Taxation law 9780409340600, 040934060X

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LexisNexis Questions and Answers

Taxation Law Dr Elfriede Sangkuhl BComFinSy (UNSW), LLB (Hons) (WSU), PhD

Tenille Buttigieg BBus (WSU), CA

LexisNexis Butterworths Australia 2016

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Sangkuhl, Elfriede. Taxation Law. 9780409340600 (pbk). 9780409340617 (ebk). Series: LexisNexis questions and answers. Notes: Includes index. Subjects: Taxation law — Law and legislation — Australia. Income tax — Law and legislation — Australia. Value-added tax — Law and legislation — Australia. Tax deductions — Australia. Depreciation allowances — Law and legislation — Australia. Other Authors/Contributors: Buttigieg, Tenille. Dewey Number: 343.9404 © 2016 Reed International Books Australia Pty Limited trading as LexisNexis. This book is copyright. Except as permitted under the Copyright Act 1968 (Cth), no part of this publication may be reproduced by any process, electronic or otherwise, without the specific written permission of the copyright owner. Neither may information be stored electronically in any form whatsoever without such permission. Inquiries should be addressed to the publishers. Typeset in Sabon LT Std and Optima LT Std.

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Preface This book was written with the aim of providing students of taxation law with a practical text that can be read on its own, or read to accompany an additional textbook on taxation law. The book explains the core principles of taxation law as well practical exercises for students to test their understanding of the law. I encourage students to attempt to answer the questions in the book before resorting to reading the sample answers provided in the book. Students are also encouraged to make use of the extensive and practical resources provided by the Australian Tax Office (ATO). Throughout the book you will find references to ATO Taxation Rulings and Guides. I urge students to access these resources as they provide splendid examples of various taxation law issues together with information on the approach taken by the ATO in dealing with these issues in most scenarios. I am grateful for the contributions of Tenille Buttigieg, my co-author. I am also grateful for the professionalism and patience shown by the publisher, especially by the commissioning editor, Georgina Gordon, and the editor, Catherine Britton. Elfriede Sangkuhl July 2016

Table of Cases References are to paragraph numbers A Antsis v Federal Commissioner of Taxation [2009] FCA 286 …. 6-16 Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314 …. 3-8 B Babka v Federal Commissioner of Taxation (1989) 20 ATR 1251 …. 416, 4-44 Bennett v Federal Commissioner of Taxation (1947) 75 CLR 480 …. 412 BHP Billiton Petroleum (Bass Strait) Pty Ltd v Federal Commissioner of Taxation [2002] FCAFC 433 …. 3-10 Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 …. 33, 3-25, 3-28, 4-12, 4-38 Broken Hill Theatres Pty Ltd v Federal Commissioner of Taxation (1952) 85 CLR 423 …. 6-20 Brookton Co-operative Society Ltd v Federal Commissioner of Taxation (1981) 147 CLR 441 …. 3-9 Brown v Commissioner of Taxation [2002] FCA 318 …. 4-7

C Case U80 (1987) 87 ATC 470 …. 6-18 Cecil Bros Pty Ltd v Federal Commissioner of Taxation (1964) 111 CLR 430 …. 2-22 Charles Moore & Co (WA) v Federal Commissioner of Taxation (1956) 95 CLR 344 …. 6-4 Commercial Union Assurance Co of Australia v Federal Commissioner of Taxation (1977) 77 ATC 4186 …. 3-16 Commissioner of Taxation v Bamford; Bamford v Commissioner of Taxation [2010] HCA 10 …. 10-9 — v Day [2008] HCA 53 …. 6-5, 6-33 — v Harris [1980] FCA 60 …. 4-7 — v Stone [2005] HCA 21 …. 4-11, 4-41 Commissioners of Inland Revenue v Lysaght [1928] AC 234 …. 2-4, 231 Commissioners of Taxation v Meeks (1915) 19 CLR 568; [1915] HCA 34 …. 2-16 D Deputy Commissioner of Taxes v Executor Trustee & Agency Co of South Australia Ltd (1938) 63 CLR 108; [1938] HCA 69 …. 3-7 E Esquire Nominees Ltd v Federal Commissioner of Taxation (1973) 129 CLR 177 …. 2-20 Evans v Federal Commissioner of Taxation (1989) 20 ATR 922 …. 416, 4-32 F Federal Commissioner of Taxation v Applegate [1979] FCA 37 …. 2-7, 2-34 — v Citylink Melbourne Ltd [2006] HCA 35 …. 3-12

— v Collings (1976) ATC 4254 …. 6-13 — v Cooper (1991) 21 ATR 1616 …. 6-22, 6-48 — v Dixon (1952) 86 CLR 540 …. 4-3, 4-29, 4-33, 4-41 — v Edwards (1994) 28 ATR 87 …. 6-18 — v Everett (1980) 143 CLR 440 …. 9-15 — v Finn (1961) 106 CLR 60 …. 6-16 — v French [1957] 98 CLR 398 …. 2-15 — v Hatchett (1971) 125 CLR 494 …. 6-15 — v James Flood Pty Ltd (1953) 88 CLR 492 …. 3-14 — v Jenkins (1982) 82 ATC 4098 …. 2-7 — v Maddalena (1971) 2 ATR 541 …. 6-10, 6-48 — v McDonald (1987) 78 ALR 588 …. 9-6, 9-9, 9-16 — v McPhail (1968) 117 CLR 111 …. 7-19 — v Miller (1946) 73 CLR 93 …. 2-4 — v Mitchum (1965) 113 CLR 401; [1965] HCA 23 …. 2-15 — v Myer Emporium Ltd (1987) 163 CLR 199 …. 4-20, 4-50, 4-51 — v Roberts & Smith (1992) 92 ATC 4380; 23 ATR 494 …. 9-12 — v Snowden & Wilson Pty Ltd (1958) 99 CLR 431 …. 6-6 — v Spotless Services Ltd (1995) 95 ATC 4775 …. 2-19 — v St Hubert’s Island Pty Ltd (in liq) [1978] HCA 10 …. 3-19 — v Studdert (1991) 22 ATR 762 …. 6-15 — v Sutton Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277 …. 3-18 — v Walker (1985) 16 ATR 331 …. 4-15, 4-47 — v Western Suburbs Cinema Ltd (1952) 86 CLR 102 …. 7-9, 7-36 — v Whitfords Beach Pty Ltd (1982) 150 CLR 355 …. 4-20 — v Whiting (1943) 68 CLR 199 …. 10-12 — v Wiener (1978) ATC 4006 …. 6-13, 6-39 Ferguson v Federal Commissioner of Taxation (1979) 9 ATR 873 ….

4-15, 4-35, 4-47 Fullerton v Federal Commissioner of Taxation (1991) ATC 4983 …. 611, 6-48 H Harmer v Federal Commissioner of Taxation [1991] HCA 51 …. 10-13 Henderson v Federal Commissioner of Taxation (1970) 119 CLR 612 …. 3-7, 3-28 Herald and Weekly Times Ltd v Federal Commissioner of Taxation (1932) 48 CLR 113 …. 6-6 Higgs v Olivier [1952] Ch 311 …. 4-12 I Investment Merchant Finance Corporation Ltd v Federal Commissioner of Taxation [1971] HCA 35 …. 3-19 J Jarrold v Boustead (1963) 41 TC 701 …. 4-12 Joachim v Federal Commissioner of Taxation (2002) 50 ATR 1072 …. 2-5 K Kelly v Federal Commissioner of Taxation (1985) 85 ATC 4283 …. 411 Koitaki Para Rubber Estates Ltd v Federal Commissioner of Taxation (1941) 64 CLR 241; [1941] HCA 13 …. 2-12 Kosciusko Thredbo Pty Ltd v Federal Commissioner of Taxation (1983) 15 ATR 165 …. 4-24 L Laidler v Perry [1965] 2 All ER 121 …. 4-8 Law Shipping Co Ltd v IRC (1923) 12 TC 621 …. 7-8, 7-42 Levene v Commissioners of Inland Revenue [1928] AC 217 …. 2-4, 2-

31, 2-34 Lindsay v Federal Commissioner of Taxation (1960) 106 CLR 377 …. 7-7 Lodge v Federal Commissioner of Taxation (1972) ATC 4174 …. 6-12, 6-48 Lunney v Federal Commissioner of Taxation; Hayley v Federal Commissioner of Taxation (1958) 100 CLR 478 …. 6-13, 6-39, 648 Lurcott v Wakely & Wheeler [1911] 1 KB 905 …. 7-6, 7-42, 7-43 M Malayan Shipping Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156; [1946] HCA 7 …. 2-12 Mansfield v Federal Commissioner of Taxation (1995) 31 ATR 367 …. 6-18 Martin v Federal Commissioner of Taxation (1953) 90 CLR 470 …. 416 — v — (1984) ATC 4513 …. 6-12, 6-48 Memorex Pty Ltd v Federal Commissioner of Taxation (1987) 19 ATR 553 …. 4-18, 4-53, 4-54 Morris v Federal Commissioner of Taxation (2002) 50 ATR 104 …. 618 P Pickford v Federal Commissioner of Taxation (1998) 40 ATR 1078 …. 4-12 Placer Pacific Management Pty Ltd v Commissioner of Taxation [1995] FCA 1362 …. 3-17 — v Federal Commissioner of Taxation (1995) 95 ATC 4459 …. 6-9 Planche v Fletcher (1779) 99 ER 164 …. 2-1 Point v Federal Commissioner of Taxation (1970) 119 CLR 453 …. 315, 7-11

R RACV Insurance Pty Ltd v Federal Commissioner of Taxation (1974) 74 ATC 4169 …. 3-16 Reuter v Federal Commissioner of Taxation (1993) 24 ATR 527 …. 412 S Samuel Jones & Co (Devondale) Ltd v IRC (1951) 32 TC 513 …. 7-7 Scott v Federal Commissioner of Taxation (1966) 117 CLR 514 …. 46, 4-29, 4-44 — v — [2002] ATC 2158 …. 9-9, 9-22, 9-29 Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation (1950) 81 CLR 188 …. 4-20, 4-51 Softwood Pulp and Paper v Federal Commissioner of Taxation (1976) 7 ATR 101 …. 4-17 Spriggs v Federal Commissioner of Taxation; Riddell v Federal Commissioner of Taxation (2009) ATC 9689; [2009] HCA 22 …. 6-10 Steele v Deputy Commissioner of Taxation (1999) 197 CLR 459 …. 68, 6-36, 6-38 Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 …. 6-21, 6-51 T Thomas v Federal Commissioner of Taxation (1972) 3 ATR 165 …. 415, 4-44, 4-47 Trautwein v Federal Commissioner of Taxation (No 2) (1936) 56 CLR 196 …. 4-16 V Vegners, Re v Commissioner of Taxation [1991] FCA 35 …. 10-10 W

W Neville & Co Ltd v Federal Commissioner of Taxation (1937) 56 CLR 290 …. 6-7 W Thomas & Co Ltd v Federal Commissioner of Taxation (1965) 115 CLR 58 …. 7-42, 7-43 Westfield Ltd v Federal Commissioner of Taxation (1991) 21 ATR 1398 …. 4-20, 4-51

Table of Statutes References are to paragraph numbers COMMONWEALTH A New Tax System (Goods and Services Tax) Act 1999 …. 1-1, 12-1 Div 13 …. 12-22 Div 19 …. 12-24 Div 38 …. 12-8, 12-20, 12-28, 12-31, 12-34 Div 38 Subdiv 38A …. 12-9 Div 38 Subdiv 38B …. 12-10 Div 38 Subdiv 38C …. 12-11 Div 38 Subdiv 38E …. 12-12 Div 38 Subdiv 38F …. 12-14 Div 38 Subdiv 38G …. 12-14 Div 38 Subdiv 38I …. 12-14 Div 38 Subdiv 38J …. 12-13 Div 38 Subdiv 38K …. 12-14 Div 38 Subdiv 38L …. 12-14 Div 38 Subdiv 38M …. 12-14 Div 38 Subdiv 38N …. 12-14 Div 38 Subdiv 38O …. 12-14

Div 38 Subdiv 38P …. 12-14 Div 38 Subdiv 38Q …. 12-14 Div 40 …. 12-15, 12-20, 12-28, 12-31, 12-34 Div 40 Subdiv 40A …. 12-16 Div 40 Subdiv 40B …. 12-17, 12-34 Div 40 Subdiv 40C …. 12-18 Div 40 Subdiv 40D …. 12-19 Div 40 Subdiv 40E …. 12-19 Div 40 Subdiv 40F …. 12-19 s 9-5 …. 12-6, 12-20, 12-28, 12-31, 12-34 s 9-15 …. 12-31 s 9-20 …. 12-5, 12-25, 12-31 s 9-20(1)(c) …. 12-34 s 9-20(2) …. 12-5 s 9-25(1) …. 12-31 s 9-30(3) …. 12-19 s 9-40 …. 12-37 s 9-70 …. 12-20, 12-31 s 11-1 …. 12-31, 12-37 s 11-5 …. 12-21, 12-31 s 11-15 …. 12-31 s 11-15(2)(1) …. 12-21 s 11-20 …. 12-31 s 11-25 …. 12-21, 12-31 s 12-2 …. 12-6 s 13-5 …. 12-22 s 13-5(3) …. 12-22 s 13-10(b) …. 12-22 s 13-20 …. 12-22

s 15-1 …. 12-37 s 15-5 …. 12-23 s 15-15 …. 12-23 s 17-5 …. 12-24 s 23-5 …. 12-31 s 29-10 …. 12-24 s 29-40 …. 12-24 s 38-1 …. 12-20 s 38-10(1)(c) …. 12-10 s 38-325 …. 12-13 s 38-A …. 12-37 s 38-E …. 12-37 s 40-1 …. 12-20 s 40-75 …. 12-18 s 42-10 …. 12-22 s 69-5 …. 12-21 s 87-25 …. 12-17 s 144-5 …. 12-5 s 195-1 …. 12-17, 12-18 Sch 1 …. 12-9 Sch 3 …. 12-10 A New Tax System (Goods and Services Tax Administration) Act 1999 …. 12-1 A New Tax System (Goods and Services Tax) Regulations 1999 reg 23-15.01 …. 12-5, 12-28, 12-34 reg 23-15.02 …. 12-5 reg 40-5.09 …. 12-16 reg 40-5.12 …. 12-16 Sch 7 …. 12-16

Bankruptcy Act 1966 …. 10-15 Corporations Act 2001 s 9 …. 11-6 Criminal Code Act 1995 …. 1-10 s 70 …. 7-28 Customs Tariff Act 1995 Sch 4 …. 12-22 Fringe Benefits Tax Act 1986 …. 1-1 Fringe Benefits Tax Assessment Act 1986 …. 1-1 Higher Education Support Act 2003 …. 7-23 Income Tax Act 1986 …. 1-1 Income Tax Assessment Act 1936 …. 1-1, 1-12, 1-21, 1-36, 1-40, 2-7, 3-3, 3-7, 3-25, 3-28, 9-6, 9-7 Pt I …. 1-13 Pt II …. 1-14 Pt III …. 1-15 Pt III Div 5 …. 9-4 Pt IV …. 1-16 Pt IVA …. 1-17 Pt VA …. 1-18 Pt VIIB …. 1-19 Pt VIII …. 1-20 Pt X …. 1-21 Div 2 …. 1-15 Div 3 …. 1-15 Div 5 ss 90–94 …. 1-15 Div 6 …. 10-3 Div 6 ss 95AAA–102UY …. 1-15 Div 6AA …. 9-11, 9-34, 10-10, 10-17, 10-18 Div 7 ss 102V–109ZE …. 1-15

