [3.30], [25.320] indirect tax .............................................. [3.30] input tax credits, entitlement to ......... [25.235] input taxed supplies ............ [25.160], [25.180] acquisitions related to ..................... [25.170], [25.214] consequences of making ................. [25.170] financial supplies .............................. [25.163] residential premises ......................... [25.167] residential rent ................................. [25.165] intangible supplies .............................. [25.297] legislation .............................................. [1.250] mixed supplies .................................... [25.175] offshore supplies ................................ [25.295] overview ...................... [1.250], [25.10]–[25.40] rate ........................................................ [25.10] registration ............................................ [25.50] annual turnover, meaning ................. [25.70] choosing to register ........................... [25.80] partnership ......................................... [19.40] taxi travel and ride-sourcing .............. [25.70] turnover threshold ............................. [25.70] reporting requirements ...................... [25.300] residential premises ........................... [25.165] definition ........................................... [25.165] rent ................................................... [25.165] sale or long-term lease .................... [25.167] services, importation of ...................... [25.255] special rules ........................................ [25.235] stock on hand ..................................... [25.235] taxable importations ........................... [25.260] consequences of making ................. [25.270] digital products and low value goods .......................................... [25.295] low value .......................................... [25.260] taxable supplies ..................... [25.90], [25.180] acquisitions where supply was .............................................. [25.225] connection with indirect tax zone ............................................. [25.120] consequences of making ................. [25.130] consideration ................................... [25.110] in the course/furtherance of an enterprise ..................... [25.115], [25.150] supply, definition ............................. [25.100] Gross income accounting ................................. [1.90], [1.100] tax purposes .............................. [1.90], [1.100] GST rulings (GSTR) .............................. [24.410]
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H Health — see also Medicare levy GST-free supplies ............................... [25.144] Medicare benefits ................................... [3.40] private health insurance offset ........... [15.160] Higher Education Contribution Scheme (HECS) overview .................................................. [3.90] Higher Education Loan Program (HELP) debt overview .................................................. [3.90] repayment rates ...................................... [3.90] Hobbies assessable income ................................. [8.60] carrying on a business ........................... [8.20] Home office expenses apportionment and capital expenses ..................................... [12.730] for convenience only .......................... [12.720] genuine ............................................... [12.710]
I Illegal activities deductibility of expenses ..................... [12.80] proceeds as assessable income .......... [5.150] Improvements capital expenditure ............................... [13.50] repairs — see Repairs separate CGT assets ........................... [11.200] Imputation — see Dividend imputation Income assessable — see Assessable income capital distinguished — see Capital or income categories of ........................................... [5.30] concept of ............................................. [1.160] constructive receipt .............................. [5.160] converting to capital ............................. [23.70] definition ................................................. [5.20] exempt — see Exempt income gross ........................................... [1.90], [1.100] mutuality ............................................... [5.170] legislation — see Tax legislation ordinary — see Ordinary income personal exertion, from — see Business income; Personal exertion/services income property — see Property income source of — see Source of income Income splitting discretionary trust beneficiaries, between ........................................ [20.40] partners ............................................... [19.150] tax arbitrage .......................................... [23.60]
06-Dec-19 14:02:21
974 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Income splitting — cont tax avoidance ........................................ [23.60] transfer of right to income from property ...................................... [23.130] Income tax Australian system ........................ [3.10], [3.30] burden ................................................... [3.100] concept of ............................................... [3.30] ETP, calculation of tax payable on ....... [6.370] formula .................................................. [3.120] introduction ........................................... [3.100] liability to pay ........................................ [3.110] partnerships .......................................... [3.110] rates .............................[1.245], [3.190], [3.210] trusts ..................................................... [3.110] Indexation cost base, of ......................... [11.490], [11.540] index reference base .......................... [11.580] Innovative Income Stream ................... [18.200] Inspector General of Taxation (IGT) Ombudsman and ................. [24.660], [24.670] role ...................................................... [24.670] Insurance companies deductions .......................................... [16.230] estimates of claims .......................... [16.240] Insurance proceeds — see also Compensation or damages business .............................................. [10.230] individual .................................. [10.60], [10.90] Interest compensation — see Compensation discounts and premiums ........................ [9.30] expenses, deductibility ....................... [12.810] capital ............................................... [12.830] gearing ................................................ [12.825] instalment payments, interest portion ........................................... [9.140] meaning .................................................. [9.20] ordinary income, as ................................ [9.40] overpayment and early payment of tax .................................................. [9.130] overview .................................................. [9.20] securities qualifying .............................................. [9.60] traditional ............................................. [9.60] source of income .................................. [4.270] taxation of financial arrangements ........ [9.70] timing of receipts .................................... [9.50] withholding tax — see Interest withholding tax Interest withholding tax foreign residents subject to ................ [22.280] overview .............................................. [22.300] rate [22.280], [22.300] International taxation — see also Foreign residents; Foreign source income
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accruals taxation — see Accruals taxation regime anti-avoidance regimes ......... [22.20], [23.250] Australia’s jurisdiction to tax ................ [22.30] base erosion and profit shifting ........... [22.30] Australian measures ........................ [22.518] diverted profits tax ............................. [22.517] double tax agreements — see Double tax agreements explanatory flowchart ........................... [22.20] legislation .............................................. [1.245] OECD Measures to Address Base Erosion and profit sharing, ......... [22.517] overview ...................... [1.245], [22.10]–[22.30] tax avoidance ...................................... [23.100] anti-avoidance regimes ...... [22.20], [23.250] hybrid entities .................................. [23.104] hybrid instruments ........................... [23.106] tax rate arbitrage .............................. [23.102] tax information exchange agreements .................. [22.500], [22.510] Automatic Exchange of Information (AEOI) .......................................... [22.513] common reporting standard (CSR) ........................................... [22.513] tax treaties ............................................. [1.245] thin capitalisation — see Thin capitalisation transfer pricing — see Transfer pricing Interpretation financial reporting standards ................. [1.30] precedent, and ........................................ [1.30] tax legislation .......................................... [1.30] Interpretative decisions — see Rulings
J Junior Minerals Exploration Incentive (JMEI) ............................................ [15.00]
L Labour related income — see Business income; Personal exertion/services income Land CGT asset ............................................ [11.170] separate CGT asset ............................. [11.200] trading stock, as .................................... [17.30] Land ownership — —see also Landholder absentee owners ................................ [26.275] aggregation of landholdings .............. [26.240] constructive ........................................ [26.180] corporations ........................................ [26.250] foreign owners .................................... [26.275] grouping .............................................. [26.250] joint ...................................................... [26.260] trusts, by (Vic) ..................................... [26.270]
06-Dec-19 14:02:21
Copyright © 2019. Thomson Reuters. All rights reserved.