Div 17 ss 159H–160AAA …. 1-15 Div 109B …. 11-7 s 6 …. 1-13, 2-6, 2-8, 2-28, 4-21, 10-2, 10-6, 11-13 s 6(1) …. 2-31 s 6(1)(a) …. 2-7 s 6(a)(ii) …. 2-9 s 6(a)(iii) …. 2-10 s 6(b) …. 2-12 s 6C …. 2-21 s 6CA …. 2-21 s 8 …. 1-14 s 14 …. 1-14 s 18 …. 3-1 s 21A …. 1-15, 4-19, 4-31, 4-41, 4-43 s 21A(1) …. 4-5 s 27H …. 4-27 s 44 …. 1-15, 3-9, 4-25, 10-20, 11-1, 11-13, 11-14, 11-25, 11-34, 11-37, 11-40 s 44(1)(a) …. 2-20 s 44(1)(a)(i) …. 3-9 s 44(1)(b) …. 2-20 s 51(1) …. 3-16, 6-1, 6-4, 9-6 s 51AH …. 6-25, 7-32 s 63 …. 3-15 s 82A …. 6-16 s 82KZL …. 3-13, 3-31 ss 82KZL–82KZMG …. 3-13 s 90 …. 9-4, 9-9, 9-22, 9-25, 9-28, 9-33 ss 90–94 …. 9-4

s 91 …. 9-4 s 92 …. 9-9, 9-22, 9-27, 9-30, 11-37 s 92(1) …. 9-4, 9-9 s 92(2) …. 9-4, 9-9 s 92(3) …. 9-4 s 92(4) …. 9-4 s 95 …. 10-9 ss 95–102 …. 10-3 s 95A(2) …. 10-8, 10-20 s 97 …. 10-15, 10-17, 10-20, 11-40 s 97(1)(a) …. 10-10 s 98 …. 10-15, 10-20 s 98(1) …. 10-14 s 98(1)(a) …. 10-14 s 98(1)(b) …. 10-14 s 99 …. 10-15, 10-20 s 99(1) …. 10-15 s 99(2) …. 10-15 s 99A …. 10-15 s 99A(2) …. 10-15 s 102AC(2) …. 9-11, 9-34, 10-17 s 102AE(2) …. 9-11, 10-17 s 102AG(2)(c) …. 10-15 s 109 …. 11-7 s 109(1)(a) …. 11-7 s 109(1)(b) …. 11-7 s 109C(1)(b) …. 11-7 s 109CA(1) …. 11-7

s 109D …. 11-7 s 109D(1) …. 11-7 s 109E …. 11-7 s 190F …. 11-7 s 109F(1) …. 11-7 s 177A …. 1-17 s 177B …. 1-17 s 177C …. 1-17 s 177D …. 1-17 s 251R …. 1-28, 1-35, 1-41 s 251S …. 1-28, 1-35, 1-41, 1-44 s 252(1) …. 11-4 s 252(1)(f) …. 11-4 Income Tax Assessment Act 1997 …. 1-1, 1-2, 1-3, 1-4, 1-5, 1-6, 1-12, 1-13, 1-21, 1-31, 1-36, 1-40, 5-12, 5-31, 5-34, 5-35, 6-27, 6-29, 630, 7-1, 7-2, 8-3, 9-5, 11-21 Ch 1 …. 1-4, 1-6 Ch 1 Div 6 …. 1-5 Ch 1 Div 9 …. 1-4 Ch 2 …. 1-7, 1-15 Ch 2 Pt 2-15 …. 1-7 Ch 2 Pt 2-20 …. 1-7 Ch 2 Pt 2-40 …. 1-7 Ch 2 Pt 2-42 …. 1-7 Ch 3 …. 1-8 Ch 4 …. 1-9, 2-23 Ch 5 …. 1-10 Ch 6 …. 1-11 Pt 3 …. 5-1

Pt 3-1 …. 5-1 Pt 3-1 Divs 100-211 …. 1-8 Pt 3-1 Subdiv 118-100 …. 5-22 Pt 3-2 …. 5-1 Pt 3-3 …. 5-1 Pt 3-3 Divs 122-152 …. 1-8 Pt 3-5 …. 1-8 Pt 3-6 …. 1-8 Pt 3-10 …. 1-8 Pt 3-25 …. 1-8 Pt 3-30 …. 1-8 Pt 3-32 …. 1-8 Pt 3-35 …. 1-8 Pt 3-45 …. 1-8 Pt 3-90 …. 1-8 Div 1 …. 1-4 Div 2 …. 1-3 Div 15 …. 1-3, 1-7, 4-2, 4-28 Div 17 …. 1-7 Div 25 …. 1-7, 7-2, 7-3, 7-4 Div 26 …. 1-7, 6-24, 7-2, 7-3, 7-21 Div 28 …. 6-14, 7-14, 7-44, 7-45, 8-6 Div 30 …. 1-7, 7-19 Div 30 Subdiv 30-DA …. 7-19 Div 32 …. 1-7, 6-25, 7-31 Div 35 …. 1-7, 4-14, 4-16, 4-48, 7-20 Div 35 s 35-5(1) …. 4-14 Div 36 …. 1-7, 7-20, 7-39, 7-41, 7-51, 7-52, 7-53, 11-19 Div 40 …. 1-7, 8-1, 8-5, 9-13

Div 40 Subdiv 40-C …. 8-13 Div 40 Subdiv 40-B …. 8-5 Div 40 Subdiv 40-E …. 8-15 Div 40 Subdiv 40-H s 40-725 …. 8-19 Div 40 Subdiv 40-I …. 8-20 Div 43 …. 1-7, 8-2, 8-4, 8-25, 9-13 Divs 50A-59 …. 1-7 Divs 61-67 …. 1-7, 1-29 Div 63 …. 1-29 Div 70 …. 1-7, 3-18, 9-13 Divs 80-83 …. 1-7 Divs 84-87 …. 1-7 Div 104 …. 5-7, 5-9 Div 104 s 104-1 …. 5-31 Div 114 …. 5-17 Div 115 …. 5-16, 5-28, 5-31, 5-37, 5-39 Div 118 …. 5-9 Div 122 …. 1-8 Div 128 …. 5-1 Div 136 …. 5-3 Div 152 …. 1-8, 5-1, 5-9, 5-34 Div 152 Subdiv 152-A …. 5-10 Div 165 …. 7-51, 7-52, 7-53, 11-21 Div 165 Subdiv 165-A …. 7-20, 11-19 Div 165 Subdiv 165-E …. 11-21 Div 200 …. 11-8 Div 205 …. 11-10 Div 207 …. 11-13

Div 207 Subdiv 207-B …. 11-15 Div 328 …. 3-21, 8-18 Div 768 …. 2-31 Div 900 …. 1-10, 6-26 Div 900 Subdiv 900-B …. 6-26 Div 900 Subdiv 900-C …. 6-26, 7-17, 7-18 Div 900 Subdiv 900-D …. 6-26 Div 905 …. 1-10 s 1-1 …. 1-4 s 1-2 …. 1-4 s 2-1 …. 1-3 s 3-5 …. 4-1 s 4-1 …. 1-22, 11-1 s 4-10 …. 1-6, 1-22, 1-31, 1-35, 1-36, 1-38, 11-22, 11-25, 11-37, 11-40 s 4-10(3) …. 1-24 s 4-15 …. 1-6, 1-31, 1-35, 6-1, 6-27, 7-39, 7-41, 11-22, 11-25, 1134, 11-37, 11-40 s 4-15(1) …. 1-23, 4-1, 11-5 s 6-1(1) …. 4-1 s 6-5 …. 3-4, 3-20, 3-25, 3-28, 4-13, 4-14, 4-21, 4-29, 4-33, 4-35, 437, 4-41, 4-43, 4-44, 9-9, 9-22, 9-25, 9-30, 10-20, 11-25, 11-34, 11-37, 11-40 s 6-5(1) …. 1-5, 4-2, 4-3 s 6-5(2) …. 2-2, 2-14, 2-25 s 6-5(3) …. 2-2, 2-14 s 6-5(3)(a) …. 2-25 s 6-5(4) …. 3-3, 3-21 s 6-10 …. 4-37, 9-9

s 6-10(1) …. 4-2 s 6-10(2) …. 4-2 s 8-1 …. 3-11, 6-1, 6-2, 6-3, 6-4, 6-5, 6-10, 6-18, 6-21, 6-29, 6-30, 6-40, 7-1, 7-2, 7-12, 9-12, 9-25 s 8-1(1) …. 3-16, 3-20, 6-19, 6-27, 6-29, 6-30, 6-33, 6-36, 6-39, 642, 6-43, 6-45, 6-46, 6-48, 8-35, 9-22, 11-25, 11-34 s 8-1(1)(a) …. 3-11, 3-31 s 8-1(1)(b) …. 6-51, 6-52 s 8-1(2) …. 6-21, 6-29, 6-30, 7-2 s 8-1(2)(a) …. 6-21, 6-51, 9-6 s 8-1(2)(b) …. 6-22, 6-33, 6-36, 6-39, 6-48 s 8-1(2)(c) …. 6-23 s 8-1(2)(d) …. 6-24, 6-48 s 8-2(2) …. 6-30 s 8-5 …. 6-1, 6-27, 7-1, 11-40 s 8-10 …. 7-1 s 12-5 …. 7-2 s 13-1 …. 1-29, 1-38, 1-40 s 15-1 …. 1-3 s 15-2 …. 4-5, 4-6, 4-28, 4-29, 4-31, 4-32, 4-41, 4-43 s 15-3 …. 4-28 s 15-5 …. 4-28 s 15-15 …. 4-20, 4-28 s 15-15(1) …. 4-14 s 15-15(2) …. 4-14 s 15-20 …. 4-26, 4-28, 4-35 s 15-22 …. 4-28 s 15-23 …. 4-28 s 15-25 …. 4-28

s 15-30 …. 4-28 s 15-35 …. 4-28 s 15-40 …. 4-28 s 15-45 …. 4-28 s 15-46 …. 4-28 s 15-50 …. 4-28 s 15-55 …. 4-28 s 15-65 …. 4-28 s 15-70 …. 4-28 s 15-75 …. 4-28 s 25-5 …. 7-4 s 25-10 …. 7-5, 7-36 s 25-10(1) …. 7-42 s 25-10(3) …. 7-42 s 25-19(3) …. 7-42 s 25-25(1) …. 7-10 s 25-25(5) …. 7-10 s 25-35 …. 7-11 s 25-55 …. 7-12 s 25-100 …. 7-13, 7-32 s 25-100(3) …. 7-13 s 25-100(4) …. 7-13 s 26 …. 6-48 s 26-5 …. 6-24, 7-21 s 26-10 …. 3-13, 7-22, 7-54 s 26-19 …. 6-16 s 26-20 …. 6-16, 6-24, 7-23 s 26-30 …. 6-24, 7-24 s 26-35 …. 6-24, 7-25

s 26-35(1) …. 7-33 s 26-35(2)(a) …. 7-33 s 26-35(4) …. 7-33 s 26-40 …. 7-26 s 26-45 …. 6-24, 7-27 s 26-52 …. 6-24, 7-28 s 26-53 …. 7-29 s 26-54 …. 6-24 s 28-13(1) …. 7-14 s 28-13(2) …. 7-14 s 28-13(3) …. 7-14 s 28-15 …. 7-14 s 28-20 …. 7-14 s 28-20(2) …. 7-14 s 28-25 …. 6-14, 7-14, 7-15, 7-45, 7-48 s 28-45 …. 6-14, 7-14, 7-16, 7-48 s 28-50 …. 7-45 s 28-50(1) …. 7-45 s 28-60 …. 7-16 s 28-70 …. 6-14, 7-14, 7-17, 7-48 s 28-75 …. 7-16, 7-17 s 28-90 …. 6-14, 7-14, 7-18, 7-45, 7-48 s 28-95 …. 7-18 s 30-15 item 2 …. 12-25 s 30-242 …. 7-19 s 30-243(3) …. 7-19 s 30-243(4) …. 7-19 s 32-10 …. 7-31

s 32-30 …. 7-31, 7-57 s 32-35 …. 7-31, 7-57 s 32-40 …. 7-31 s 32-45 …. 7-31, 7-57 s 35-10 …. 7-20 s 35-30 …. 4-14 s 35-35 …. 4-14 s 35-40 …. 4-14 s 35-45 …. 4-14 s 36-10 …. 7-20, 7-39, 11-19 s 36-17 …. 7-51, 11-19 s 36-17(2) …. 7-51 s 36-55 …. 11-14 s 40-15 …. 8-1 s 40-25 …. 8-3 s 40-25(1) …. 8-3 s 40-30 …. 8-4, 8-14, 8-38 s 40-30(1) …. 8-4 s 40-30(2) …. 8-4, 8-5 s 40-35 …. 8-3 s 40-45(2) …. 8-4 s 40-50 …. 8-5 s 40-50(2) …. 8-5 s 40-55 …. 8-6 s 40-60 …. 8-7 s 40-60(2) …. 8-7, 8-26 s 40-70 …. 8-8 s 40-72 …. 8-32, 8-35, 8-44 s 40-75 …. 8-8, 8-29

s 40-80(2) …. 8-7, 8-41, 8-43, 8-44, 8-46 s 40-100 …. 8-11 s 40-105 …. 8-11 s 40-180 …. 8-13 s 40-180(3) …. 8-26 s 40-185 …. 8-13, 8-26 s 40-190 …. 8-13, 8-26 s 40-280 …. 8-14 s 40-285 …. 8-14, 8-38 s 40-295 …. 8-14 s 40-300 …. 8-14, 9-13 s 40-300(1)(b) …. 8-14 s 40-300(2) …. 9-13 s 40-305 …. 8-14 s 40-340(2) …. 9-13 s 40-420 …. 8-15 s 40-425 …. 8-16, 8-47 s 40-440 …. 8-16, 8-47, 8-48 s 40-450 …. 8-17 s 40-455 …. 8-17 s 40-830(3) …. 8-22 s 40-832(1) …. 8-23 s 40-840 …. 8-21 s 40-880 …. 8-24 s 43-1 …. 8-2 s 43-10(2) …. 8-25 s 43-30 …. 8-25 s 43-140 …. 8-25

s 43-145 …. 8-25 s 51-10 …. 6-23 s 63-10 …. 1-29 s 67-25 …. 1-29 s 70-1 …. 3-18 s 70-5 …. 3-18 s 70-10(a) …. 3-18 s 70-10(b) …. 3-18 s 70-35 …. 3-20 s 70-35(2) …. 3-20 s 70-35(3) …. 3-20 s 70-40 …. 3-20 s 70-45 …. 3-20 s 70-100 …. 9-13 s 70-100(2) …. 9-13 s 70-100(4) …. 9-13 s 100-10 …. 5-1 s 100-15 …. 5-4 s 100-25 …. 5-31 s 100-25(1) …. 5-2 s 100-25(2) …. 5-8, 5-33 s 100-25(3) …. 5-8 s 100-30(1) …. 5-9 s 100-30(2) …. 5-9 s 100-30(3) …. 5-9 s 100-45 …. 5-13, 5-37 s 100-55 …. 5-34 s 102-5 …. 5-6, 5-28, 5-37 s 102-25 …. 5-37

s 104-5 …. 5-7, 5-13, 5-34 s 104-10 …. 5-31 s 104-10(1) …. 5-22 s 104-10(4) …. 5-22 s 104-10(5) …. 5-9 s 104-10(5)(a) …. 5-31 s 104-20(1) …. 5-22 s 106-5 …. 9-15, 9-37 s 108-5 …. 5-7, 5-31 s 108-10 …. 5-8 s 108-10(2) …. 5-31, 5-34 s 108-10(4) …. 5-31 s 108-20 …. 5-31, 5-34 ss 108-20-108-30 …. 5-8 s 108-20(2) …. 5-31 s 110-25 …. 5-13 s 110-25(2) …. 5-14, 5-31, 5-37 s 110-25(3) …. 5-14, 5-31, 5-37 s 110-25(4) …. 5-14, 5-31, 5-37 s 110-25(5) …. 5-14, 5-31 s 110-25(6) …. 5-14, 5-31 s 110-35 …. 5-13, 5-31 s 110-35(1) …. 5-15 s 110-35(2) …. 5-15, 5-31, 5-37 s 110-35(3) …. 5-15, 5-31, 5-37 s 110-35(4) …. 5-15 s 110-35(5) …. 5-15 s 110-35(6) …. 5-15

s 110-36 …. 5-17 s 110-36(2) …. 5-17 s 110-40(2) …. 5-14 s 110-55 …. 5-18 s 115-10 …. 5-16 s 115-15 …. 5-16 s 115-20 …. 5-16 s 115-25 …. 5-16 s 116-20 …. 5-31 s 116-20(1) …. 5-13 s 116-30 …. 5-37 s 118-5 …. 5-9, 5-34 s 118-10 …. 5-9 s 118-10(1) …. 5-34 s 118-10(3) …. 5-34 s 118-12 …. 5-9 s 118-37(1) …. 5-9 s 118-37(1)(c) …. 5-9 s 118-100 …. 5-11, 5-19 s 118-110 …. 5-34 s 118-120 …. 5-11 s 118-120(3) …. 5-11 s 118-120(5) …. 5-11 s 118-120(6) …. 5-11 s 118-145 …. 5-12 s 118-145(1) …. 5-12 s 118-145(2) …. 5-12 s 118-145(3) …. 5-12, 5-25, 5-26 s 118-185 …. 5-12, 5-28

s 152-5 …. 5-34 s 152-20(1) …. 5-10 s 152-20(2) …. 5-10 s 152-40 …. 5-10 s 152-105 …. 5-10 s 152-205 …. 5-10 s 152-300 …. 5-34 s 152-305 …. 5-10 s 152-400 …. 5-10 s 165-10 …. 7-51, 11-20 s 165-12 …. 11-43 s 165-12(1) …. 11-20 s 165-12(2) …. 11-20 s 165-12(3) …. 11-20 s 165-12(4) …. 11-20 s 165-13 …. 11-21 s 165-210 …. 11-21 s 200-5 …. 11-8 s 200-10 …. 11-9 s 200-15 …. 11-10 s 200-15(1) …. 11-9 s 200-25(1) …. 11-11 s 202-55 …. 11-11 s 202-60 …. 11-25, 11-34, 11-37, 11-40 s 202-60(2) …. 11-11 s 202-65 …. 11-11 s 202-75 …. 11-12 s 202-80(3) …. 11-12

s 203-35(1) …. 11-12 s 205-70(1) …. 11-11 s 205-70(2) …. 11-11 s 207-15 …. 11-14 s 207-20 …. 10-20, 11-14 s 207-35 …. 10-20 s 207-35(1) …. 9-14 s 207-45 …. 11-25, 11-37 s 328-10 …. 3-21 s 328-50 …. 3-21 s 328-110 …. 3-21, 8-18 s 328-115 …. 3-21 s 328-120(1) …. 3-21 s 328-120(5) …. 3-21 s 768-905 …. 2-11 s 768-910(3)(a) …. 2-11 s 995 …. 1-38, 2-11, 3-1, 3-19, 3-22, 4-47, 7-29, 7-31, 9-1, 9-5, 916, 9-19, 10-1, 11-3 s 995-1 …. 4-14 Income Tax Rates Act 1986 …. 1-1, 1-24, 1-31, 1-35, 1-36 s 23 …. 1-27, 1-32, 11-5 Sch 7 …. 1-24, 1-32 International Tax Agreements Act 1953 …. 1-1 Migration Act 1958 …. 2-3, 2-30, 2-31 Public Service Act 1922 …. 6-5 Taxation (Interest on Overpayments and Early Payments) Act 1983 …. 4-28 NEW SOUTH WALES

Partnership Act 1892 …. 9-2 s 1 …. 9-1, 9-5

Contents

Preface Table of Cases Table of Statutes Chapter 1

Introduction and Income Tax Basics

Chapter 2

International Tax

Chapter 3

Income Tax Accounting

Chapter 4

Assessable Income

Chapter 5

Capital Gains and Losses

Chapter 6

General Deductions

Chapter 7

Specific Deductions

Chapter 8

Capital Allowances

Chapter 9

Partnerships

Chapter 10

Trusts

Chapter 11

Companies and Shareholders

Chapter 12

Goods and Services Tax

Index

[page 1]

Chapter 1

Introduction and Income Tax Basics

Key Issues 1-1 The imposition of income tax in Australia is governed by complex and interdependent Commonwealth legislation. The most important legislation is: • Income Tax Assessment Act 1997 (ITAA 1997); and • Income Tax Assessment Act 1936 (ITAA 1936). These two Acts came about when the Commonwealth Government decided to rewrite the ITAA 1936 in order to remove undue complexity. As a result the Tax Law Improvement Project (TLIP) was instituted to complete this task. Subsequently, the Commonwealth Government disbanded the TLIP before the work was completed. As a result the ITAA 1997 exists alongside the ITAA 1936 and both Acts deal with the imposition of tax. This legislation is to be considered in conjunction with other tax legislation included in: • A New Tax System (Goods and Services Tax) 1999 (GST Act 1999); • Fringe Benefits Tax Assessment Act 1986 (FBT 1986); • International Tax Agreements Act 1953; • Income Tax Act 1986; • Income Tax Rates Act 1986 (ITRA 1986); and • Fringe Benefits Tax Act 1986.

The above list is not comprehensive; it merely lists the more relevant pieces of legislation for the purposes of this work.

Overview of the ITAA 1997 1-2 The ITAA 1997 is arranged into six chapters. Each chapter is further divided into parts, divisions and sections of the legislation.

Types of sections Guides 1-3 These sections appear at the front of each division and tell the reader ‘What this division is about’. For example, the Guide to Div 2 [page 2] in ITAA 1997 s 2-1 states ‘this Act is designed to help you identify accurately and quickly the provisions that are relevant to your purpose in reading the income tax law’. Another example, in ITAA 1997, the Guide to Div 15, found in s 15-1 states, ‘This Division sets out some items that are included in your assessable income’. Other material to help the reader 1-4 The other material can be checklists, examples or useful information explaining the impact of the operating provisions that follow. For example, ITAA 1997, Div 1, contains no operative provisions but consists of preliminary information. Section 1-1 is the ‘Short Title’, ‘This Act may be cited as the Income Tax assessment Act 1997,’ s 1-2 ‘This Act commences on 1 July 1997’ and so on. Most of Ch 1 of ITAA 1997 consists of explanatory material with few operative provisions. For example, Div 9 of Ch 1 consists entirely of checklists that guide the reader to appropriate operative provisions in the Act. Operative provisions

1-5 Operative words ‘in a formal legal document such as an enactment … are … the words that have legal operation to affect rights and liabilities of persons covered by the enactment’.1 The operative provisions are the ones that impose legal obligations on taxpayers. For example, in ITAA 1997 Ch 1, Div 6, the operative provisions of the Act commence. The first operative provision is s 6-5(1) which states ‘Your assessable income includes income according to ordinary concepts, which is called ordinary income’.

Chapters of ITAA 1997 Chapter 1 — Introduction and core provisions 1-6 This chapter provides a guide to the Act and how to navigate the legislation. The core provisions in this chapter deal with ordinary income, exempt income, non-assessable non-exempt income, general deductions and specific deductions. The chapter also details how to ‘work out taxable income’ (ITAA 1997 s 4-15) and ‘how to work out how much income tax you must pay’ (ITAA 1997 s 4-10). Chapter 2 — Liability rules of general application 1-7 This chapter deals with a large variety of matters and contains most of the operative provisions dealing with assessable income and allowable deductions: [page 3] • • • •

Division 15 contains the rules relating to ‘Some items of assessable income’. Division 17 deals with the ‘effect of GST etc on assessable income’. Division 25 contains the rules about deductibility of particular kinds of expenses, that is, various types of specific deductions. Division 26 deals with expenditure ‘you cannot deduct, or cannot

• • • • • • •

•

• •

•

deduct in full’. Division 30 deals with gifts or contributions. Division 32 deals with the deductibility and limits to the deductions for entertainment expenses. Division 35 deals with the special deferral rules for treating losses from non-commercial business activities. Division 36 deals with the treatment of tax losses of earlier income years. Division 40 deals with the deductibility of capital allowances, that is, depreciation expense. Division 43 deals with deductions for capital works. Chapter 2, Pt 2-15 contains Divs 50A–59, which deal with nonassessable income. These divisions deal with income earned by entities exempt from taxation, exempt income and other pensions, benefits, receipts and allowances that are exempt from income tax. Chapter 2, Pt 2-20 contains Divs 61–67, which deal with tax offsets. Tax offsets are entitlements provided to taxpayers who assist in the maintenance of dependants who are unable to work, or because of their care obligations. Division 70 deals with the tax treatment of trading stock. Chapter 2, Pt 2-40 contains Divs 80–83, which deal with rules affecting employees in the matters of pay as you go (PAYG) withholding payments, employment termination payments, unused annual leave and long service leave payments. Chapter 2, Pt 2-42 contains Divs 84–87, which deal with personal services income.

Chapter 3 — Specialist liability rules 1-8 This chapter deals with particular liability rules pertinent to particular transactions and particular types of taxpayers. The majority of the chapter deals with capital gains tax (CGT). The chapter then deals with particular types of taxpayers, such as companies, superannuation funds, insurance companies, primary producers etc: • Part 3-1, Divs 100–211, deals with general topics relating to CGT.

•

The Part explains how to calculate a capital gain or loss, explains what constitutes a CGT event and what constitutes capital assets. Part 3-3, Divs 122–152, deals with specialist CGT topics and taxpayers. For example, Div 122 deals with the CGT consequences of transferring CGT assets to a company. Division 152 deals with [page 4]

• • • • •

• • •

•

the various CGT concessions and special treatment afforded to small business. Part 3-5 deals with corporate taxpayers and corporate distributions. Part 3-6 deals with the dividend imputation system. Part 3-10 deals with the taxation of various financial transactions and financial arrangements. Part 3-25 deals with Australian managed investment trusts. Part 3-30 deals with superannuation covering matters such as superannuation contributions, excess concessional contributions, the taxation of superannuation entities and the taxation treatment of superannuation benefits. Part 3-32 deals with co-operatives and mutual entities. Part 3-35 deals with insurance business, life insurance and general insurance companies. Part 3-45 deals with particular industries and occupations: – small business entities; – research and development; – films; – primary production; – forestry managed investment schemes; and – above-average special professional income of authors, inventors, performing artists, production associates and sportspersons. Part 3-90 deals with consolidated groups.

Chapter 4 — International aspects of income tax 1-9 This chapter deals with taxation matters pertinent to foreign taxpayers and foreign source income. The chapter covers topics such as exempt foreign income, foreign income tax offsets, foreign currency gains and losses, cross-border transfer pricing and thin capitalisation rules. Chapter 5 — Administration 1-10

This chapter deals with record-keeping and other obligations:

•

Division 900 deals with the rules for the substantiation of deductions as follows: – Subdivision 900-B substantiating work expenses; – Subdivision 900-C substantiating car expenses; – Subdivision 900-D substantiating business travel expenses; – Subdivision 900-E written evidence; – Subdivision 900-F travel records; – Subdivision 900-G retaining and producing records; – Subdivision 900-H relief from the effects of failing to substantiate deductions claimed; and – Subdivision 900-I award transport payments; and Division 905 deals with offences, and states that the Criminal Code applies to all offences against the tax legislation.

•

[page 5] Chapter 6 — The dictionary 1-11 This chapter includes a dictionary of terms used in the legislation and also contains operative provisions.

Overview of the ITAA 1936 1-12 Large tracts of the ITAA 1936 have been rewritten and placed in the ITAA 1997. However, the ITAA 1936 still contains many extremely

important and substantive sections of the income tax legislation. The ITAA 1936 does not contain chapters, but is arranged into parts, divisions and sections. The ITAA 1936 was largely written well before 1997 and, as a result, the language of the 1936 Act may be difficult to understand as it uses older forms of expression. Part I — Preliminary 1-13 Section 6 of this part is an ‘Interpretation’ section containing the definition of terms used in the legislation. Many of the terms in this section refer the reader to the 1997 Act as the term has been rewritten, for example, ‘allowable deduction has the same meaning as deduction has in the Income Tax Assessment Act 1997’. However, s 6 also still contains many important definitions that need to be understood when reading the income tax legislation. For example, terms such as ‘assessment’, ‘permanent establishment’, ‘resident or resident of Australia’ and ‘royalties’ are defined here. Part II — Administration 1-14 • •

The entirety of this part consists of: Section 8 which states that the ‘Commissioner shall have the general administration of this Act’; and Section 14 which requires the Commissioner to furnish the minister with an annual report.

Part III — Liability to taxation 1-15 This part is similar to Ch 2 of the ITAA 1997 in that it contains many and varied operative provisions dealing with a variety of taxation matters. The most important of these matters are: • Section 21A Non-cash business benefits, which are to be treated as though they were convertible to cash and are to be brought to account at their arm’s length value. • Section 44 Dividends, which states that the assessable income of a shareholder in a company includes dividends paid. • Division 2 which deals with particular types of assessable income, for example, certain film proceeds.

•

Division 3 which deals with particular types of deductions, for example, the deductibility of certain advance expenditure. [page 6]

• • • •

Division 5, ss 90–94, deals with partnerships. Division 6, ss 95AAA–102UY, deals with trusts. Division 7, ss102V–109ZE, deals with private companies and their distributions. Division 17, ss 159H–160AAA, deals with concessional rebates for dependants, certain low income taxpayers and medical expenses.

Part IV — Returns and assessments 1-16 This part deals with the requirements for taxpayers to lodge annual returns to the Commissioner and deals with the assessments of these returns by the Commissioner, deemed assessments, default assessments, special assessments and notice of assessments. The part also deals with objections against assessments which can be lodged by taxpayers dissatisfied with an assessment made. Part IVA — Schemes to reduce income tax 1-17 This part contains the general anti-tax avoidance provisions in the legislation. The main operative provisions of this part are: • Section 177A Interpretation which defines the terms used in the part; • Section 177B Operation of Part; • Section 177C Benefits, which explains how a tax benefit in connection with a scheme will be identified by the Commissioner; and • Section 177D Schemes to which this Part applies are defined as those schemes where the relevant taxpayer obtained a tax benefit. Part VA — Tax file numbers

1-18 This part deals with tax file numbers including the issuing and quotation of them. Part VIIB — Medicare levy and Medicare levy surcharge 1-19 This part deals with the Medicare levy including notices of assessment and administration of the levy. Part VIII — Miscellaneous 1-20 • • • •

This part deals with: public officers; the taxpayer’s duty to keep records; the Commissioner’s powers to access those records; and the Commissioner’s powers with respect to acquiring information and evidence in relation to any matters in relation to the tax legislation.

Part X — Attribution of foreign income in respect of controlled foreign companies 1-21 The taxation legislation comprising both the ITAA 1997 and the ITAA 1936 needs to be read as one piece of legislation. However, due [page 7] to the complexity of the subject matter, that is, taxation and the fact of having two pieces of legislation, the reader needs to be familiar with the broad outline of where to find relevant tax law.