INDEX 975 Land tax calculation ........................................... [26.290] exemptions ......................................... [26.280] others exemptions ........................... [26.286] primary production .......................... [26.284] principal place of residence ............. [26.282] land value measurement time ........... [26.230] landholder, imposition on .................. [26.220] legislation ............................................ [26.210] liability calculation .............................. [26.290] overview ................................. [26.00], [26.210] key issues ......................................... [26.210] possession of land .............................. [26.220] rates (Qld) ........................................... [26.290] surcharge rates absentee/foreign owners ................. [26.275] ownership of land by trusts (Vic) .... [26.270] vacant residential land tax (Vic) ...... [26.278] taxable value of land .......................... [26.230] tax-free threshold ............................... [26.230] Landholder — see also Land ownership duty ..................................................... [26.160] landholding entities ......................... [26.170] land-rich test .................................... [26.170] landholder provisions ...................... [26.160] landholders ...................................... [26.170] landholding thresholds .................... [26.170] land tax imposed on ........................... [26.220] possession of land .............................. [26.220] Law Companion Rulings (LCRs) .......... [24.415] Leases amount for obligation to repair ............ [9.180] CGT events .......................................... [11.100] duty ..................................................... [26.200] finance leases ..................................... [23.320] premiums .............................................. [9.170] tax avoidance ...................................... [23.320] Legal expenses deductibility ......................... [12.840], [12.850] Legal professional privilege (LPP) Commissioner’s access powers ........ [24.560] ATO access manual ......................... [24.580] substantiation of claims ................... [24.570] elements .............................................. [24.570] Ombudsman ....................................... [24.660] statutory privilege ............................... [24.600] third party communications ............... [24.570] Liability to pay tax .................................. [3.110] Limited GST-registration, .................... [25.313] Liquidators’ distribution to shareholders ............................... [21.140] Live stock trading stock, as .................................... [17.20] Loan fringe benefits exempt benefits .................................... [7.180] overview ................................................ [7.170] taxable value ......................................... [7.190]
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otherwise deductible rule .................. [7.390] Losses or outgoings — see also Deductions amount of deduction .......................... [12.290] actual or reasonable expense ......... [12.300] capital allowances — see Capital allowances capital or capital in nature .................. [12.170] form and substance ......................... [12.200] judicial tests ...................................... [12.180] summary .......................................... [12.210] cessation of business ......................... [16.150] child care expenses ............................ [12.370] clothing — see Clothing expenses company losses — see Companies employment-related expenses child care .......................................... [12.370] clothing — see Clothing expenses gaining employment ........................ [12.340] home office — see Home office expenses relocation .......................................... [12.360] self-education — see Self-education expenses travel — see Travel expenses foreign losses ...................................... [22.240] future expenses insurance companies ........ [16.230]–[16.240] provisions for leave .......... [16.190]–[16.210] reduction of ....................... [12.100], [16.160] timing of deduction ........... [16.190]–[16.240] future income ....................... [12.130], [16.170] home office expenses — see Home office expenses illegal activities ...................................... [12.80] incurred in gaining assessable income ........................................ [16.120] future income ................................... [12.130] incurred, meaning ............. [16.120], [16.130] involuntary expenses ....................... [12.110] past income ....................... [12.140], [12.150] temporal connection ........................ [12.120] insurance companies ......................... [16.230] estimates of claims .......................... [16.240] interest expenses ................................ [12.810] legal expenses ..................... [12.840], [12.850] non-commercial losses — see Non-commercial losses non-deductible ..................... [12.160]–[12.260] partnership losses ................................ [19.70] loans to partners .............................. [19.100] partner’s salary ................................... [19.90] positive limbs ......................... [12.40]–[12.150] previous year expenses ..................... [16.140] cessation of business ....................... [16.150] provisions for leave actual payment .................. [16.190], [16.200] timing of deduction ........... [16.190]–[16.210] year of payment ............................... [16.210] reimbursed expenditure ..................... [12.260] relocation expenses ........................... [12.360] self-education expenses — see Self-education expenses
06-Dec-19 14:02:21
976 PRINCIPLES OF TAXATION LAW 2020 Losses or outgoings — cont tax accounting .................................... [16.120] future expenses .............................. [16.160], [16.190]–[16.210] future income ................................... [16.170] incurred, meaning ............. [16.120], [16.130] insurance companies ........ [16.230]–[16.240] post-cessation of business .............. [16.150] previous year expenses .................. [16.140], [16.150] provisions for leave .......... [16.190]–[16.210] travel expenses — see Travel expenses trusts ...........................[1.160], [1.160], [20.60] Lost or destroyed assets CGT event ............................................. [11.70] compensation for capital assets .................................... [10.210] depreciable assets ........................... [10.200] trading stock ..................................... [10.220] Low income rebate ............................... [15.170] Low income superannuation tax offset ........................................... [18.120] Low income tax offset (LITO) ............... [15.30], [15.140], [15.170] Low value goods, .................................. [25.299]
Copyright © 2019. Thomson Reuters. All rights reserved.
M Mareva orders ....................................... [24.180] Meal entertainment fringe benefits overview ................................................ [7.230] taxable value ......................................... [7.240] 50/50 split method ................ [7.240], [7.320] 12-week register method ................... [7.240] Medicare levy basic levy principle ................................. [3.50] exemptions ............................................. [3.70] foreign residents not liable .................... [3.40], [4.30], [22.270] low-income earners ................................ [3.60] Medicare benefits ................................... [3.40] NDIS, funding .......................................... [3.50] overview .................................................. [3.40] reduction ................................................. [3.60] surcharge ................................................ [3.80] Membership fees deductions .......................................... [13.100] exempt fringe benefits ......................... [7.340] Mining industry tax avoidance ........................................ [23.40] Minor beneficiaries discretionary trusts ............................... [20.40] overview .............................................. [20.160] tax rates ............................................... [20.160]
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Multiple Entry Consolidated Group (MEC group) CGT events .......................................... [11.160] overview .............................................. [21.400] Mutuality principle clubs, co-operatives, associations and Owners’ Corporations ........... [5.170]
N National Tax Practitioners Board ........ [24.690] Non-arm’s length dealings tax avoidance ....................... [22.350], [23.120] trading stock .......................... [17.70], [23.120] transfer price manipulation ................ [22.350] Non-assessable non-exempt income foreign branch income ....................... [22.100] foreign dividends .................................. [22.90] fringe benefits as .................................. [7.440] list of provisions ................................... [3.170] not subject to tax .................................. [3.170] overview ......................[3.140], [3.170], [10.40] Non-commercial losses anti-avoidance rules ........................... [23.150] hobby farms ........................................ [23.150] partnerships .......................................... [19.70] Non-compliant payments for work and services ................................ [12.240] Non-residents — see Foreign residents
O Objections — see also Appeal or review amended assessment ......................... [24.210] approved form .................................... [24.210] Commissioner’s decision ................... [24.230] lodgment ............................................. [24.210] preparation expenses ......................... [24.220] review of decision — see Appeal or review rulings, against private rulings ..................... [1.290], [24.400] public rulings ....................... [1.300], [24.410] time limit ............................................. [24.210] withdrawal ........................................... [24.220] Occupation-specific clothing — see Clothing expenses Offences and penalties prescribed offences ............................ [24.200] promoters ........................................... [24.690] penalties ........................................... [24.207] rationale .............................................. [24.200] remission of penalties ........................ [24.206] return prepared by tax practitioner ... [24.205] taxation offences ................. [24.200], [24.203] Offshore information notices ............... [24.610]
06-Dec-19 14:02:21
Copyright © 2019. Thomson Reuters. All rights reserved.