How to ascertain the liability to income tax 1-22 ITAA 1997 s 4-1 states that ‘income tax is payable by each individual and company, and by some other entities’. In order to

calculate the tax payable, the individual, in s 4-10 method statement, needs to: 1. work out their taxable income for the year; 2. work out their basic income tax liability on their taxable income; 3. reduce their basic tax liability by the amount of any tax offsets that may apply to the individual; and 4. subtract the tax offsets from the income tax liability, resulting in an amount which will be the tax payable or refundable for the financial year. This method statement provided in the legislation does not deal with the effects of the Medicare levy and tax credits on the calculation. These are dealt with below.

How to work out taxable income 1-23

ITAA 1997 s 4-15(1) states:

Work out your taxable income for the income year like this: Taxable Income = Assessable Income – Deductions

The method statement gives the steps to ascertaining taxable income as follows: Step 1 Add up all the assessable income for the income year. Step 2 Add up all the deductions for the income year. Step 3 Subtract the deductions from the assessable income (unless they exceed it). The result is the taxable income. (If the deductions equal or exceed the assessable income, then there is no taxable income.)

How to work out the basic income tax liability 1-24

ITAA 1997 s 4-10(3) states:

Work out your income tax for the financial year as follows: Income tax = (Taxable income × Rate) – Tax offsets

The income tax rates are found in the ITRA 1986. The general rates of tax for individuals, resident and non-resident are found in Sch 7 of the ITRA 1986. [page 8]

Tax rates 2015–16 — individual resident 1-25 These rates apply to individuals who are Australian residents for tax purposes: The following rates for 2015–16 apply from 1 July 2015. Table 1-1: Individual Resident Tax Rates

Taxable income

Tax on this income

0–$18,200

Nil

$18,201–$37,000

19c for each $1 over $18,200

$37,001–$80,000

$3572 plus 32.5c for each $1 over $37,000

$80,001–$180,000

$17,547 plus 37c for each $1 over $80,000

$180,001 and over

$54,547 plus 45c for each $1 over $180,000

The above rates do not include the Medicare levy of 2%.

Tax rates 2015–16 — individual nonresident 1-26 These rates apply to individuals who are not Australian residents for tax purposes. Table 1-2: Individual Non-resident Tax Rates

Taxable income

Tax on this income

$0–$80,000

32.5c for each $1

$80,001–$180,000

$26,000 + 37c for each $1 over $80,000

$180,001 and over

$63,000 + 47c for each $1 over $180,000

Non-residents do not pay the Medicare levy.

Tax rates 2015–16 — companies 1-27 These rates apply to companies, other than a company in the capacity of a trustee: ITRA 1986 s 23. The rate of tax in respect of the taxable income of a company is 30%. As from 1 July 2015 the company tax rate for eligible small companies has been reduced from 30% to 28.5%. An eligible small company is one with an aggregated annual turnover of less than $2 million. However, it should be noted that this company tax rate does not apply to: • a life insurance company; • a provider of retirement savings accounts; • a provider of first home saver accounts; or • a pooled development fund. Companies do not pay the Medicare levy. [page 9]

How to calculate the Medicare levy 1-28 The Medicare levy is payable by all resident taxpayers and from 1 July 2014 the Medicare levy is payable at the rate of 2% of taxable income, an increase from the previous levy of 1.5%. The Medicare levy is imposed in the ITAA 1936 ss 251R and 251S. A taxpayer may be exempt from the levy or have the levy reduced if their taxable income is below a certain threshold. The Medicare levy is calculated by the Australian Tax Office (ATO)

based on the information provided in the tax return. However, the ATO also has a Medicare levy calculator at on its website if taxpayers wish to ascertain their Medicare payment. For the income tax year 2014–15 the low income threshold is $20,542 for all individual taxpayers, except those eligible for the seniors and pensioners tax offset. Taxpayers earning between $20,542 and $24,167 pay only part of the Medicare levy. Taxpayers earning above $24,167 pay the full Medicare levy. For families, the full Medicare levy is imposed for family taxpayers earning over a combined family taxable income of $40,431 plus $3713 for each dependent child. For taxpayers eligible for the seniors and pensioners tax offset, the low income threshold is $32,279. Taxpayers earning between $32,279 and $37,975 pay only part of the Medicare levy and taxpayers earning above $37,975 pay the full Medicare levy. The full Medicare levy for family taxpayers eligible for the seniors and pensioners tax offset is a combined family income of over $54,117 plus $3713 for each dependent child. Taxpayers may also qualify for a Medicare levy exemption in a number of circumstances. There are a number of medical exemptions, for example, blind pensioners, persons receiving sickness allowance from Centrelink or those entitled to free medical care. The other exemptions include foreign residents, residents of Norfolk Island and people not entitled to Medicare benefits who have obtained a Medicare exemption certificate. In addition to the base Medicare levy, high income earners who do not have private health insurance may be liable to pay a Medicare levy surcharge (MLS). The MLS rate, payable on the total taxable income, can be 1%, 1.25% or 1.5% depending on the income. If high income earners have private health insurance for part of the tax year, the surcharge will be pro-rated for the number of days when the taxpayer did not have insurance. [page 10]

Table 1-3: Income Thresholds for the Medicare Levy Surcharge

How to apply tax offsets to the basic income tax liability 1-29 A tax offset, sometimes called a rebate, is an amount which reduces the income tax payable by a taxpayer, excluding the Medicare levy. Most tax offsets are limited to the amount of income tax payable by a taxpayer. In other words if the offset exceeds the tax payable, the offset is limited to the amount of tax payable; a comprehensive list of tax offsets is found in ITAA 1997 s 13-1. Some of the common tax offsets include: • dependent carer tax offset; • national sole parent rebate; • low income tax offset; • seniors and pensioners tax offset; • beneficiary rebate for taxpayers in receipt of social security; • means-tested private health insurance tax offset; • mature age worker tax offset; • dividend franking tax offset (a refundable offset); and • research and development tax offset (a refundable offset). ITAA 1997 Divs 61–67 deals with tax offsets. Division 63 sets out the rules common to tax offsets and s 63-10 sets out the priority rules a taxpayer must follow when the taxpayer is entitled to one or more tax offsets. Section 63-10 also sets out when a tax offset can be transferred to a spouse, or carried forward to another tax year. Some tax offsets, however, are refundable. That is, if the tax offset is greater than the income tax payable, the taxpayer will receive a refund

of tax paid. In other words, if the tax offset is greater than the income tax payable, the excess offset will be refunded to the taxpayer. The most common refundable tax offset is the dividend franking offset: ITAA 1997 s 67-25. This allows taxpayers receiving franked dividend income to offset the amount of franking credit applicable to the dividend from their tax payable. [page 11]

How to apply tax credits to the basic income tax liability 1-30 A tax credit is the tax paid by a taxpayer, or on behalf of a taxpayer, during the course of a year of income. The most common tax credit is PAYG withholding tax paid by employers on behalf of their employees. A tax credit also arises by taxpayers paying monthly or quarterly instalment tax based on their previous year’s income, and interest and dividend withholding tax paid when the taxpayer has not quoted a tax file number. Tax credits are subtracted from the basic income tax liability and the Medicare levy, and may result in a tax refund.

How to calculate the income tax payable or refundable 1-31 1. Calculate the taxable income per ITAA 1997 s 4-15: Taxable Income = Assessable income – Deductions. 2. Calculate the basic income tax liability using the income tax rates applicable to the taxpayer, per the ITRA 1986 above. 3. Calculate the Medicare levy applicable. 4. Determine whether there are any tax offsets.

5. Ensure that all applicable tax credits are taken into account. 6. Calculate the income tax payable or refundable. This is included in the method statement of ITAA 1997 s 4-10; however, the method statement does not remind the reader of the need to subtract any tax credits.

Question 1 Calculate the income tax payable, ignoring the Medicare levy, for the following taxpayers for the year ended 30 June 2015: (a) An Australian resident individual with a taxable income of $15,000. (b) An Australian non-resident individual with a taxable income of $15,000. (c) An Australian company with a taxable income of $15,000. (d) An Australian resident individual with a taxable income of $155,000. (e) An Australian non-resident individual with a taxable income of $155,000. (f) An Australian company with a taxable income of $155,000. (g) An Australian resident individual with a taxable income of $255,000. (h) An Australian non-resident individual with a taxable income of $255,000. (i) An Australian company with a taxable income of $255,000.

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Answer Plan This is an easy calculation type question. In order to answer these question students need to understand how to use the income tax rates tables for different types of taxpayers.

Answer 1-32 The income tax rates for individuals, both resident and nonresident, are found in the ITRA 1986 Sch 7. The income tax rates for companies are set out in ITRA 1986 s 23.

(a) Resident taxable income less than $18,200, therefore no tax payable. (b) Non-resident taxable income $15,000 × 32.5% = $4875 tax payable. Non-resident taxpayers are not entitled to the tax free component of taxable income. (c) Company taxable income $15,000 × 30% = $4500. (d) Resident taxable income: $155,000 = 17,547 + ((155,000 – 80,000) × 37%) = 17,547 + (75,000 × 37%) = 17,547 + 27,750 = $45,297 (e) Non-resident taxable income: $155,000 = 26,000 + ((155,000 – 80,000) × 37%) = 26,000 + (75,000 × 37%) = 26,000 + 27,750 = $53,750 (f) Company taxable income $155,000 × 30% = $46,500. (g) Resident taxable income: $255,000 = 54,547 + ((255,000 – 180,000) × 47%) = 54,547 + (75,000 × 47%) = 54,547 + 35,250 = $89,297 (h) Non-resident taxable income: $255,000 = 63,000 + ((255,000 – 180,000) × 47%) = 63,000 + (75,000 × 47%) = 63,000 + 35,250 = $98,250 (i) Company taxable income $255,000 × 30% = $76,500.

Examiner’s Comments

1-33 Students should always attempt to refer to the relevant law that supports their answers. Even though the answer may be discoverable from reading their text or the ‘Key Issues’ above, this is not law, but a guide to understanding the law. The law is found in legislation, cases and Australian Tax Office Rulings. [page 13] Students need to be able to use the tax rates tables with confidence as most calculation questions will require students to calculate the income tax payable. Students are to be aware that non-resident individual taxpayers pay tax from the first dollar of taxable income earned, that is, they enjoy no tax free threshold. Students are to be aware that the company rate of tax is a flat rate from the first dollar of taxable income earned.

Keep in Mind 1-34 Students should ensure that they are using the correct tax table for the taxpayer in question.

Question 2 Your client, Timothy, has the following income and deductions for the financial year ended 30 June 2015: salary, $32,000; bank interest received, $150; and allowable deductions for special work clothing, $450. Timothy’s employer has deducted $2600 as PAYG tax from his salary during the year. Calculate Timothy’s income tax payable or refundable.

Answer Plan

This is a relatively easy question, although it does require careful attention to detail. It requires you to perform a calculation using the steps in how to calculate income tax payable or refundable, as above. Students are to take care to ensure that they include the relevant legislative provisions supporting their answer.

Answer 1-35 (a) Per ITAA 1997 s 4-15 Timothy’s taxable income = assessable income – deductions. = (salary + interest earned) – deductions = (32,000 + 150) – 450 = $31,700 (b) Timothy’s basic income tax liability per the ITRA 1986 is: = taxable income × tax rate = 31,700 × (19% over $18,200) = (31,700 – 18,200) × 19% = 13,500 × 19% = $2565 [page 14] (c) The Medicare levy = taxable income × 2% = 31,700 × 2% = $634 The Medicare levy is imposed by ITAA 1936 ss 251R and 251S. The Medicare levy does not apply to low income earners. As Timothy’s taxable income is above the low income threshold of $24,167 he is liable to pay the levy. (d) The facts do not indicate that Timothy is entitled to any tax offsets. (e) Tax credits need to be considered. Timothy has tax credits of

$2600 PAYG tax deducted by his employer. (f) Income tax payable or refundable, ITAA 1997, method statement in s 4-10 = basic tax payable + Medicare levy – tax offsets – tax credits = 2565 + 634 – 0 – 2600 = $599 tax payable

Examiner’s Comments 1-36 Students will have noted, from the above question, that the income tax legislation in support of the calculation of income tax payable is contained in three separate pieces of legislation: ITAA 1997; ITAA 1936; and ITRA 1986. The calculation of income tax payable and refundable, even though provided for in the method statement of ITAA 1997 s 4-10 which reminds students to be alert to the Medicare levy and tax offsets, ignores the treatment of tax credits.

Keep in Mind 1-37 When asked to calculate taxable income, remember to consider all of the steps in the calculation to ensure that they are considered, even if not relevant to the facts of the particular question. This way will ensure that no steps are inadvertently overlooked. Even when answering a calculation question, students should always insert the relevant legal support for the calculation.

Question 3 What is the difference between a tax offset and a tax credit? Students should identify and explain why they are treated differently in the calculation of income tax payable.

Answer Plan This is an essay type question of moderate difficulty. It requires you to: • define the terms used; [page 15] • •

explain the different treatment of a tax offset and a tax credit; and consider why the treatment is different.

Answer 1-38 ITAA 1997 s 995 defines a tax offset as ‘tax offset has the meaning given by section 4-10’. Section 4-10 merely states that ‘a tax offset reduces the amount of income tax you have to pay’. The section then refers the reader to s 13-1 for a comprehensive list of tax offsets available to individual taxpayers. This list then guides readers to the substantive provisions dealing with all of the individual tax offsets. This list of offsets includes the following items: • dependent carer tax offset; • national sole parent rebate; • low income tax offset; • seniors and pensioners tax offset; • beneficiary rebate for taxpayers in receipt of social security; • means tested private health insurance tax offset; • mature age worker tax offset; • dividend franking tax offset (a refundable offset); and • research and development tax offset (a refundable offset). These items appear to be a list of matters where government policy has determined that taxpayers who care for dependents, are old and on low incomes should get a rebate of tax paid because of their circumstances. The tax offsets also appear to be used to encourage

taxpayers to act in a certain way, for example, encouraging high income earners to take out medical health insurance and encouraging research and development. The offsets appear to be a way of government encouraging taxpayers to behave in a certain way. Therefore, the offset reduces that taxpayer’s liability to tax if they meet certain conditions. Tax credits reduce a taxpayer’s income tax payable and may result in a refund. Tax credits are not defined in the ITAA because they represent income tax paid on behalf of a taxpayer by a third party. The most common tax credit arises from the normal PAYG tax paid on behalf of employees by employers to the Australian Tax Office before an employee receives their regular salary. Tax credits also arise when banks deduct tax on behalf of a depositor, before they pay interest due to a depositor. The other common instance of a tax credit is when companies deduct an amount of tax from a dividend before paying the net dividend to the shareholder. Tax offsets are, therefore, government concessions granted to taxpayer, whereas, tax credits actually represent tax paid by a taxpayer before the ascertainment of the taxpayer’s final tax liability. The government concessions would therefore be subject to limits and strict rules. This also explains why some offsets do not provide for a refund or the ability to transfer the offset to another taxpayer; whereas, the tax credit, [page 16] which represents the tax paid by a taxpayer would not be subject to the limitations of a tax offset.

Examiner’s Comments 1-39 Students should be aware that rules governing the granting of tax offsets, because they represent a government concession, are complex and detailed and impose many limitations and restrictions on

their application. Tax offsets and tax rebates are subject to changes, income limits and other eligibility requirements. Tax credits on the other hand represent actual tax paid, usually during the course of an income tax year, on behalf of a taxpayer. In other words the tax paid ‘belongs’ to the account of the taxpayer. This is why there are no limitations as to the refundability of tax credits paid that exceed the tax liability of the taxpayer.