INDEX 977 Ombudsman Inspector General and ......... [24.660], [24.670] powers and functions ......................... [24.660] Options CGT asset ............................................ [11.170] CGT events ............................... [11.70], [11.80] Ordinary income — see also Personal exertion/services income assessable income, part of ................... [3.140] benefit saving taxpayer money ............ [5.165] business income — see Business income capital gains tax, and ............... [5.40], [11.310] categories of income .............................. [5.30] characteristics ......................................... [5.80] flow concept .......................... [5.100]–[5.110] nexus with earning source .............................. [5.110], [5.130] regular or periodic ............................... [5.90] severable from earning source ......... [5.110] compensation ....................................... [5.140] constructive receipt ................. [3.150], [5.160] definition ..............[3.150], [5.10], [5.20], [6.10] development of concept ...................... [1.100] examples .................................. [1.170], [5.120] exceptions ........[5.40], [5.145], [5.165], [8.265] gifts .......................................................... [6.90] interest — see Interest judicial tests .......................................... [1.170] supplementary tests .......................... [1.170] legality of ............................................... [5.150] overview ...............[1.90], [1.170], [5.10], [6.10] personal exertion — see Personal exertion/services income personal gifts .......................................... [6.90] prerequisites ........................................... [5.50] cash or cash convertible ...................... [5.60] real gain ................................................ [5.70] property — see Property income receipts characterisation in taxpayers’ hand .... [5.50] extraordinary income ........................ [8.265] reward for services, as — see Personal exertion/services income unrealised gains .................................... [5.145] Overseas civilian tax offset .................. [15.190] Overseas forces rebate ......................... [15.190]
P Partnerships alienation of share of partnership income ........................................ [19.150] assessable income of partner .............. [19.60] capital gains tax .................................. [19.130] assignment of interests ................... [19.150] disposal of CGT assets .................... [19.130] new partner ...................................... [19.130]
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carrying on a business ......................... [19.40] changes in composition ..................... [19.160] depreciating assets .......................... [19.180] trading stock ..................................... [19.180] work in progress .............................. [19.170] characteristics .......................... [19.20], [19.30] compliance obligations ........................ [19.40] co-ownership distinguished ................. [19.30] corporate limited partnerships .......... [19.190], [21.20] death of partner .................................. [19.160] definition .....................[19.00], [19.20], [19.30] depreciating assets ............................... [14.30] changes in composition of partnership .................................. [19.180] dissolution of partnership .................. [19.160] dividend imputation ........................... [21.250] dividends ............................................. [19.120] Everett assignments ........................... [19.150] general taxation rules ........................... [19.10] GST, registration for ............................. [19.40] income splitting .................................. [19.150] interest payments ............................... [19.100] law of ..................................................... [19.20] liability to pay tax .................................. [3.110] limited partnerships ............... [19.190], [21.20] loans to partners ................................. [19.100] nature of ................................... [19.10], [19.20] net income ............................... [19.40], [19.60] assessable income of partner includes share of .......................... [19.60] definition ............................................. [19.60] dividends .......................................... [21.250] new partner, admission of ................. [19.160] CGT consequences .......................... [19.130] overview ................................... [19.00], [19.10] partners’ salaries ................................... [19.90] partnership agreement .......... [19.20], [19.160] partnership income .............................. [19.60] assignment of share of .................... [19.150] net income ............................ [19.40], [19.60] uncontrolled ..................................... [19.140] partnership losses ................................ [19.70] passive investment income .................. [19.30] refinancing principle ........................... [19.100] retirement of partner .......................... [19.160] CGT consequences .......................... [19.130] work in progress .............................. [19.170] statutory provisions .............................. [19.20] superannuation contributions ............ [19.110] tax advantages ...................................... [19.10] tax consequences ................................. [19.50] tax law definition ..................... [19.00], [19.30] tax returns ............................................. [19.40] tax treatments ....................................... [19.80] trading stock changes in composition of partnership .................................. [19.180] uncontrolled partnership income ...... [19.140] work in progress ................................. [19.170]
06-Dec-19 14:02:21
Copyright © 2019. Thomson Reuters. All rights reserved.
978 PRINCIPLES OF TAXATION LAW 2020 PAYG instalments ................................. [24.160] PAYG withholding ................................ [24.160] Payroll tax calculation ........................................... [26.330] employees and independent contractors ................... [26.360], [26.370] case study ........................................ [26.362] contractual relationship ................... [26.364] control .............................................. [26.362] relevant contract .............................. [26.370] relevant contract, exemptions to .... [26.380] risk .................................................... [26.366] tools and equipment ........................ [26.368] exempt organisations ......................... [26.390] exemptions ......................................... [26.380] grouping .............................................. [26.350] legislation ............................................ [26.300] ‘maximum deduction’ amounts ......... [26.330] overview ................................. [26.00], [26.300] rates ..................................................... [26.330] rebates ................................................ [26.340] taxable wages ..................................... [26.320] thresholds ........................................... [26.330] Penalties administrative ..................................... [24.201] deductibility, interest payments ......... [12.810] general interest charge (GIC) ............. [24.150] prescribed offences ............................ [24.200] rationale .............................................. [24.200] shortfall interest charge (SIC) ............. [24.150] taxation offences ................. [24.200], [24.203] Pensions account-based superannuation pensions, taxation ...................... [18.200] double tax agreements ....................... [22.490] Personal services income — see also Business income; Personal services income vs business income ................................ [8.20] capital receipts ............[6.140], [6.150], [6.170] compensation receipts ......................... [6.230] convertibility to cash ............................ [6.130] customer loyalty programs .................. [6.130] double tax agreements ....................... [22.490] foreign residents ................................. [22.340] foreign service income ......................... [22.80] non-cash benefits ..................... [6.20], [6.130], [6.240] frequent flyer schemes ...................... [6.130] fringe benefits ......................... [6.20], [6.240] ordinary income ........................... [6.10], [6.20] bonuses ..................................... [6.40], [6.70] commission .......................................... [6.40] definition ............................................... [6.20] fees for service ..................................... [6.40] gifts, personal ........................... [6.30], [6.70], [6.90], [6.100] nexus with service .........[6.20], [6.30], [6.50]
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prizes and chance winnings ............... [6.70], [6.110], [6.120] salary .................................................... [6.40] salary sacrifice ...................................... [6.60] sign-on fees ........................................ [6.180] sportspeople ........................... [6.120], [8.80] third-party payments ................ [6.40], [6.80] timing of payment ................................ [6.40] tips ............................................. [6.70], [6.80] voluntary payments .....[6.70], [6.90], [6.100] wages ................................................... [6.30] overview ................................................ [10.40] restrictive covenants ............... [6.160]–[6.170] entering a contract, on ....................... [6.170] genuine capital payment ................... [6.170] ordinary income ................................. [6.170] restraint of trade ................................. [6.170] shared economy ................................... [8.105] source .................................................... [4.260] statutory income .......................... [6.10], [6.20] compensation receipts ...................... [6.230] fringe benefits .................................... [6.240] nexus with service ............................. [6.220] requirements of s 15-2 .......... [6.190]–[6.220] return-to-work payments ................... [6.250] termination payments — see Termination of employment Personal gifts — see Gifts Personal services business business premises test ....................... [23.230] determination ....................... [23.190], [23.240] employment test ................................. [23.220] personal services entity ...................... [23.190] personal services income regime not applicable .................................... [23.190] results test ............................ [23.190], [23.200] tests for ............................................... [23.190] unrelated clients test .......................... [23.210] unusual circumstances ....................... [23.240] Personal services income anti-avoidance provisions ....... [6.60], [23.160] application of PSI regime ................... [23.160] personal services business excluded ..................................... [23.190] deductions .......................................... [23.180] meaning .............................................. [23.170] overview .............................................. [23.170] personal services business exclusion from PSI regime .............. [23.190] tests for — see Personal services business statutory provisions ............................ [23.160] tax avoidance ...................................... [23.160] Personal use assets CGT ....................................... [11.170], [11.190] exclusions ........................................ [11.190] exemption ..........[11.190], [11.220], [11.240] definition ............................................. [11.190]
06-Dec-19 14:02:22
Copyright © 2019. Thomson Reuters. All rights reserved.
INDEX 979 Plant or equipment — see Capital allowances; Leases Pooled development fund (PDF) CGT exemption ................................... [11.260] Practical Compliance Guidelines (PCG) ........................................... [24.360] Precedent doctrine of ............................................... [1.30] interpretation, and .................................. [1.30] study approach ....................................... [1.30] problem solving ........................ [1.40], [1.60] using ........................................................ [1.40] Prepayment of expenses apportionment rule ............................. [16.180] exceptions ........................................ [16.182] deductions .......................................... [16.180] deferring derivation of income ............ [23.50] derivation of income ............................. [16.90] tax avoidance ........................................ [23.50] timing of deductibility ......................... [16.180] Prior year losses — see Capital gains or losses; Tax losses Private rulings — see Rulings Prizes CGT exemption ................................... [11.300] ordinary income ......................... [6.70], [6.110] sportspersons ....................................... [6.120] Property, dutiable — —see Dutiable property Property fringe benefits exempt benefits .................................... [7.260] external benefits ................................... [7.270] in-house benefits .................................. [7.270] reduction in taxable value ................. [7.370] overview ................................................ [7.250] taxable value ......................................... [7.270] reduction ............................................ [7.370] Property income annuities ................................................ [9.210] dividends — see Dividends financial arrangements — see Financial arrangements interest — see Interest investment income as ............................ [8.90] lease amount for obligation to repair ......... [9.180] premiums ........................................... [9.170] meaning .................................................. [9.10] overview .................................................. [9.10] rent ........................................................ [9.160] royalties — see Royalties Protective clothing — see Clothing expenses Public companies — see Companies Public officers .......................................... [21.30] Public rulings — see Rulings Public trading trusts .................. [20.30], [21.20]
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R Rates of tax — see Tax rates Real property — see also Land double tax agreements ....................... [22.480] Rebates — see Tax offsets Record keeping overview .............................................. [24.520] substantiation ..................................... [24.520] Refundable tax offsets ........................... [15.40] Reimbursement of expenses assessability ......................... [10.260]–[10.290] capital receipts .................................... [10.270] deductibility ........................................ [12.260] incident of business ............................ [10.280] indemnity or recoupments ................. [10.290] ordinary course of business ............... [10.280] previously deducted expense ............ [10.260] statutory provisions ............................ [10.290] Relocation expenses deductibility ........................................ [12.360] Repairs capital expenses ................................... [13.37] deductibility .......................................... [13.30] improvements distinguished ............... [13.50] income-producing purpose .................. [13.35] initial repairs .......................................... [13.40] meaning ................................................ [13.33] notional repairs ..................................... [13.70] replacements ........................................ [13.60] Repayment income thresholds and rates for the 2018–19 Table ............ [3.4] Residency — see also Foreign residents; Source of income Australian resident, definition .......................... [4.40], [22.250] cessation, CGT event .......................... [11.130] companies .....................[4.10], [4.170], [22.40] central management and control test ....................... [4.190], [4.200] controlling shareholders .................... [4.210] dual residency .................................... [4.220] incorporation test ............................... [4.180] voting power test ............................... [4.210] determination .......................................... [4.50] domicile, meaning ................................ [4.100] domicile test ............................... [4.50], [4.100] considerations .................................... [4.120] examples ............................................ [4.120] period of absence .............................. [4.120] permanent place of abode ............... [4.110], [4.120], [4.145] individuals .......................[4.10], [4.50], [22.40] domicile test .......................... [4.100]–[4.120] ordinary concepts test .............. [4.60]–[4.90] superannuation test ........................... [4.140] tests for determining ............................ [4.50]
06-Dec-19 14:02:22
980 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Residency — cont legislative framework ............................. [4.20] 183-day rule ..................[4.50], [4.130], [4.145] ordinary concepts test ................ [4.60]– [4.90] considerations ........................... [4.80], [4.90] examples .............................................. [4.90] question of fact and degree ................. [4.70] resides, definition ................................. [4.60] overview ..........................[4.10], [4.40], [22.40] period of ................................................ [4.145] resident, definition ..........[4.40], [4.50], [4.170] statutory provisions ................................ [4.20] superannuation test ................... [4.50], [4.140] tax rates and ........................................... [4.30] temporary residents ............................. [4.150] Residential premises definition ............................................. [25.165] GST, input taxed supplies rent ................................................... [25.165] sale or long-term lease .................... [25.167] Retirement early retirement scheme payments ......................... [6.340], [6.350] threshold ............................................ [6.360] small business CGT concessions ....... [11.360] transition to retirement accounts ....... [18.215] Returns — see Tax returns Royalties assessability of ..............[8.265], [9.10], [9.200] definition ................................ [9.190], [22.310] overview ................................................ [9.190] source of income .................................. [4.290] Royalty withholding tax definition of royalty ............................. [22.310] foreign residents subject to ................ [22.280] overview .............................................. [22.310] rates ...................................... [22.280], [22.290] Rulings amendment of assessments .............. [24.400] class rulings ........................................ [24.430] Commissioner’s assumptions ............ [24.400] common rules ..................................... [24.380] GSTR 2018/1 ....................................... [25.120] GSTR 2018/2 ....................................... [25.120] inconsistent rulings ............................ [24.390] interpretative decisions ........................ [1.290] legislative regime ................................ [24.370] oral rulings .......................................... [24.490] application for .................................. [24.400] further information, request for ....... [24.400] future event, assumptions about ........................................... [24.400] inconsistent ruling ............................ [24.390] overview ................................. [1.280], [24.370] private rulings ........................ [1.290], [24.450] application for ................... [24.400], [24.460] application only to rule .................... [24.460]
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delay in issue .................................... [24.470] further information, request for ....... [24.400] future event, assumptions about ...... [24.400] inconsistent ruling ............................ [24.390] interpretative decisions ..................... [1.290] objection against .............................. [24.400] register of ......................................... [24.480] product rulings .................................... [24.420] public rulings ......................... [1.300], [24.410] inconsistent private ruling ............... [24.390] Project Refresh .................................... [24.410] taxation determinations ...................... [24.440]
S Salary or wages — see also Payroll tax compensation for loss of ......... [6.230], [10.60] insurance or indemnity ......... [10.60], [10.90] loss of earning capacity ..................... [10.80] lump sum ........................................... [10.70] payment to employer ........................ [10.70] replacement principle ........................ [10.60] partners’ salaries ................................... [19.90] salary sacrifice ........................... [6.60], [23.90] tax benefits ....................................... [18.140] source of services income ................... [4.260] taxable wages ..................................... [26.320] Sale and leaseback tax avoidance ...................................... [23.320] Sale of capital assets — see Disposal of assets Sale of property — see also Trading stock source of income .................................. [4.250] Secrecy .................................................. [24.620] Self-education expenses deductibility ........................................ [12.580] apportionment ................................. [12.690] capital expenses .............................. [12.660] nexus, establishing .......................... [12.610] private or domestic expenses ......... [12.670] relating to current career ................. [12.600] travel expenses ................................ [12.620] unrelated to employment income ... [12.640] up-to-date requirement ................... [12.630] Youth Allowance deduction ............ [12.640] definition ........................................ [12.640] employment income, not related to .. [12.640] non-deductible .................................... [12.680] Seminars deductibility of registration fees ........ [12.690] Serious Financial Crimes Taskforce .................................... [24.203] Services income — see Personal exertion/services income Shareholders definition ............................................... [21.50]
06-Dec-19 14:02:22
INDEX 981
Copyright © 2019. Thomson Reuters. All rights reserved.