Keep in Mind 1-40 The rules pertaining to tax offsets are included in both the ITAA 1997 and the ITAA 1936. The list of tax offsets contained in ITAA 1997 s 13-1 is not an operative section, it is merely a guidance section, and points the way to the appropriate operative section in the legislation. When answering a question that includes specific tax terms, it is always useful to check whether those terms are defined in the tax legislation.

Question 4 Calculate the Medicare levy payable for the year ended 30 June 2015 for the following taxpayers: (a) An Australian resident, aged 25 years, with a taxable income of $18,000. (b) An Australian resident, eligible for a seniors tax offset, with a taxable income of $32,000. (c) An Australian resident, aged 45 years, with a taxable income of $45,000. (d) A taxpayer, who is not a resident for tax purposes, with a taxable income of $45,000. (e) An Australian resident company with a taxable income of $2,500,000. (f) An Australian resident, aged 45 years, with a taxable income of $110,000, and no private health insurance. (g) An Australian resident, aged 45 years, with a taxable income of $110,000, holding private health insurance.

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Answer Plan This is an easy calculation question. Students need to cite the legislation imposing the Medicare levy and to ensure that the calculation is performed for all parts of the question.

Answer 1-41 The Medicare levy is imposed by the ITAA 1936 ss 251R and 251S. The levy is imposed at a basic rate of 2%; however, there are exemptions for low income earners and there are surcharges applicable to high income earners who do not have private health insurance. (a) The low income threshold for an individual is $20,542. As this taxpayer earned less than the threshold, no Medicare levy is payable. (b) The low income threshold for an individual eligible for the seniors and pensioners tax offset is $32,279. As this taxpayer is eligible for the seniors tax offset, and earned less than the threshold, no Medicare levy is payable. (c) The Medicare levy payable is $45,000 × 2% = $900.00 (d) The Medicare levy is not payable by non-resident taxpayers and therefore no levy is payable. (e) Companies are not required to pay the Medicare levy and therefore no levy is payable. (f) The Medicare levy payable is $110,000 × 2% = $2200. (g) The Medicare levy payable is ($110,000 × 2%) + ($110,000 × 1%) = $3300. This taxpayer needs to pay a Medicare levy surcharge as the taxpayer holds no private health insurance.

Examiner’s Comments 1-42 Students need to be careful when using the tax tables that they check to ensure that:

•

•

•

The taxpayer is required to pay the Medicare levy. Remember that non-resident taxpayers and companies are exempt from paying the levy irrespective of their taxable income. The relevant taxpayer is earning an income over the Medicare threshold. Then the students need to ensure the correct threshold is applied. The threshold depends on whether the taxpayer is single, in a family or eligible for the seniors or pensioners tax offset. If the taxpayer is earning a high income to ensure whether the Medicare levy surcharge is payable. The surcharge is not payable if the high income earning taxpayer has appropriate private health insurance cover. [page 18]

Keep in Mind 1-43 Students should keep in mind that the Medicare levy is normally calculated by the ATO based on the information provided in the tax return. However, the ATO also has a Medicare levy calculator at on its website. Students should use this site to ensure that they have the correct answer.

Question 5 The application of the Medicare levy is complex which is why the ATO provides a tax calculator to assist taxpayers, and is also why the Medicare levy is calculated by the ATO. Why do you believe the Medicare levy is so complex? What objectives are the government attempting to achieve by the imposition of the Medicare levy in its current form?

Answer Plan This is an essay type question of moderate difficulty. In order to answer these question students need to display that they understand how the Medicare levy is imposed. Students then need to reflect on the need for a Medicare levy as a separate item of tax rather than merely a higher overall tax rate.

Answer 1-44 The Medicare levy is imposed under ITAA 1936 s 251S. The tax legislation does not define the levy; however, the Australian Tax Office has produced guides explaining how the levy is imposed, see . This ATO guide states that ‘Medicare is the scheme that gives Australian residents access to health care. To help fund the scheme, most taxpayers pay a Medicare levy of 2% of their taxable income’. However, the details of the various exemptions, income thresholds and the Medicare levy surcharge make a superficially simple tax of 2% a complex tax to impose. Some of the details of the Medicare levy include: • The Medicare levy is not payable by companies or non-resident individuals. As the levy is used to fund universal health care, companies and non-residents probably have no need for, or access to, Australian health care, thus justifying their exemption from the levy. • There are low income thresholds below which individuals are exempt from the levy. The low income thresholds are different for individual taxpayers, family taxpayers and taxpayers eligible for the seniors and pensioners tax offset. [page 19]

There are also taxable income thresholds for the phasing in of the levy until certain income levels are reached. • There are also high income thresholds above which individuals, without private health insurance cover, have to pay a Medicare levy surcharge. The high income thresholds are different for individual taxpayers, family taxpayers and taxpayers eligible for the seniors and pensioners tax offset. I believe that the Medicare levy is complex because, in addition to being a tax, it is also an instrument of government policy. The government wishes to ensure that all Australians have access to health care. At the same time, the levy cannot be imposed on those taxpayers who will not be taking advantage of the Australian health care system, that is, companies and non-resident taxpayers. The levy also excludes low income earners and taxpayers in special categories, that is, seniors and pensioners. This is to ensure that only taxpayers who can afford the levy are paying the levy. The levy also penalises high income earners without private health insurance by charging them a surcharge. This is to encourage those taxpayers with high incomes to take out private health insurance and so take pressure from the public health system. Therefore, it appears to me that the Medicare levy is complex in operation because the government is trying to achieve a number of objectives: • a universal health care system for all Australian residents, regardless of income; • raise funds to help pay for that system of universal health care; • ensure that taxpayers who are disadvantaged, by earning low incomes, do not have to pay the levy; and • encourage high income earners to take out private health insurance. •

Examiner’s Comments 1-45 Students should note that in order to answer the question they need to understand why the Medicare levy was imposed and to display

that understanding to the examiner. Then they need to demonstrate that they understand the various components of the imposition of the levy. Once students understand the components of the levy they need to reflect on the probable reasons for each of the components.

Keep in Mind 1-46 Although the Medicare levy is called a ‘levy’, it is actually a component of income tax.

1.

P Nygh and P Butt (eds), Butterworths Australian Legal Dictionary, Butterworths, Australia, 1997, p 821.

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Chapter 2

International Tax

Key Issues 2-1 Modern globalisation means that goods, services, money, transnational corporations and, to a lesser extent, people can move and operate freely between countries. This means that determining where income is earned for tax purposes is no longer a simple matter. This chapter, international tax, deals with the way Australian taxing authorities determine whether a taxpayer is an Australian resident for tax purposes and determines the source of income earned. Although globalisation has freed the movement of goods and services between countries, laws tend to operate within the sovereign borders of nation states. In other words, Australian tax laws have no standing to operate in other countries. This may be moderated when countries sign international tax treaties. In Planche v Fletcher (1779) 99 ER 164 it appeared that English goods being sent to France from London had been sent via a third port, Ostend, in order to reduce or avoid French import duties. In his decision, Lord Mansfield held that ‘at any rate, this was no fraud on this country (England). One nation does not take notice of the revenue laws of another country’. 2-2 The Income Tax Assessment Act 1997 (Cth) (ITAA 1997) s 65(2) states:

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.

ITAA 1997 s 6-5(3) states: 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.

Individual income tax rates make a distinction according to whether the taxpayer is an Australian resident or a foreign resident as follows: • There is no tax-free threshold for foreign residents. • Foreign residents initially pay tax at a higher rate than Australian residents. [page 22] • Foreign residents are denied certain tax offsets. • Foreign residents do not pay the Medicare levy. Therefore, in order to determine the taxable income of a taxpayer and the tax payable on that income it is important to determine the residency status of the taxpayer and the source of the income of the taxpayer.

Residency of individual taxpayers 2-3

There are four tests of residence for individual taxpayers:

1. the ordinary concepts test, which is based on common law; 2. the domicile test which generally applies to outgoing individuals; 3. the 183-day rule; and 4. the superannuation rule. A taxpayer needs to satisfy only one of the above tests to be considered a resident of Australia for tax purposes. It is important to

note that Australian residency for the purpose of the Migration Act 1958 (Cth) is not the same as Australian residency for tax purposes.

Ordinary concepts test 2-4 In the case of Federal Commissioner of Taxation v Miller (1946) 73 CLR 93 it was held that ‘whether a person resides in Australia is a question of fact and degree’. This means that each case must be examined on its merits. Decided cases in Australia and in the United Kingdom provide guidance as to the matters a court will take into account before determining whether or not a taxpayer is an Australian resident for tax purposes. In the United Kingdom House of Lords case of Levene v Commissioners of Inland Revenue [1928] AC 217 the taxpayer ‘was ordinarily resident in the United Kingdom until December 1919’. After that time he went abroad for the sake of his health for between seven and eight months per year. He disbanded his London residence in 1918 and lived in hotels when he returned to the United Kingdom. His visits to England were to obtain medical advice, visit relatives, attend Jewish religious observances, visit the graves of parents and attend to tax affairs. The House of Lords held that ‘until he took a lease of a flat in Monte Carlo, he continued to be a resident of the United Kingdom’. According to Viscount Cave LC the reason for this decision was because of the taxpayer’s ‘ties with this country, and his freedom from attachments abroad’. In the following United Kingdom House of Lords case of Commissioners of Inland Revenue v Lysaght [1928] AC 234 the same decision was reached even though the taxpayer had a residence in another country. In this case the taxpayer was also ordinarily resident in the United Kingdom until 1919. After that time he moved permanently with his family to estates in the Irish Free State. However, the taxpayer was compelled [page 23]

to return to England, ‘solely for business purposes’ on a monthly basis when he resided in hotels. The reason advanced for holding that the taxpayer was a resident of the United Kingdom for tax purposes was, per Lord Buckmaster that ‘ordinarily resident means in my opinion no more than that the residence is not casual and uncertain but that the person held to reside does so in the ordinary course of his life’. 2-5 The Australian decision of the Administrative Appeals Tribunal (AAT) in Joachim v Federal Commissioner of Taxation (2002) 50 ATR 1072 is the decision that demonstrates the Australian approach to residency for tax purposes. This case incorporates the principles decided in the above United Kingdom cases. In Joachim the taxpayer and his family migrated to Australia from Sri Lanka in 1994. The taxpayer, a master mariner, was unable to obtain work on Australian vessels and so took work on Sri Lankan vessels. During the relevant tax year the taxpayer had spent 316 days outside Australia. He spent time in Australia when he was in between contracts of employment with the Sri Lankan agency. The tribunal member M D Allen held that the taxpayer: … although employed on Sri Lankan flag vessels, maintains a home for his wife and children in Australia. It seems to me that under the ordinary principles of the law, he is a resident of Australia.

2-6 The Australian Tax Office (ATO) has codified the ordinary concepts test by providing a Taxation Ruling, TR 1998/17, ‘Income Tax: Residency Status of Individuals Entering Australia’. The ruling can be accessed at . The ruling applies to most individuals entering Australia and provides the ATO interpretation of the meaning of the word ‘resides’ within the definition of resident in the ITAA 1936 s 6. The ruling gives excellent examples and demonstrates to students how the law is applied in different types of cases. Taxation Ruling TR 1998/17 emphasises that in order to determine whether an individual resides in Australia for tax purposes ‘all the facts and circumstances that describe an individual’s behaviour in Australia are relevant’. The following factors are a useful guide in making a determination of an individual’s residency status: • intention or purpose of presence;

• • •

family and business/employment ties; maintenance and location of assets; and social and living arrangements.

Domicile test 2-7 The domicile test generally applies to individuals leaving Australia. All individuals have a domicile of birth. The domicile test, however, generally deals with individuals who are pursuing a domicile of choice. [page 24] The Australian Federal Court decision of Federal Commissioner of Taxation v Applegate [1979] FCA 37 considered the definition of an Australian resident for tax purposes in the ITAA 1936. ITAA 1936 s 6(1)(a) defines a resident of Australia as: (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.

The facts of Federal Commissioner of Taxation v Applegate were that on 8 October 1971 the taxpayer and his wife left Sydney for an indefinite period so that the taxpayer could open a branch office on behalf of his employer, a firm of solicitors, in Vila in the New Hebrides. The taxpayer gave up his lease on his flat in Sydney and left no assets in Sydney. When he arrived in the New Hebrides the taxpayer obtained the lease of a house for 12 months, was admitted as a legal practitioner and obtained a residency permit for 12 months which was subsequently renewed to a second term of two years. In July 1973 the taxpayer became ill and returned to Sydney for treatment. During their time in the New Hebrides the taxpayer did build up a branch for his employer. He also visited Sydney on holidays, and for the birth of a child. In deciding that the taxpayer had a permanent place of abode outside Australia for the relevant year, Northrop J (at [19]) held: The Act is not concerned with domicile except to the extent necessary to show whether a

taxpayer has an Australian domicile. What is of importance is whether the taxpayer has abandoned any residence or place of abode he may have had in Australia. Each year of income must be looked at separately. If in that year a taxpayer has … formed the intention to, and in fact has, resided outside Australia, then truly it can be said that his permanent place of abode is outside Australia during that year of income.

This judgment supports the reasoning of Franki J (at [10]), in the same case, who held that: … ‘permanent place of abode outside Australia’ is to be read as something less than a permanent place of abode in which the taxpayer intends to live for the rest of his life.

The case of Federal Commissioner of Taxation v Jenkins (1982) 82 ATC 4098 involved an ANZ Bank accountant who had agreed to work in the ANZ Bank in Vila, the New Hebrides for a period of three years. The taxpayer attempted to sell his home, and when that did not succeed, the bank leased the home and paid to store the taxpayer’s furniture. The taxpayer and his family moved to Vila in February 1977. The taxpayer and his wife and children entered fully into the social and recreational activities in Vila and two of his children went to school there. … After 18 months the taxpayer returned to Australia for his health and ‘because of his inability to cope efficiently with his duties: at 4099.

[page 25] In deciding that the taxpayer had a permanent place of abode outside Australia in the relevant year, Sheahan J considered (at 4101) the fact that because the taxpayer had agreed to go for a fixed term, that is, three years: … did this fact make his stay ‘temporary’ in the sense in which that word is used in contradistinction to ‘permanent’ [and that as] ‘permanent does not mean everlasting’ the question is ‘one of fact and degree’ and that the taxpayer did in fact have, at the relevant time, ‘a permanent place of abode outside Australia.

2-8 The ATO has codified the domicile test in the Taxation Ruling IT 2650. This ruling can be found at . The ruling applies to most individuals leaving their Australian domicile and provides the ATO meaning of the terms ‘reside’, ‘domicile’ and ‘permanent place of abode’

within the statutory definition of ‘resident’ in ITAA 1936 s 6. The ruling gives excellent examples and demonstrates to students how the law is applied in different types of cases. Ruling IT 2650 emphasises that while ‘it is not possible to provide conclusive rules for determining the residency status of individuals leaving Australia temporarily … the following factors need to be taken into account’: • the intended and actual length of stay in the overseas country; • any intention either to return to Australia or to travel to another country; • the establishment of a home outside Australia; • the abandonment of any residence or place of abode in Australia; • the duration and continuity of presence in another country; and • the durability of association that the individual has with a particular place in Australia.

183- day rule 2-9 The 183-day rule generally applies to individuals entering Australia. The rule, defined in ITAA 1936 s 6(a)(ii), provides that a resident of Australia is 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 the person’s usual place of abode is outside Australia and that the person does not intend to take up residence in Australia.