Shareholders — cont dividends — see Dividend imputation; Dividends registration ............................................ [21.50] tax offsets for ........................... [15.70], [15.80] Shares CGT assets .......................................... [11.170] CGT events .......................................... [11.110] liquidation ......................................... [21.140] PDF shares ....................................... [11.260] debt/equity rules ................................... [9.150] dividend income from — see Dividends liquidation ............................ [11.110], [21.140] Sharing economy Air BNB .................................................. [8.105] Airtasker ................................................ [8.105] ATO’s Black Economy Taskforce ........................ [8.105], [24.680] income tax obligations ......................... [8.105] personal services .................................. [8.105] Shortfall interest charge ......... [24.30], [24.150] Similar Business Test (SiBT) ................ [21.340] Single Touch Payroll ............................. [24.160] Small business entities cash or accruals accounting ................. [16.50] CGT concessions ............................... [11.320], [11.550], [21.350] basic conditions ............................... [11.330] 15-year exemption ........................... [11.340] 50% reduction .................................. [11.350] retirement concession ..................... [11.360] roll-over relief .................... [11.370], [11.430] turnover test ..................................... [11.330] concessional unincorporated offset ........................................... [15.130] deductions, timing .............................. [16.185] depreciating assets ............................. [14.165] roll-over relief ...................................... [11.430] tax rates .................................. [3.210], [15.130] Small Taxation Claims Tribunal .......... [24.280] Source of income — see also Foreign source income; Residency ascertaining source ................. [4.230], [22.40] assessable income ............................... [4.230] categories of income ............................ [4.230] companies ............................................... [4.10] dividends ............................................... [4.280] foreign residents .........[4.10], [4.230], [22.250] Australian sourced income taxed .................................... [4.10], [4.30] natural resources ............................... [23.40] tax avoidance ..................................... [23.40] tax rate .................................................. [4.30] individuals ............................................... [4.10] interest .................................................. [4.270] legislative framework ............................. [4.20]
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overview ........................[4.10], [4.230], [22.30] royalties ................................................. [4.290] salary or wages ..................................... [4.260] sale of property ..................................... [4.250] services income .................................... [4.260] tax avoidance ........................................ [23.40] trading stock ......................................... [4.240] Sportspersons carrying on a business ........................... [8.80] double tax agreements ....................... [22.490] ordinary income ......................... [6.110], [8.80] playing fees ............................................. [8.80] prizes ........................................ [6.110], [6.120] sign-on fees .......................................... [6.180] Stamp duty — see also Duties failure to lodge documents for stamping ..................................... [26.140] legislation .............................................. [26.20] harmonisation .................................... [26.30] overview ................................... [26.00], [26.20] key issues ........................................... [26.50] tax base .................................... [26.40], [26.50] Standard GST-registration .................. [25.313] Start-up companies GST exemption for investments ........ [11.265] State taxes overview ................................... [26.00], [26.10] revenue authorities ............................... [26.10] stamp duty — see Stamp duty States and territories governance ........................................... [26.10] powers .................................................. [26.10] taxes — see State taxes Statutory income — see also Capital gains tax assessable income, part of ................... [3.140] capital gains tax, and .......................... [11.310] constructive receipt rule ....................... [3.160] definition .................................... [3.160], [5.10] dividends ............................................... [9.150] employment and services, from .......... [6.190] overview ..........................[3.160], [5.10], [6.10] receipts .................................................. [8.265] royalties ................................................. [9.190] Strict liability ......................................... [24.203] Structured settlements ........................ [10.140] Study skills assignments applying law to problem .................... [2.180] approach ............................................ [2.110] authority ............................................. [2.240] body text ............................................ [2.230] conclusion ............................. [2.190], [2.260] glossary of terms ............................... [2.490] identifying issues ............................... [2.140] introduction ........................................ [2.220] note-taking ......................................... [2.170]
06-Dec-19 14:02:22
982 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Study skills — cont plan ..................................................... [2.210] post-writing check .............................. [2.270] referencing ......................................... [2.250] research — see resources, —below structure ............................................. [2.220] understanding question ..................... [2.130] course aims ...................................................... [2.20] assessment ........................................... [2.40] exam format ......................................... [2.50] knowledge level required .................... [2.30] development, problem-solving skills ............................................... [2.310] exams applying law to problem .................... [2.410] conclusion .......................................... [2.420] format ................................................... [2.50] glossary of exam terms ..................... [2.490] identifying relevant law ...................... [2.400] multiple-choice ................................... [2.370] open-book .......................................... [2.360] preparation ............................ [2.280]–[2.330] problem-type questions .................... [2.390] reading time ....................................... [2.350] resources to take in .............................. [2.50] sample question and answers ............................ [2.430]–[2.450] techniques ............................. [2.340], [2.460] mistakes ................................... [2.120], [2.330] notes and summaries detailed .................................... [2.90], [2.170] overviews ............................................. [2.80] purpose ................................................ [2.70] sample ....................................... [2.70], [2.80] resources allowed in exams ................................. [2.50] case law ....................[2.160], [2.165], [2.180] casebooks .......................................... [2.100] citing authority ...................... [2.240], [2.400] guidebooks ......................................... [2.100] legislation .............................. [2.150], [2.180] list of helpful links .............................. [2.480] referencing ......................................... [2.250] study plan overview ............................................... [2.60] Subscriptions exempt fringe benefits ......................... [7.340] Substantiation of deductions requirements ....................................... [24.520] Superannuation age limits ............................................. [18.125] age for access ..................................... [18.170] transition to retirement accounts ........[18.215] benefits — see Superannuation benefits contributions — see Superannuation contributions definition ............................................... [18.10]
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Fund Ruling 2009/1 ................................. [8.90] funds — see Superannuation funds guarantee charge .................................. [18.10] overview ................................... [18.00], [18.10] preservation age ................... [18.170] [18.215] transition to retirement accounts ........[18.215] residency test ........................................ [4.140] salary sacrifice ........................... [6.60], [23.90] tax benefits ....................................... [18.140] self-managed funds ................. [18.20], [18.30] simplified law ........................................ [18.10] superannuation guarantee charge ....... [18.10] tax offsets ................................. [15.70], [15.90] tax shelters ............................................ [23.90] taxation of .............................. [18.50], [18.130] transition to retirement accounts ....... [18.215] Superannuation benefits death benefit ....................................... [18.220] binding death benefit nomination .......[18.225] entitlement ....................................... [18.225] taxation ............................................. [18.230] taxation case study .......................... [18.230] income streams, taxation ......[18.200], [18.210] lump sum payments taxation taxed fund, from .............................. [18.180] untaxed fund, from .......................... [18.190] pension or annuity, taxation .............. [18.200] self-managed funds ................. [18.20], [18.30] simplified law ........................................ [18.10] tax offset .................................. [15.70], [15.90] taxation of ........................................... [18.160] income stream ................................. [18.200] lump sum payments ......... [18.180], [18.190] Superannuation contributions age limits ............................................. [18.125] co-contribution scheme ..................... [18.110] concessional contributions .................. [18.70] cap ...................................................... [18.80] contribution caps carried forward cap ............................ [18.80] concessional ....................................... [18.80] non-concessional ............................. [18.100] employer contributions ........................ [18.70] government co-contributions ............ [18.110] low income superannuation tax offset ........................................... [18.120] non-concessional contributions ........... [18.90] cap .................................................... [18.100] partnerships ........................................ [19.110] self-employed taxpayer, by .................. [18.70] taxation of .............................. [18.60], [18.140] Superannuation funds ............................ [14.20] access to ............................................. [18.170] transition to retirement accounts ...... [18.215] complying superannuation funds ........ [18.30] taxation ............................................. [18.130] Constitutionally Protected Funds ......... [18.40] contributions received by, taxation of ................................... [18.140]
06-Dec-19 14:02:22
INDEX 983 Superannuation funds — cont death benefit ....................................... [18.220] binding death benefit nomination .................................. [18.225] entitlement ....................................... [18.225] taxation ............................................. [18.230] taxation case study .......................... [18.230] earnings, taxation of ........................... [18.150] income .................................................. [18.10] non-complying superannuation funds ............................................. [18.30] overview ................................................ [18.20] preservation age ................................. [18.170] transition to retirement accounts ...................................... [18.215] self-managed funds (SMSF) ............................. [18.20], [18.30] taxation of ............................ [18.140], [18.150] contributions received ..................... [18.140] deeming provisions for “income stream mode” ............................. [18.150] earnings ............................................ [18.150] taxed and untaxed ................................ [18.40] trust, form of ......................................... [18.20] Superannuation guarantee charge ........ [18.10]
Copyright © 2019. Thomson Reuters. All rights reserved.
T Tax accounting advice ...................................................... [1.50] cash or accruals .................................... [16.40] large business .................................... [16.60] small business entities ....................... [16.50] switching between methods ........................... [16.70], [16.80] deductions, timing of .......................... [16.120] bad debts .......................................... [16.220] future expenses .............................. [16.160], [16.190]–[16.210], [16.230]–[16.240] future income ................................... [16.170] incurred, meaning ............. [16.120], [16.130] insurance companies ........ [16.230]–[16.240] non-business expenditure ............... [16.186] post-cessation of business .............. [16.150] prepaid expenses .............. [16.180], [16.182] previous years ................... [16.140], [16.150] provisions for leave .......... [16.190]–[16.210] small business entities ..................... [16.185] derivation of income ................ [16.20], [16.40] derive, definition ................................ [16.20] disputed amounts ............................ [16.110] dividend income .............................. [16.100] lay-by sales ......................................... [16.95] prepayments ...................................... [16.90] timing of derivation ............................ [16.30] financial accounting distinguished ..... [16.10], [16.120]
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financial year ......................................... [16.10] income year .......................................... [16.10] lay-by sales ........................................... [16.95] overview ................................................ [16.10] prepayment of expenses apportionment rule .......................... [16.180] derivation of income .......................... [16.90] exceptions to 12-month rule ........... [16.182] timing of deductibility ...................... [16.180] recoverable debt ................................... [16.40] small business entities cash or accruals ................................. [16.50] deductions, timing ........................... [16.185] trading stock — see Trading stock Tax administration assessment — see Assessment ATO role — see Australian Taxation Office collection — see Collection of tax explanatory flowchart ........................... [24.10] legislation .............................................. [1.245] overview ................................................ [24.10] self-assessment .................................... [24.40] Tax advice accounting advice, distinction ............... [1.50] overview .................................................. [1.50] Tax arbitrage income splitting .................................... [23.60] multinational entities .......................... [23.100] tax rate arbitrage ................................. [23.102] Tax practitioners, regulation of code of professional conduct ............ [24.695] complaints and investigations ........... [24.698] “safe-harbour” provisions .................. [24.690] Tax Practitioners Board (TPB) ............ [24.690] Taxation officers ................................... [24.620] Tax avoidance — see also Tax minimisation capital gains tax .................................... [23.80] converting income to capital ................ [23.70] deemed dividends for private companies ................... [21.110], [23.140] deferring derivation of income ............ [23.50] discretionary trusts ............................... [23.80] Diverted Profits Tax ............................ [22.517] excessive payments to associates ..... [23.120] explanatory flowchart ........................... [23.10] general anti-avoidance regime ........... [23.20], [23.260] amendments to Pt IVA ...... [23.270], [23.290] historical background ...................... [23.260] key elements of Pt IVA ..................... [23.270] specific provisions and ...................... [23.20] tax avoidance scheme — see Tax avoidance schemes hobby farms ........................................ [23.150] income splitting ..................... [23.60], [23.130] partners ............................................ [19.150] international ........................................ [23.100] anti-avoidance regimes ...... [22.20], [23.250]
06-Dec-19 14:02:22
984 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Tax avoidance — cont hybrid entities .................................. [23.104] hybrid instruments ........................... [23.106] tax rate arbitrage .............................. [23.102] non-arm’s length dealings ................. [22.350], [23.120] non-commercial losses ...................... [23.150] overview .................................. [1.130], [23.00], [23.10], [23.110] personal services income .................. [23.160] prepayments ......................................... [23.50] scheme — see Tax avoidance schemes source of income .................................. [23.40] specific provisions ................. [23.20], [23.110] priority over general provisions ........ [23.20] statutory provisions ................. [1.130], [23.20] general ................................. [23.20], [23.260] specific ................................. [23.20], [23.110] tax evasion distinguished ..................... [23.10] tax planning distinguished ................... [23.10] tax rate arbitrage ................................. [23.102] tax shelters ............................................ [23.90] techniques ............................................. [23.30] trading stock non-arm’s length dealings ................ [17.70], [23.120] purchase at overprice from associate ..................................... [23.120] transfer of right to income from property ...................................... [23.130] transfer price manipulation ................ [22.350] Tax avoidance schemes agricultural schemes .......................... [23.330] mass-marketed schemes ................. [23.330] non-recourse loans .......................... [23.330] round-robin finance ......................... [23.330] sham transactions ............................ [23.330] alternative postulate ........................... [23.290] amendments to Pt IVA ........ [23.270], [23.290] retrospective application ................. [23.270] capital gains tax .................................. [23.330] wash sales ........................................ [23.340] case law ............................................... [23.310] definition of scheme ........................... [23.280] Diverted Profits Tax ............................ [22.517] dominant purpose ............... [23.270], [23.300] criteria for determining .................... [23.300] dominant, meaning .......................... [23.300] tax benefit, to gain ............ [23.270], [23.280] Everett assignments ........................... [19.150] explanatory flowchart ........................... [23.10] finance leasing .................................... [23.320] foreign source income ....................... [23.310] High Court cases ................................. [23.310] interposed entities .............................. [23.310] key elements of Pt IVA ....................... [23.270] leasing ................................................. [23.320] mass-marketed schemes ................... [23.310] agricultural schemes ........................ [23.330]
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promoter penalties ........................... [24.690] partners, income-splitting .................. [19.150] sale and leaseback .............................. [23.320] scheme, definition ............. [23.280], [23.3210] sole or dominant purpose ...... [23.270], [23.300] factors for determining .................... [23.300] tax benefit, to gain ............ [23.270], [23.280] tax benefit ............................ [23.270], [23.290] definition ........................................... [23.290] dominant purpose of gaining ......... [23.270], [23.280] trusts ..................................................... [23.80] anti-loss trafficking provisions ........... [20.60] discretionary trusts ............................ [23.80] unilateral scheme ................................ [23.270] value shifting ....................................... [23.310] wash sales ........................................... [23.340] Tax contextual information ................. [24.600] Tax evasion — see also Tax avoidance amendment of assessment ................ [24.140] overview ................................................ [23.10] tax avoidance distinguished ................ [23.10] tax planning distinguished ................... [23.10] Tax exploitation scheme ...................... [24.207] Tax file number ATO data-matching services .............. [24.330] financial institution, failure to give to .....[24.330] no-TFN withholding mechanism ........ [24.160] partnership ............................................ [19.40] Tax gap .................................................... [24.30] Tax information exchange agreements current TIEAs ...................................... [22.510] DTAs compared .................................. [22.500] OECD/G20 BEPS project .................... [22.517] Automatic Exchange of Information (AEOI) .......................................... [22.513] common reporting standard (CSR) ....[22.513] other tax agreements ......................... [22.513] purpose ............................................... [22.500] Tax law — see also Tax legislation accounting, distinction .......................... [1.20], [1.70]–[1.140] entity relationships ............................. [1.130] expenses ............................................ [1.110] gross income ........................... [1.90], [1.100] policy considerations ......................... [1.120] recognition of receipts ............ [1.80]–[1.100] timing rules ........................................ [1.140] anti-avoidance provisions .................... [1.130] capital or revenue expenses ................ [1.110] exempt income ..................................... [1.120] gross income ............................. [1.90], [1.100] judicial concepts ................................... [1.150] income ................................... [1.160], [1.170] ordinary income ................................. [1.170] origins of ............................... [1.150]–[1.170] taxable income ................................... [1.160] trust law, and ...................................... [1.160]
06-Dec-19 14:02:23
INDEX 985
Copyright © 2019. Thomson Reuters. All rights reserved.