This definition which appears to define an Australian resident in strict legal terms, as a person who has been resident for more than one half of a year, contains the proviso, ‘unless the Commissioner is satisfied …’. In practice, the Commissioner looks to the factors listed in TR 1998/17 to determine whether a person resides in Australia for tax purposes. Additionally, a person may reside in Australia for more than one half of the year and not be considered a resident for tax purposes if they are classed as a ‘temporary resident’ which is considered below. [page 26]

Superannuation rule 2-10 The superannuation test applies to Commonwealth public servants and their families. The rule defined in ITAA 1936 s 6(a)(iii) provides that a resident of Australia is a person who is: (A) a member of the superannuation scheme established by deed under the Superannuation Act 1990; or (B) an eligible employee for the purposes of the Superannuation Act 1976; or (C) the spouse, or a child under 16, of a person covered by sub-subparagraph (A) or (B).

Temporary residents 2-11 if:

A person is a temporary resident, defined in ITAA 1997 s 995,

(a) you hold a temporary visa granted under the Migration Act 1958; and (b) you are not an Australian resident within the meaning of the Social Security Act 1991; and (c) your spouse is not an Australian resident within the meaning of the Social Security Act 1991.

The taxation advantage in being classed as a temporary resident is that, according to ITAA 1997 s 768-905, temporary residents are accorded tax relief on most foreign sourced income and capital gains and they are relieved of the burdens associated with complying with most record-keeping obligations and interest withholding tax obligations. However, under ITAA 1997 s 768-910(3)(a), the assessable income of temporary residents will include ordinary income derived from other than an Australian source to the extent that it is remuneration, for employment undertaken, or services provided, while a temporary resident.

Residency of company taxpayers 2-12 To be an Australian resident company the company must pass either one of the following statutory tests provided in ITAA 1936 s 6(b): • the place of incorporation is Australia; or • the company does business in Australia and the place of central management and control is in Australia; or

the company does business in Australia and the controlling • shareholders are in Australia. In Koitaki Para Rubber Estates Ltd v Federal Commissioner of Taxation (1941) 64 CLR 241; [1941] HCA 13 the company, was registered in New South Wales, had its central management and control in New South Wales and it was where the majority of shareholders resided. Koitaki asserted that the company was not an Australian resident for tax purposes because its business, the production of rubber occurred in Papua and the Papuan resident manager held a power of attorney to conduct the business of the company in Papua. The rubber was, however, shipped to Australia [page 27] and sold in Australia through commission agents. The High Court (per Starke J) held1 that ‘the ascertainment of the residence of a company is mainly a question of fact’. According to Starke J the company ‘was not incorporated in Papua, its central management and control was not there exercised, and the voting power of its shareholders was not located there’ leading to the conclusion that the company was not resident in Papua. The case of Malayan Shipping Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156; [1946] HCA 7 dealt with a company incorporated in Singapore with its registered office in Singapore. The company’s majority shareholder, Mr Sleigh, was based in Melbourne, Australia and he was also the company’s managing director. In Singapore there were two resident nominee shareholders who were also resident directors. The nominee shares were held in trust for Mr Sleigh. The company’s articles of association provided that any resolution of the directors had no effect unless agreed to by Mr Sleigh. The business of the company consisted solely of the charter of a Norwegian tanker, via a contract signed in London on Mr Sleigh’s instructions and the conduct of ten charter voyages. The issue was whether or not the company carried on business in Australia. The court (per Williams J)

held that although ‘trade is carried on where contracts are habitually made’ in this case ‘the essence of the business was his [Mr Sleigh’s] decision in Melbourne to charter and sub-charter the tanker’. 2-13 The ATO has codified case law in this area in Taxation Ruling 2004/15, ‘Income Tax: Residence of Companies Not Incorporated in Australia — Carrying on Business in Australia and Central Management and Control’. The ruling can be accessed at . The ruling (at para 1) ‘provides guidelines for determining whether a company, not incorporated in Australia, is a resident of Australia’. The ruling considers what is meant by ‘carrying on a business in Australia’ and what is meant by ‘central management and control’ and where it is located. TR 2004/15 para 9 states that ‘the question of where a business is carried on is one of fact’.

Source of income 2-14 The assessable income of Australian residents for tax purposes ‘includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year’: ITAA 1997 s 6-5(2). The assessable income for foreign residents for tax purposes includes only the ‘ordinary income you derived directly or indirectly from all Australian sources’: ITAA 1997 s 6-5(3). Australian residents will pay Australian tax on foreign sourced income and may also be liable to tax in the country where the income was earned. For example, an Australian [page 28] taxpayer earning rental income from a property owned in Germany will pay tax in Germany on that income and will have to declare that income in his or her Australian tax return.

In the early case of Nathan v Federal Commissioner of Taxation (1918) 25 CLR 183; [1918] HCA 45 the issue to be decided was the ‘true source’ of dividends. The dividends were paid by English companies to the shareholder in England. However, a portion of the dividends were ‘attributable to profits derived by each of the companies from that part of their respective businesses which is carried on in Australia’. The court found that ‘the ascertainment of the actual source of a given income is a practical, hard matter of fact’. The court found that the Australian sourced income should be taxed in Australia. In a modern world of complex transactions, multinational corporations, online trading and online provision of services, the ‘practical, hard matter of fact’ is no longer easily able to be determined. As a result ‘source’ rules have been adopted for different classes of income and most of these source rules come from case law. Income must therefore first be classified into its relevant class before determining the source of the income. The major classes of income are:

Income from personal services 2-15 In Federal Commissioner of Taxation v French [1957] 98 CLR 398 the respondent was a resident of New South Wales, was employed as an engineer and his salary was paid monthly to his New South Wales bank account. The employer company, incorporated in New South Wales, but with operations in New Zealand, sent French to work in New Zealand for a short period. The High Court (at 398) considered the issue of whether salary paid to French in Australia, relating to his work time in New Zealand, was actually ‘income derived from sources out of Australia’. Dixon CJ held (at 404) that the ‘place of payment is a strange thing to be treated as the source’ and that ‘[t]he real service, as a matter of hard fact, was the fact that the respondent worked in New Zealand’. In Federal Commissioner of Taxation v Mitchum (1965) 113 CLR 401; [1965] HCA 23; the respondent, the United States based actor Robert Mitchum, had been contracted by a Swiss company to perform

in two movies for a period of up to 14 weeks each for a fee of US$50,000 per movie. The terms of the contract included that Mitchum would provide advice as to cast selection, cast coaching and consultation with the producer. The Swiss company lent out Mitchum’s services to a United Kingdom company to star in a film, ‘The Sundowners’, filmed in Australia, and eventually assigned the benefit of their agreement to a United States company. In the event Mitchum came to Australia for 11 weeks in 1959 to perform the role in ‘The Sundowners’. The issue was whether the portion of the US$50,000 fee paid to Mitchum for his [page 29] service in Australia was income from an Australian source. Barwick CJ held (at [28]) that the US$50,000 could not be treated as ‘wages for work’ and that the ‘special circumstances’ of this case meant that an apportionment of the fee would not be ‘permissible’. The inference was that as the taxpayer was an ‘artist’ he was being paid for more than mere work. Despite the decision in the Mitchum case, it appears that for most employees the source of income from personal services is the place the personal service was performed.

Business income 2-16 In Commissioners of Taxation v Meeks (Public Officer of the Sulphide Corporation Ltd) (1915) 19 CLR 568; [1915] HCA 34 it was held (per Griffith CJ) that the ‘locality of the source [of business income] is the place where the undertaking is carried on’. Further, the court left it open to the taxpayer to present a case for the apportionment of income between jurisdictions where the company may conduct parts of their business.

Sale of goods

2-17 The source of sales income depends on a range of factors including the place of the contract, the place of negotiation and the place of payment.

Sale of property other than trading stock 2-18 The source of income from the sale of property depends on the type of property sold. If the property sold is real property, then the source of income is usually where the property is situated. If the property sold is intangible property, then the factors taken into account when determining the source are the place of the contract, the place of negotiations, the place of payment and if relevant, the place where the location of the intangible property is being used.

Interest 2-19 In the case of Federal Commissioner of Taxation v Spotless Services Ltd (1995) 95 ATC 4775 one of the issues before the Full Federal Court was to determine the source of interest income earned by Spotless. Spotless had deposited surplus funds in the Cook Islands with a Cook Islands corporation, the European Pacific Banking Co Ltd. At that time interest earned outside Australia by an Australian resident was exempt from Australian tax if it was not exempt from tax in the foreign country source. It was held by Beaumont J (at 4789) that the source of income needed to be judged in a practical way and that in this instance ‘the place or places where the contract was made and the money lent’ were the important factors and that the interest was therefore held to have a source in the Cook Islands. In concluding, Beaumont held [page 30] (at (4791) that ‘the source of the entitlement to interest was located at the place, the Cook Islands, where the certificate issued and where it was enforceable’.

Dividends 2-20 ITAA 1936 s 44(1)(a) states that the assessable income of an Australian resident shareholder includes ‘dividends paid to the shareholder by the company out of profits derived by it from any source. ITAA 1936 s 44(1)(b) states that the assessable income of a nonresident shareholder includes dividends paid by the company only ‘to the extent to which they are paid out of profits derived by it from sources in Australia’. In Esquire Nominees Ltd v Federal Commissioner of Taxation (1973) 129 CLR 177 it was held, by majority, that dividend income derived by residents in Norfolk Island from a company incorporated in Norfolk Island was sourced in Norfolk. The company paying the dividend in Norfolk had derived the income from an Australian company with operations, a pharmacy, in Australia. The decision overturned the Federal Court decision of Gibbs J who had held (at [41]) that the dividend ‘ultimately received, came from the profits made by the conduct of a business in Australia’ and that that was the ‘reality’ of the source. Stephen J, in the majority, (at [21]) held the dividend’s source was Norfolk Island because the share register and the ‘fund of profits available for distribution’ and the ‘business activities of the company paying the dividend, that is to say, the activity of holding shares and receiving payment of dividends, which was its only business activity’ were situated in Norfolk Island. The fact, that other companies in the chain ultimately had their origin of Australia, was regarded ‘as too remote to be relevant to the source of the taxpayer’s income’.

Royalties 2-21 ITAA 1936 ss 6C and 6CA deal with the source of royalty and natural resource income derived by non-residents. The legislation (s 6C) provides that the source of royalty is Australian if: … it consists of an outgoing incurred by the person or persons by whom it is paid or credited in carrying on a business in Australia at or through a permanent establishment of that person or those persons in Australia.

The source of natural resource income is deemed to be attributable to an Australian source if it (s 6CA) ‘is calculated, in whole or in part, by

reference to the value or quantity of natural resources produced’ in Australia.

Transfer pricing 2-22 Transfer pricing is a technique used by multinational enterprises (MNEs), also called transnational corporations, to transfer profits between companies within a group of companies. Transfer pricing is a legal tax avoidance technique that effectively allows multinational companies to artificially construct the prices of their goods and services. This gives [page 31] them the opportunity to increase their costs in high taxing countries while shifting profits to low taxing jurisdictions. MNEs using transfer pricing are, for taxation purposes, required by the ATO to price the transactions that they are shifting around the world using the ‘arm’s length principle’. Only related corporations within a group of corporations can take advantage of transfer pricing in order to minimise their income tax liability. When goods and services are traded between related companies the prices charged for those goods and services is the transfer price. Transfer pricing is the mechanism used by these related companies to value the goods or services trading between them. In this way profits and losses may be allocated between companies in a group by simply adjusting the price charged for goods and services ‘sold’ between group members. This profit shifting between group companies is irrelevant if all the companies in the group are taxed in the same jurisdiction. However, if one of the group companies operates in a different taxing jurisdiction, groups of companies use transfer pricing to shift profits from high taxing jurisdictions to low-taxing jurisdictions. In Australia, in 1964, the decision by the High Court in Cecil Bros Pty Ltd v Federal Commissioner of Taxation (1964) 111 CLR 430

confirmed that it was legal for a company in a group of companies to determine in which company the profits would be ‘made’. In the Cecil Bros case the companies in the group were both resident in Australia, so there was no impact on Australian tax revenue, as one company reported an artificially low profit and the other an artificially high profit. The profit shifting by MNEs operating in Australia between various countries is, however, not tax neutral in Australia. 2-23 Australian Transfer Pricing rules are found in the ITAA 1997 in Ch 4 International Aspects of Income Tax. The law is also supplemented by numerous Taxation Rulings (TRs) issued by the ATO. The most important of these rulings are: • TR 94/14 ‘Income Tax: Application of Division 13 of Part III (International Profit Shifting) — Some Basic Concepts Underlying the Operation of Division 13 and Some Circumstances in Which Section 136AD Will Be Applied’ provides guidelines to assist taxpayers to price their international dealings between related parties so that the correct amount of income tax and withholding tax is payable. • TR 97/20 ‘Income Tax: Arm’s Length Transfer Pricing Methodologies for International Dealings’ sets out the transfer pricing methodologies acceptable to the ATO, when they are appropriate and definitional issues that arise in applying them. • TR 98/10 ‘IncomeTax: Documentation and Practical Issues Associated with Setting and Reviewing Transfer Pricing in International Dealings’ examines the nature and type of documentation required to be kept by the MNE to support the contention that international dealings with associated enterprises comply with the arm’s length principle. [page 32]

Double tax treaties 2-24

‘Australia has tax treaties with more than 40 countries.’2 Tax

treaties are also called tax conventions or double tax agreements (DTA). The aim of tax treaties is to prevent the double taxation of income, minimise tax evasion and enhance cooperation between international tax authorities in the enforcement of tax laws. The only taxpayers impacted by tax treaties are those residing in a tax treaty country. Tax treaties are negotiated by the Commonwealth Treasury department and administered by the ATO. The DTAs allocate to the country of source, sometimes at limited rates, a taxing right over various income, profits or gains. It is accepted that both countries possess the right to tax the income of their own residents under their own domestic laws and as such, the DTA wording will not always explicitly restate this rule. However, where the country of residence is to be given the sole taxing right over certain types of income, profits or gains, this sole right is usually represented by the words shall be taxable only in that country. The agreement also provides that where income, profits or gains may be taxed in both countries, the country of residence (if it taxes) is to allow double tax relief against its own tax for the tax imposed by the country of source.3

According to the ATO, Australia’s tax treaties operate to: • keep the right to tax certain classes of income entirely for the income earner’s country of residence; • ensure that all other income may be taxed in the country in which the income is earned; • specify rules to resolve conflicting claims about the residential status of a taxpayer and the source of income; • provide an avenue for a taxpayer to present a case to the relevant tax authorities if they believe the tax treatment has not been in accordance with the terms of a tax treaty; • provide for the allocation of profits between related parties on an arm’s length basis; • generally preserve the application of domestic law rules that are designed to address transfer pricing and other international avoidance practices; and • provide avenues for exchange of information between tax authorities.4 [page 33]

Australia has DTAs in force with over 40 countries. Tax treaties are maintained by the Commonwealth Treasury and can be found at .

Question 1 Explain why it is important to determine: (a) the tax residency of a taxpayer; and (b) the source of income of a taxpayer?

Answer Plan This is an easy essay type question. Students need to consider both parts of the question and reflect on the relationship between residence and source.

Answer 2-25 (a) The Australian tax law assess tax on income for Australian resident taxpayers differently from the way it does for foreign residents for tax purposes. Under ITAA 1997 s 6-5(2) the assessable income of an Australian resident taxpayer includes the ordinary income derived ‘from all sources, whether in or out of Australia during the income year’. In other words Australian tax residents are subject to tax on their worldwide income. Foreign residents, on the other hand, are only subject to Australian tax on income ‘derived directly or indirectly from all Australian sources’: ITAA 1997 s 6-5(3)(a). (b) It is important to determine the source of income for both Australian resident taxpayers and non-resident taxpayers, but for different reasons. As Australian resident taxpayers are taxed on

their worldwide income, it would appear that the source of an Australian resident taxpayer’s income would be unimportant. However, because Australia has tax treaties with a number of countries, it may be relevant to an Australian resident to determine where their foreign sourced income originated. For example, if the income came from a tax treaty country, then the Australian taxpayer may be entitled to a credit for tax paid in that treaty country when determining their Australian tax liability. The source of income for a non-Australian resident taxpayer is important because they are only liable to taxation in Australia on their Australian sourced income.