Tax law — cont ordinary income ............[1.90], [1.100], [1.170] judicial tests ........................................ [1.170] precedent ................................................ [1.30] recognition of receipts ........................... [1.90] sources .................................................. [1.180] case law ....................[1.270], [2.160], [2.180] legislation — see Tax legislation list of ................................................... [2.480] rulings .................................... [1.280]–[1.300] study — see also Study skills approach ................................... [1.10], [1.20] precedents ............................................ [1.30] problem-solving ........................ [1.40], [1.60] tax law rewrite ...................................... [1.210] Tax legislation administration rules .............................. [1.245] assessable income definition ................. [1.90] capital gains tax .................................... [1.230] concurrent income tax Acts ................. [1.220] fringe benefits tax ................................. [1.240] goods and services tax ......................... [1.250] income tax .................. [1.200]–[1.220], [1.240] rates .................................................... [1.245] international tax agreements ............... [1.245] interpretation ................[1.30], [2.150], [2.180] precedent ................................................ [1.30] rewrite ................................................... [1.210] Tax losses calculation ........................................... [13.180] carry forward ...................................... [13.180] companies ..........[13.190], [21.310], [21.320] continuity of ownership test ............ [21.330] franking offsets, and ......... [21.220], [21.230] individuals ........................................ [13.190] limitations ......................................... [13.200] same business test .......................... [21.340] SiBT .................................................. [21.340] unrealised losses ............................. [21.350] companies ........................................... [21.310] anti-avoidance provisions .................... [21.310]–[21.340] carry back ......................................... [21.320] carry forward .................... [11.530], [21.230], [21.310], [21.320] loss trafficking .................................. [21.310] multiplication of ............................... [21.360] pre-consolidation losses .................. [21.440] realised losses .................................. [21.320] unrealised losses ............................. [21.350] overview ................................... [3.20], [13.180] Tax minimisation — see also Tax avoidance choice of entity ..................................... [23.80] conversion of income to capital ........... [23.70] discretionary trusts ............................... [23.80] entitlement to minimise tax .................. [23.10] legal and illegal ..................................... [23.10] overview ................................................ [23.10]
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prepayments ......................................... [23.50] source of income .................................. [23.40] tax shelters ............................................ [23.90] Tax offsets carer .................................................... [15.150] carried forward ..................................... [15.60] claimable in year in which arise ........... [15.20] concessional tax offsets ........ [15.20], [15.140] capping income tax rates ................ [15.130] concessional deductions and .......... [15.120] phased out ....................................... [15.200] subsidies ........................................... [15.110] dependency offset .............................. [15.150] dividend tax offsets — see Dividend tax offsets foreign income tax offset .................. [15.100], [22.120], [22.130], [22.140], [22.150] invalid .................................................. [15.150] invalid carer ........................................ [15.150] low income rebate .............................. [15.180] low income superannuation tax offset ........................................... [18.120] low income (LITO) .............................. [15.140] order of taking .................................... [15.210] overseas civilian tax offset ................. [15.190] overseas forces rebate ....................... [15.190] overview ................................... [3.220], [15.10] payroll tax ........................................... [26.340] recognition for taxes previously levied ................................ [15.20], [15.70] refundable offsets ................................. [15.40] shareholders ............................ [15.70], [15.80] subsidies ............................................. [15.110] superannuation fund members .......................... [15.70], [15.90] superannuation funds ......................... [18.120] tapered offsets ...................................... [15.30] tax benchmarks and variations statement .................................... [15.140] transferable offsets ............................... [15.50] types ...................................................... [15.20] zone rebate ......................................... [15.180] Tax planning — see also Tax minimisation tax avoidance, and ................................ [23.10] Tax rates companies ............................................. [3.210] concessional tax offsets to cap ........... [15.90], [15.130] FBT rate ................................................. [7.420] foreign companies .............................. [22.270] foreign residents .........[3.200], [4.30], [22.270] GST ........................................................ [25.10] HELP repayments ................................... [3.90] individuals ............................................. [3.200] legislation .............................................. [1.245] progressive changes to corporate rate ................................................ [3.210] residency, and ........................................ [4.30]
06-Dec-19 14:02:23
986 PRINCIPLES OF TAXATION LAW 2020
Copyright © 2019. Thomson Reuters. All rights reserved.
Tax rates — cont small business entities ......................... [3.210] study and training support loans ........... [3.90] tax-free threshold ................................... [4.30] foreign residents .............................. [22.270] taxpayers, types of ............................... [3.190] withholding tax ................................... [22.280] working holiday markers ......... [3.200], [4.155] Tax-related expenses deductibility .......................................... [13.20] preparation of objections ................... [24.220] Tax returns approved form ...................................... [24.20] Business Activity Statement ..... [1.260], [25.300] lodgment ............................................... [24.20] overview ................................... [24.10], [24.20] partnerships .......................................... [19.40] pre-filing items ...................................... [24.30] process .................................................. [24.30] proposed reform ................................ [24.30] risk assessment by ATO ........ [24.50], [24.300] self-assessment system ....................... [24.40] trusts ..................................................... [20.10] Tax rulings — see Rulings Tax shelters ............................................. [23.90] Tax treaties — see Double tax agreements Tax year fringe benefits tax ........................ [7.10], [7.40] income tax .............................................. [7.10] Taxable income definition ............................................... [1.160] determination ........................................ [3.130] formula ..................................... [3.120], [3.130] Taxation law — see Tax law Taxation of crowdfunded donation ...... [8.107] Taxation of financial arrangements (TOFA) — see Financial arrangements Taxation power of Commonwealth ........ [3.20] Taxation Ruling 2019/D1 .......................... [8.90] Taxes composition .......................................... [26.00] Taxi travel and ride-sourcing GST registration .................................... [25.70] Uber ....................................................... [25.70] Taxpayer alerts ..................................... [24.500] Taxpayer lodgements annual tax returns ................................. [24.20] business activity statements ................ [24.35] Pay As You Go (PAYG) instalment system ........................................... [24.30] Taxpayer’s Charter ............................... [24.350] Temporary residents CGT discount, no entitlement ............. [4.150], [22.330]
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CGT main residence exemption .......... [4.150] foreign source income ......................... [4.150] non-final withholding tax applied to capital gains on Australian property ...................................... [22.335] requirements ......................................... [4.150] tax relief ................................................. [4.150] Termination of employment compensation for wrongful dismissal ...................... [10.125], [11.290] death benefit termination payment, taxation of ..................................... [6.380] early retirement scheme payments ......................... [6.340], [6.350] threshold ............................................ [6.360] employment termination payments (ETPs) ............................................ [6.260] examples ............................................ [6.280] exclusions .......................................... [6.280] “in consequence of” ............. [6.290], [6.300] non-excluded components ............... [6.370] preservation age, and ........................ [6.370] redundancy payment ......................... [6.370] requirements for ................................ [6.280] tax calculation .................................... [6.370] tax rebate ............................................ [6.370] types ................................................... [6.270] “whole of income cap” ...................... [6.370] genuine ................................................. [6.310] genuine redundancy payments .......... [6.320], [6.330], [6.350] threshold ............................................ [6.360] thresholds ............................................. [6.360] unused annual and long service leave payments ............................. [6.390] Territories — see States and territories Tertiary education HECS and HELP debts ............................ [3.90] HELP repayment rate .............................. [3.90] persons living overseas ....................... [3.90] study and training support loans ........... [3.90] Testamentary trusts ............................... [20.50] Thin capitalisation application of rules ............................ [22.390], [22.400], [22.430] exceptions ........................................ [22.400] categories of entities .......................... [22.410] debt-to-equity ratio ............................. [22.390] entities affected ................................... [22.390] financial entities .................................. [22.410] former rules ........................................ [22.380] inward-investing entities ..... [22.400], [22.410] application of rules .......................... [22.430] maximum allowable debt ................... [22.420] outward-investing entities ................. [22.400], [22.410] application of ruls ............................ [22.430] overview ................................. [22.20], [22.380]