Examiner’s Comments 2-26 When answering this question, students need to ensure they answer both parts of the question. They also need to refer to relevant law in their answer. [page 34]

Keep in Mind 2-27 Students should keep in mind that although Australian residents are subject to tax on their worldwide income, double tax treaties that Australia has with a number of countries mean that it is still important for Australian resident taxpayers to identify the source of their income.

Question 2 Dr Jane Smith is an academic employed by a university in England. She takes a fivemonth sabbatical to undertake research at an Australian university. While she is in Australia, she continues to be paid her salary by her English university. While she is in Australia, Dr Smith lives in accommodation provided to her on the campus of the

Australian university. Her husband stays in England and only joins her in Australia for a brief holiday. At the conclusion of her sabbatical, Dr Smith returns to England and her university. Is Dr Smith an Australian resident for tax purposes?

Answer Plan This is a relatively easy problem question. The question requires that students apply legal reasoning in order to fully answer the question. Students are required to identify the legal issue in the question. Once the legal issue has been identified, students should be able to identify the relevant law, either legislative, case law or the ATO Taxation Rulings. The students then need to apply legal reasoning to the problem, weighing up the various factors before coming to a conclusion.

Answer 2-28 Issue: Is Dr Smith an Australian resident for tax purposes or a foreign resident? Law and Application: In ITAA 1936 s 6 a resident of Australia is defined as person ‘whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia’. In order to determine the domicile of a person living in Australia, the Commissioner would consider a number of factors set out in TR 1998/17 ‘Income Tax: Residency Status of Individuals Entering Australia’. Under this ruling residency is a question of fact (TR 1998/17 para 22) and the Commissioner will ‘assess the quality and character of the individual’s behaviour while in Australia’ to determine whether the individual is a resident of Australia. In our case Dr Smith is in Australia only for a specified period to undertake a specific task. She does not set up a home in Australia as she lives on campus. Also, her husband does not accompany her for the duration of her stay.

[page 35] In conclusion, Dr Smith would not be considered a resident of Australia for tax purposes.

Examiner’s Comments 2-29 Students should only mention the law they apply to the facts in the problem. If law is mentioned and not applied, then students will not gain marks. When students mention law they should paraphrase their understanding of the law to demonstrate their understanding to the examiner.

Keep in Mind 2-30 Students should be careful to apply the correct law, remembering that the Taxation Ruling TR 1998/17 deals with the residency status of individuals entering Australia and the Taxation Ruling IT 2650 deals with the residency status of persons leaving Australia.

Question 3 Andrea has lived in Australia since January 2015 when she and her spouse came from their country of origin, India. Andrea is on a short- term visa granted under the Migration Act 1958 (Cth). The visa does not deem Andrea or her husband as Australian residents. Andrea has leased an apartment in Bondi and has commenced studying at an Australian University. She and her husband both work part-time. They have made friends in Australia and participate in an active social life in Bondi. Andrea has also joined a local gym and works out three times a week. Andrea intends staying in Australia until she completes a three-year accounting degree. (a) Is Andrea an Australian resident for tax purposes? (b) Calculate Andrea’s taxable income and tax payable (excluding the Medicare levy) for the year ended 30 June 2015. During this year she has earned the following receipts: (i) interest earned on bank account held in India — $10,000; and

(ii) wages as a part-time waitress in Bondi — $18,500.

Answer Plan This is a problem question of moderate difficulty. The question requires that students apply legal reasoning in order to fully answer the question. Students are required to identify the legal issue in the question. Once the legal issue has been identified, students should be able to identify the relevant law, either legislative, case law or the ATO Taxation Rulings. The students then need to apply legal reasoning to the problem, weighing up the various factors before coming to a conclusion. [page 36]

Answer 2-31 (a) Issue: Is Andrea an Australian or foreign resident for tax purposes? Law and Application: The relevant law is contained in ITAA 1936 s 6(1), the ordinary resident test. It is necessary to look at all relevant facts and a number of factors to determine whether Andrea resides in Australia. These factors have been identified by the ATO in TR 1998/17. The factors that would support Andrea being an Australian resident include: • her physical presence in Australia; • her husband has accompanied her; • the maintenance of a home in Australia; and • the duration of her visit is expected to be three years. However, it could also be argued that Andrea is not a resident for the following factors:

• her Indian nationality; and • the purpose of her visit (to gain an education). The cases Levene v Commissioners of Inland Revenue [1928] AC 217 and Commissioners of Inland Revenue v Lysaght [1928] AC 234 decided on the issue of residence for residents leaving their domicile and determining when the domicile had changed. In Levene the House of Lords held that until the taxpayer leased a flat in Monte Carlo he remained a UK resident for tax purposes. In this case Andrea has leased a flat in Bondi. In Lysaght Lord Buckmaster held that to be resident a taxpayer must live in a domicile in the normal cours of his life and not in a casual or uncertain way. In this case Andrea is residing in Australia in the normal course of her life; she is living in normal housing accommodation with her husband and is studying and working part-time. In conclusion, it is likely that Andrea will be a resident of Australia for tax purposes as she resides here. (b) As a resident, Andrea will be taxed on her income from all sources However, Andrea is entitled to tax relief from foreign sourced income under the temporary residents provision: ITAA 1997 Div 768. Andrea passes the following tests for temporary residents: • She holds a temporary visa. • She is not an Australian resident within the meaning of the Migration Act. [page 37] Hence Andrea will only be taxed on her Australian sourced income. Taxable income = $18,500 Tax payable = 18,500 – 18,200 = $300 × 19c = $57

Examiner’s Comments 2-32 Students should only mention the law that they apply to the facts in the problem. If law is mentioned and not applied, then students will not gain marks. When students mention law they should paraphrase their understanding of the law to demonstrate their understanding to the examiner. Also, students need to weigh up all the relevant facts in the problem before coming to their conclusion.

Keep in Mind 2-33 This question has two parts and students need to be aware of the additional issue of temporary residence.

Question 4 Prasad was a chartered accountant working for a major accounting firm in Sydney where he lived with his parents. Prasad was offered a posting to New York for a minimum of two years in order to expand his expertise in international mergers and acquisition work. Prasad moved to New York, found a share apartment in Manhattan and threw himself into his new job and the New York lifestyle. He closed his Australian bank accounts and obtained a visa to work in America because he did not know whether he would stay on in America after the minimum two-year period. At the end of the minimum two years in New York, and before returning home to Australia, he took a 12month leave of absence from his work to travel the world. Before embarking on his travels he sent all of his personal effects, apart from a rucksack of clothes, to his parents’ home in Sydney. On returning home to Sydney, Prasad intended to move out of his parents’ home and into his own rented apartment. Was Prasad an Australian resident for tax purposes during his absence from Australia?

Answer Plan This is a quite a difficult problem question. As with all problem questions, students are required to apply legal reasoning in order to fully answer the question. Students need to identify the legal issue and

then identify the relevant law, either legislative, case law or the ATO Taxation Rulings which they must then apply to the facts in the question before coming to a conclusion. [page 38]

Answer 2-34 Issue: Was Prasad an Australian resident or foreign for tax purposes during his absence from Australia? Law and Application: Prasad is leaving Australia and so the domicile test which applies to Australians leaving Australia applies. However, as Prasad gives up his New York apartment before returning home the ordinary concepts test will also apply. In the case of Federal Commissioner of Taxation v Applegate [1979] FCA 37 the court held that the taxpayer had a permanent place of abode outside Australia for the relevant year, because, according to Northrop J (at [19]): What is of importance is whether the taxpayer has abandoned any residence or place of abode he may have had in Australia. Each year of income must be looked at separately. If in that year a taxpayer has … formed the intention to, and in fact has, resided outside Australia, then truly it can be said that his permanent place of abode is outside Australia during that year of income.

This judgment supports the reasoning of Franki J (at [10]), in the same case, who held that: … ‘permanent place of abode outside Australia’ is to be read as something less than a permanent place of abode in which the taxpayer intends to live for the rest of his life.

In this case Prasad did form an intention to live outside Australia and, even though he did not intend to leave Australia permanently, he did set up a new place of abode in New York. He formed an intention to reside in New York for two years, and he did reside in New York for two years. According to Taxation Ruling IT 2650 (para 27) a taxpayer who leaves Australia with the intention of returning to Australia would remain a resident of Australia ‘unless he or she can satisfy the

Commissioner’ that their permanent place of abode was outside Australia. In order to satisfy the Commissioner, the following factors are considered (para 23): (a) Intended and actual length of stay overseas In this case Prasad intended to stay for a minimum of two years which he did. He obtained an American work visa because he was not sure if he would stay in America for longer than two years. (b) Whether the taxpayer intended to stay in the overseas country temporarily or return to Australia at some definite point in time In this case, when Prasad left Australia he was not sure if he would stay in New York indefinitely, but had prepared himself, by obtaining a work visa, for an indefinite stay. (c) Whether the taxpayer had established a home outside Australia Prasad rented a share apartment and ‘threw himself into’ the New York lifestyle. Therefore he appeared to have established a home in New York. [page 39] (d) Whether a place of abode exists in Australia or whether he abandoned that place of abode Prasad was living with his parents, and he did leave that place of abode. Prasad did not intent to return to his parents’ home but intended to establish a new home/abode in Australia. (e) Duration of his presence in an overseas country Prasad had a durable residence in New York for two years. His intention when leaving New York was to travel for twelve months, so for those twelve months Prasad would have no durable connection outside of Australia. (f) Durability of association that the person has with Australia Prasad closed his Australian bank accounts and left his parents’ home. Even though his parents still live in Australia, Prasad has no intention of returning to the parental home on his return. However, as each year of income must be looked at separately, the

year that Prasad gave up his place of abode in New York to travel must also be examined. In the final year of Prasad’s stay outside of Australia he will be travelling, that is, he will have no permanent home. As in the case of Levene v Commissioners of Inland Revenue [1928] AC 217 where the House of Lords held that ‘until he took a lease of a flat in Monte Carlo, he continued to be a resident of the United Kingdom’, in this case while Prasad is travelling his place of residence will be Australia. While Prasad was living and working in New York, his place of abode was outside Australia.

Examiner’s Comments 2-35

The comments are as for Question 3 above at 2-32.

Keep in Mind 2-36 This was quite a difficult question because the facts of the question had to be read with a deep understanding of the relevant law in the area. Students need to understand, in a nuanced way, that the given facts of the question gave rise to two different answers for each of the income tax years under consideration.

1. 2.

See . Australian Taxation Office, , accessed 2 March 2015.

3.

Taken from the General Outline of the DTA between Australia and Argentina, , accessed 3 March 2015. Above n 2.

4.

[page 41]

Chapter 3

Income Tax Accounting

Key Issues 3-1 Accounting for the purposes of income tax is not the same as accounting for other purposes, such as reporting to shareholders. Issues can therefore arise for taxpayers when calculating their assessable income and their allowable deductions to ascertain their taxable income because their taxable income can be different from their accounting income for other purposes. In Australia the financial year for income tax, Income Tax Assessment Act 1997 (Cth) (ITAA 1997) s 995, ‘means a period of 12 months beginning on 1 July’. Income Tax Assessment Act 1936 (Cth) (ITAA 1936) s 18 provides that: … any person may, with the leave of the Commissioner, adopt an accounting period being the 12 months ending on some date other than 30 June. For the purposes of this Act, the person’s accounting period for each succeeding year shall end on the corresponding date of that year …

In other words, the income tax year, for most Australian taxpayers, is from 1 July–30 June. 3-2 The key issues dealt with in this chapter are: • •

the timing of taxable income, that is, the tax year in which income should be treated as ‘derived’ for tax purposes; whether or not it is appropriate to use the receipts (cash basis) or earnings method (accruals basis) of accounting for the purposes of

• • •

determining taxable income; the timing of outgoings, that is, in which tax year should outgoings, be treated as ‘incurred’ for tax purposes; how trading stock is treated for tax purposes; and special concessions available to small business enterprises (SBEs).

Timing of taxable income 3-3

ITAA 1997 s 6-5(4) provides that:

… 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.

The most common example of how income is ‘applied’ on behalf of a wage and salary earning taxpayer is when pay as you go (PAYG) tax is [page 42] deducted from a person’s salary and sent directly to the Australian Tax Office (ATO). This deduction is being paid on behalf of the taxpayer to the ATO and the amount is included in the taxpayer’s gross income to be declared in the income tax return. Other examples of applying income on behalf of a taxpayer can include employee superannuation contributions, payments of union dues, staff car parking fees or health fund contributions on behalf of an employee, at the employee’s direction. In the case of Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 at 428, Gibbs J held: … 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.

Determining the ‘correct’ method of accounting

3-4 Taxation Ruling TR 1998/1, ‘Income Tax: Determination of Income; Receipts versus Earnings’ was promulgated as a guide to assist taxpayers and their advisers in adopting the appropriate method of determining when income is derived under ITAA 1997 s 6-5. The two commonly used methods are the receipts method and the earnings method: TR 1998/1 para 2. The receipts method, also called the cash received or cash basis, recognises income as being derived when it is either actually or constructively received: TR 1998/1 para 8. The earnings method, also called the accruals or credit method, recognises income as derived when it is ‘earned’. In this method income is earned when there is a recoverable debt, that is, when the taxpayer is legally entitled to an ascertainable amount as a result of having performed an agreed service or sold goods: TR 1998/1 paras 9–10. The ruling (TR 1998/1 paras 18–19) states that the receipts method is the most appropriate method for: • income derived by an employee; • non-business income derived from the provision of knowledge or the exercise of skill by the taxpayer; • business income where the income is derived from the provision of knowledge or the exercise of skill by the taxpayer; and • income derived from investments. The ruling (para 20) states that the earnings method is the most appropriate method to account for business income derived from a trading or manufacturing business. 3-5 If it is unclear whether or not a taxpayer should use the receipts or earnings method in computing their taxable income, the ruling has listed [page 43] a number of factors (paras 53–59) that the ATO will consider as relevant. These factors are: • Size of the business — The larger the business and the more

reliant the business is on employees to generate income, the more likely that the earnings method would be the most appropriate method. • Circulating capital and consumables — The more reliant the business is on circulating capital and consumables, that is, the turnover of trading stock or manufacturing, the more likely that the earnings method would be the most appropriate method. • Capital items — The more reliant a business is on the use of capital items, for example, expensive equipment, to produce income, the more likely that the earnings method would be the most appropriate method. • Credit policy and debt recovery — A taxpayer that regularly extends credit to customers and clients and has formal procedures for the extension of credit and debt recovery would be more likely to use the earnings method as the appropriate method. • Books of account — Where books of account are kept, the way they are kept, that is, using either the receipts or earnings method, is considered a relevant but not determinative factor to the question of when income is to be recognised. 3-6 Taxation Ruling TR 1998/1 codified a number of cases that considered the appropriate method of bringing income to account for tax purposes. Some of the cases and issues considered in those cases are as follows:

Professional practices 3-7 The case of Henderson v Federal Commissioner of Taxation (1970) 119 CLR 612 considered, among other matters, the manner in which the income of a professional partnership should be calculated. Henderson was a partner in the West Australian accountancy firm of CP Bird & Associates. At the relevant times the firm employed 295 persons, of whom about 150 were qualified accountants. In 1964 the partnership decided that (Windeyer J (at [15])) ‘it would be better if the partnership income tax return were rendered on an earnings, or accrual, basis instead of as theretofore on a cash receipts basis’. Barwick CJ (at [7]) held:

It is apparent, in my opinion, that what such a business earns in a year will represent its income derived in that year for the purposes of the Act. The circumstances that led the majority of the Court to conclude in Carden’s case [1938] HCA 69; (1938) 63 CLR 108 that a cash basis was appropriate to determine the income of the professional practice carried on by the taxpayer personally are not present in this case.