06-Dec-19 14:02:23
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INDEX 987 Third parties collection of tax from .......................... [24.170] TOFA — see Financial arrangements Trading stock accounting for ........................ [17.50]–[17.140] acquisitions .............................. [17.60], [17.70] explanatory flowchart ........................ [17.10] non-arm’s length dealings ..... [17.70], [23.120] assessable income ............................... [17.90] deemed disposal .............................. [17.260] non-arm’s length transactions ........... [17.70] outside ordinary business ............... [17.110] capital gains tax .................................. [11.310] ceasing to be ........................ [17.260], [17.270] CGT events ............[17.250], [17.260], [17.280] common items ......................... [17.30]–[17.50] compensation for loss of .................... [10.220] computer spare parts ........................... [15.50] cost ....................................... [17.150], [17.160] definition ............................................... [17.20] disposals ................................ [17.80]–[17.110] becoming trading stock deemed ...... [17.250] ceasing to be trading stock deemed ....................................... [17.260] deemed disposals ............. [17.250], [17.260] explanatory flowchart ........................ [17.10] non-arm’s length dealings ................ [17.70], [23.120] ordinary course of business .............. [17.90] outside ordinary business ............... [17.110] explanatory flowcharts ......................... [17.10] intangible items .................................... [17.30] land ........................................................ [17.30] livestock ................................................ [17.20] obsolescence ...................................... [17.190] other tax provisions ............................ [17.290] overview ................................................ [17.10] partnership changes in composition .................. [19.180] purchase at overprice from associate ..................................... [23.120] roll-over relief ...................................... [11.430] source of income .................................. [4.240] stock on hand ..................................... [17.220] stocktake ............................................. [17.120] taxpayer’s asset becoming trading stock ................... [17.250] ceasing to be trading stock ............. [17.260] value at end of year ............................ [17.140] absorption cost method .................. [17.150] cost .................................... [17.150], [17.160] direct cost method ........................... [17.150] market selling value ......................... [17.170] new livestock from reproduction ............................... [17.200] obsolescence ................................... [17.190] replacement value ........................... [17.180] value at start of year ........................... [17.130] year-end adjustments ......................... [17.120]
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Training support loans rates of repayment ................................. [3.90] persons living overseas ....................... [3.90] Transfer duty — —see also Duties additional for foreign purchasers ....... [26.135] calculation of duty payable ................ [26.130] determination steps .............................. [26.60] foreign purchasers of residential property ...................................... [26.135] overview ................................... [26.00], [26.60] rates (NSW) ......................................... [26.130] relevant acquisition ............................ [26.190] Transfer pricing application of provisions .................... [22.350] arm’s length principle .......... [22.350], [22.360] compliance with requirements .......... [22.370] country-by-country reporting ............. [22.375] disclosure of information ................... [22.370] International Dealing Schedule .......... [22.370] methodologies .................................... [22.360] new rules ............................................. [22.350] non-arm’s length agreements ............ [22.370] OECD guidelines ................................. [22.350] overview ................................. [22.20], [22.350] tax avoidance ...................................... [22.350] Transferable offsets ................................ [15.40] Transportation bulky items .......................................... [12.420] Travel expenses alternative workplaces ........................ [12.430] between home and work ................... [12.390] outside normal work hours ............ [12.390], [12.400] between workplaces ............ [12.440], [13.110] car expenses ....................................... [12.450] “cents per kilometer” method ......................... [12.460]–[12.480] “log book” method ............ [12.550]–[12.570] carrying bulky items ........................... [12.420] ‘fly in-fly out’ employees .................... [12.390] itinerant workers ................................. [12.410] self-education ..................................... [12.620] substantiation ..................................... [12.320] Treasury Laws Amendment Bill 2018 ....... [15.00] Trust income Bamford case ........................................ [20.90] interim measures in response to ..... [20.100] capital and income ................ [1.160], [20.130] capital gains CGT discount .................................... [20.130] distributed to beneficiaries .............. [20.130] compensation or damages received by trustee .................................... [10.100] definition ............................................... [20.80] discretionary trusts ............................... [20.40] default beneficiary provision ........... [20.150] share in, meaning .............................. [20.90]
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988 PRINCIPLES OF TAXATION LAW 2020
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Trust income — cont distributed to beneficiaries ................. [20.130] character preserved ......................... [20.130] dividend imputation ........................... [21.250] dividends ............................................. [20.130] income of the trust estate .................... [20.80] losses .................................................... [20.60] minor beneficiaries ................ [20.40], [20.160] tax rates ............................................ [20.160] net income ............................... [20.60], [20.80] adjustment of ..................................... [20.80] trust income distinguished ................ [20.80] share in, meaning ................................. [20.90] proportionate vs quantum view ........ [20.90] taxation of ................................ [20.00], [20.60] beneficiary presently entitled, not under legal disability .................... [20.70] beneficiary presently entitled, under legal disability .................. [20.140] no beneficiary presently entitled ..... [20.150] trustees ............................................. [20.150] trust and tax law ................................... [1.160] Trusts bare trusts ............................................. [20.20] beneficiaries — see Beneficiaries CGT events ............................. [11.90], [20.180] corporate limited .................................. [21.20] definition ............................................... [20.20] discretionary trusts .................. [20.20], [20.40] appointor ............................................ [20.40] beneficiaries ....................................... [20.40] deed of settlement ............................. [20.40] default beneficiary provision ........... [20.150] dividend imputation ......................... [21.250] minor beneficiaries ............................ [20.40] reasons for use ..................... [20.10], [20.40] settlor .................................................. [20.40] splitting income between beneficiaries .................................. [20.40] trustee obligations ............................. [20.40] fixed trusts ............................... [20.20], [20.30] income — see Trust income land ownership by (Vic) ...................... [26.270] legislative provisions relating to taxation of ..................................... [20.10] liability to pay tax .................................. [3.110] losses or outgoings ................. [1.160], [20.60] nature of ................................................ [20.10] overview ................................... [20.00], [20.10] public trading trusts .............................. [20.30] taxed as companies .............. [20.30], [21.20] reasons for use ..................................... [20.10] superannuation funds — see Superannuation funds tax avoidance ........................................ [23.80] anti-loss trafficking provisions ........... [20.60] discretionary trusts ............................ [23.80] tax returns ............................................. [20.10] taxation of, overview ............... [20.10], [20.60]
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taxation of income — see Trust income testamentary trusts ............................... [20.50] types of trusts ....................................... [20.20] unit trusts .............................................. [20.30] corporate unit trust ............... [20.30], [21.20] public trading trusts .............. [20.30], [21.20] taxed as companies .............. [20.30], [21.20]
U Uniforms — see Clothing expenses Unit trusts beneficiaries’ entitlement to income ...... [20.30] corporate unit trusts ................ [20.30], [21.20] overview ................................................ [20.30] public trading trusts .............................. [20.30] taxed as companies .............. [20.30], [21.20] units compared to shares ..................... [20.30]
V Valour decorations CGT exemption ................................... [11.230] Value shifting tax avoidance scheme ........................ [23.310]
W Wages — see Salary or wages Wash sales tax avoidance ...................................... [23.340] Withholding tax dividends — see Dividend withholding tax interest ................................. [22.280], [22.300] PAYG withholding .............................. [24.160] purpose of regime .............................. [22.280] rates ..................................................... [22.280] royalties ................................ [22.280], [22.310] Work in progress partnership, change in composition ......[19.170] Working holiday makers ........... [3.200], [4.155] Wrongful dismissal compensation ...................... [10.125], [11.290]
Y Youth Allowance self-education expenses and ............. [12.640]
Z Zone rebate ........................................... [15.180]
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