In other words, Barwick CJ was confirming that for small professional practices, where the majority of the income was the result of the skill of [page 44] the practitioner, using the receipts method was appropriate to determine taxable income. However, as in the present case of a large professional practice, the earnings method was appropriate to determine taxable income. Barwick CJ stated, further, that when changing from cash to accruals method, ‘the uncollected fees earned in a prior year cannot be included in the assessable income of the next year. They are simply untaxed earnings’.

Prepayments 3-8 The case of Arthur Murray (NSW) Pty Ltd v Federal Commissioner of Taxation (1965) 114 CLR 314 dealt with the issue of income received in advance, or prepayments. In this case the appellant conducted a dancing school where students paid for tuition in advance. The court held (at 317): The student was given no contractual right to a refund in the event of his not completing the course — indeed the form of contract in general use denied such a right — though in practice refunds were sometimes given. In the company’s books, fees were credited immediately upon their being received to an account styled ‘unearned deposits’.

The Commissioner assessed the company on the basis that the unearned fees were in fact income from the moment of receipt. The court held (at 319) that: … 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.

Dividend income 3-9 ITAA 1936 s 44 states that the assessable income of a taxpayer includes ‘(1)(a)(i) dividends … that are paid to the shareholder by the company’. The case of Brookton Co-operative Society Ltd v Federal Commissioner of Taxation (1981) 147 CLR 441 considered the issue of whether the declaration of an interim dividend was income as being a dividend actually ‘paid’. Gibbs CJ held (at 33) ‘that there was no payment by the directors of the taxpayer of an interim dividend and that the directors were entitled to rescind their declaration’. In other words, a dividend should only be treated as income in the hands of a shareholder when actually paid and not just declared by directors. This is because the directors can rescind the decision to pay the dividend at any time up until payment.

Timing of the derivation of disputed income 3-10 In the case of BHP Billiton Petroleum (Bass Strait) Pty Ltd v Federal Commissioner of Taxation [2002] FCAFC 433 the Full Federal Court had to consider (at [1]) the issue of when: … income from the sale of a commodity [is] derived where a part of the consideration for the sale of the commodity is the subject of a bona fide dispute between the seller and the buyer.

[page 45] The commodity at issue was gas from the Bass Strait. The Federal Commissioner of Taxation considered that income was derived when the gas is delivered. The taxpayers submitted (at [3]) that: … it is only when the dispute between buyer and seller is resolved, so that it is known what the amount payable to the seller is, that the income from the sale of gas has been derived.

The majority of the court held (at [100]): … that there is no Australian authority which requires the conclusion that where there is a bona fide dispute a tax payer on an accruals basis is obliged to account for trading income that is the subject of the dispute in the year when the goods are sold, if the

taxpayer is a trader in goods or in the year when the services are rendered, if the taxpayer derives income from services performed.

The reasons for the decision were that: • The court should be slow to adopt a fiction that the successful litigant was going to be successful) in preference for reality. • The decision avoids the difficulty of reopening accounts where a deduction for a possible bad debt may be the subject of doubt. • It avoids the unfairness to a taxpayer in being required to pay tax immediately on amounts where recoverability is out of the control of the taxpayer.

Timing of outgoings 3-11 Allowable outgoings of taxpayers may be deducted from assessable income when they are incurred in gaining or producing assessable income: ITAA 1997 s 8-1(1)(a). The meaning of the word ‘incurred’ is not defined in the legislation but is defined in TR 1997/7 ‘Income Tax: Section 8-1 — Meaning of ‘Incurred’ — Timing of Deductions’. Paragraph 5 states that ‘you incur an outgoing at the time you owe a present money debt that you cannot escape’. Paragraph 6(a) states that ‘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’. The ruling allows taxpayers who use a cash receipts based accounting system a deduction for a loss or outgoing that has not necessarily been paid a deduction as long as the loss or outgoing has actually been ‘incurred’. However, a taxpayer is prevented from doubling up on deductions because (para 12) ‘you cannot claim an unpaid expense in one year on the basis that it has been incurred, then claim again in a subsequent year when it is paid’. 3-12 In the case of Federal Commissioner of Taxation v Citylink Melbourne Ltd [2006] HCA 35 the High Court had to consider the issues of when an outgoing was actually incurred and whether or not the outgoing was an outgoing of capital. The facts of this case were that [page 46]

the taxpayer had been contracted to ‘design, construct and maintain a system of roads’ for the State of Victoria with the intent of ultimately, after 25 years, transferring the infrastructure to the state: at [81]. As consideration for this concession the taxpayer was required to pay the state a concession fee of $95.6 million annually, payable six monthly in arrears: at [85]. However, while the fees were accrued by the taxpayer every six months, the fees were able to be deferred until such time as the roads were completed and ‘until sufficient money is available for withdrawal’: at [113]. That is, the taxpayer could defer payment until sufficient tolls had been collected for payment of the fees, theoretically, up until the expiration of the deed in 2034: at [100]. The taxpayer had claimed concession fees amounting to $224.45 million in the three years ending 30 June 1998 during the construction period of the roads: at [87]. The majority of the High Court held (at [155]) that the ‘concession fees satisfy the test for deductibility at their full face value in respect of each of the income years in which they are claimed as deductions’. The reason for the decision was that the concession fees were held (at [154]) to be in periodic licence fees in respect of assets from which the taxpayer derives income, which assets would ultimately be returned to the state. 3-13 Outgoings will be recognised as being incurred only when ‘definitively committed’. TR 97/7 (para 6(a)) states that: … 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.

What this means in practice is that there will generally be no deductions allowed for prepayments or provisions: • As to prepaid expenses the timing of their deductibility are regulated in ITAA 1936 ss 82KZL–82KZMG. Section 82KZL provides that expenditure for loan interest, rents, lease payments and insurances are taken to be incurred ‘during the period to which the payment relates’. • As to the raising of provisions in accounts and attempting to claim

a deduction, ITAA 1997 s 26-10 provides that: (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.

3-14 The deductibility of leave provisions was considered in the case of Federal Commissioner of Taxation v James Flood Pty Ltd (1953) [page 47] 88 CLR 492. The taxpayer, for the year ended 30 June 1947, had returned holiday and sick pay as a deduction which amount included £578 10s 2d of (at 500) ‘charges which had been accrued but had not been paid during the year’. The Federal Commissioner of Taxation disallowed this amount as an allowable deduction. The accrual was made on the basis of an award which provided that (at 502) ‘annual leave must be allowed and must be taken and that payment shall not be made or accepted in lieu of annual leave’. The view taken by the taxpayer was (at 504) that the amount provided ‘was a definite pecuniary liability arising out of the employment of the employees and that is was impossible to escape it’. The Full High Court, however, held (at 508) that: … there was at best an inchoate liability in process of accrual but subject to a variety of contingencies … and that … this conclusion means that pay for annual leave is deductible year by year as it is paid.

3-15 The non-deductibility of leave provisions extends to provisions for doubtful debts. TR 1992/18 ‘Income Tax: Bad Debts’ makes it clear that in order to obtain a bad debt deduction under ITAA 1936 s 63 (para 2) ‘a debt must exist before it can be written off’. The ruling (para 3) goes on to state unambiguously that ‘the debt, however, must not merely be doubtful’. In the case of Point v Federal Commissioner of Taxation (1970) 119 CLR 453 the appellant held all the shares (bar one share) in a trucking

company, White Trucks Pty Ltd. In late 1963 White Trucks was in financial difficulty and a provisional liquidator was appointed. In order to salvage something from the company for the creditors, the appellant entered a deed to release White Trucks of a debt of £70,734 19s 7d in May 1964: at 457. After September 1964 the appellant attempted to write off the debt in his books. Owen J held (at 456) that: … whatever debt was owed by the company to the appellant as at 30 June 1964 ceased to exist at latest in July 1964. Thereafter there was no debt in existence which could be written off as a bad debt.

In other words, as the appellant had waived the debt via a deed of release there was no debt in existence that could be written off as bad.

The legal interpretation of when an expense has been ‘incurred’ has been given a wider meaning by the courts in the case of insurance companies 3-16 In the case of RACV Insurance Pty Ltd v Federal Commissioner of Taxation (1974) 74 ATC 4169 at 4172 the issue was whether an amount of $1,420,424 included by the taxpayer in its return as ‘unreported claims’ was allowable as a deduction. The amount represented ‘784 claims (for compulsory third party insurance) arising out of events which occurred in the financial year but which had not been reported in that year’: at 4174. [page 48] In the Supreme Court of Victoria, Menhennit J held (at 4180) that the taxpayer was entitled to a deduction because: … in relation to compulsory third party insurance, once the events have occurred which give rise to a liability to indemnify … Then … it is more than a loss or expenditure which is no more than impending, threatened or expected.

Further (at 4183): … having regard to the fact that there is an unanswerable liability to indemnify the driver of the vehicle once the personal injury occurs is seems to me that a loss or outgoing is incurred within the meaning of sec. 51(1) of the Act [predecessor section to the present ITAA 1997 s 8-1(1)] once the events giving rise to the liability occur.

In the case of Commercial Union Assurance Co of Australia v Federal Commissioner of Taxation (1977) 77 ATC 4186 at 4186 the issue was ‘the extent to which provision made for claims incurred but not reported were allowable deductions’. The fact was that many of the insurance policies issued required the policyholders to notify the insurance company ‘forthwith’ or ‘as soon as possible’ after the occurrence of the event insured against: at 4192. The taxpayer claimed a deduction for estimated future claims for damages to be paid to policyholders that had not notified the insurance company within the stipulated time period. Even though this notification was a ‘condition precedent’ of the policy, it was the ‘invariable practice’ to pay claims in full: at 4193. Newton J of the Victorian Supreme Court allowed the deduction (at 4193) on the basis that it was: … the long established policy and practice … that the claim would be paid, whether or not the condition as to notice was complied with. Payment was a matter of commercial certainty, and was not subject to any contingency which would be regarded as such in the world of ordinary business affairs.

Outgoings can be incurred long after the income year in which they were incurred, even after the business has ceased. In these cases the outgoing is still a tax deduction 3-17 In the case of Placer Pacific Management Pty Ltd v Commissioner of Taxation [1995] FCA 1362 the issue was whether an outgoing incurred after the sale of the business was deductible. The taxpayer, among other things, was a manufacturer of conveyor belts. In April 1979 they manufactured and installed a conveyor system in a colliery. In August 1981 the colliery claimed that the conveyor system was faulty and commenced proceeding for damages which were ultimately settled and paid. The taxpayer claimed the amount of damages and legal fees in the sum of $383,379 in its 1989 tax year. In the meantime, the taxpayer had, in July 1981, sold its conveyor belt business. The Commissioner disallowed the deduction on the basis that the taxpayer failed the ‘continuing business test’: at [1]–[8].

[page 49] The court held (at [32]) that: The fact that the division had been subsequently 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.

The approach taken by the court was the payments were held to be deductible because the occasion of the outgoings arose out of the taxpayer’s business activities: at [33].

Treatment of trading stock 3-18 ITAA 1997 Div 70 deals with the statutory rules governing the tax treatment of trading stock. In the Division, s 70-1 deals with amounts a taxpayer can deduct, and amounts to be included in assessable income when: • trading stock is acquired; • a taxpayer who carries on a business holds trading stock at the start or end of the income year; and • trading stock is disposed of outside of the ordinary course of business or when an item ceases to be trading stock. ITAA 1997 s 70-5 states that ‘the purpose of income tax accounting for trading stock is to produce an overall result that … properly reflects your activities with your trading stock during the income year’. ITAA 1997 s 70-10(a) defines trading stock in very broad terms as ‘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’. In Federal Commissioner of Taxation v Sutton Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277 the definition of trading stock was considered, and confirmed the definition of trading stock in the legislation as ‘expansive’. In this case the taxpayer carried on a business

‘retailing new motor vehicles manufactured by General MotorsHolden’s Ltd’: at [1]. The taxpayer had obtained delivery of the motor vehicles from the finance company of the Holden group, who remained the owner of the vehicles up until they were sold by the taxpayer. The taxpayer purchased the motor vehicles from the finance company just before selling the vehicle to a customer. The relevant vehicles in the possession of the taxpayer, and in their showrooms, were actually the property of the finance company and not the taxpayer. The issue considered by the High Court was ‘whether the relevant vehicles were … trading stock on hand in relation to a business that was carried on by the taxpayer’: at [1]. The High Court held that the motor vehicles in the possession of the taxpayer were trading stock even though the motor vehicles were not owned by the taxpayer. [page 50] 3-19 Assets that are normally considered capital items can be trading stock if the business holding those items is in the business of trading in those items. For example, in the case of Investment Merchant Finance Corporation Ltd v Federal Commissioner of Taxation [1971] HCA 35 the High Court held that ‘shares in the hands of a trader (in shares) and held by him for sale were stock in trade’. The High Court in Federal Commissioner of Taxation v St Hubert’s Island Pty Ltd (in liq) [1978] HCA 10 held that just as shares can be trading stock so can land when held by a trader in land. The court rejected the taxpayer’s submission that ‘land can never be trading stock’ because: … to exclude from the concept of ‘trading stock’ the parcels of land in which a dealer in land trades would be to make such a discrimination solely by reference to the particular subject-matter traded in [which would be anomalous].

Livestock is clearly included in the definition of trading stock. ITAA 1997 s 995 defines livestock thus: [L]ivestock does not include animals used as beasts of burden or working beasts in a business other than a primary production business. This means that poultry in a primary production business such as an egg producing business or a poultry meat producer would

be livestock. However, poultry used as exhibits in a petting zoo for children would not be considered livestock.

3-20 The tax treatment of trading stock requires the taxpayer to bring trading stock to account by comparing the value of trading stock at the end of a financial year with the value of trading stock at the beginning of a financial year: ITAA 1997 s 70-35. Section 70-35(2) provides that where the value of trading stock at the end of the year is greater than trading stock at the beginning of the year, the difference is included in assessable income. Section 70-35(3) provides that where the value of trading stock at the end of the year is less than the value of the trading stock at the beginning of the year, the difference is an allowable deduction. ITAA 1997 s 70-40 provides that the closing value of trading stock in one financial year becomes the opening value of trading stock in the next year. ITAA 1997 s 70-45 provides that trading stock can be valued at either of: (a) its cost; or (b) its market selling value; or (c) its replacement value. Purchases of trading stock are treated as allowable deductions under the general deductions provision ITAA 1997 s 8-1(1). Sales of trading stock are treated as assessable ordinary income under ITAA 1997 s 6-5. Any purchases or sales of trading stock that are a non-arm’s length [page 51] transaction, where the transaction occurred at a value greater than the market value, are to be treated as having occurred at market value. This means that the purchaser must include the purchase price of the trading stock at market value and the seller must record the sale of the trading stock at market value.

Small business concessions 3-21 The income tax legislation provides some special taxation rules, in ITAA 1997 Div 328, for eligible small businesses that aim to benefit those businesses by (in s 328-50): • reducing their tax; • providing simpler rules for determining their income and deductions; • providing simpler capital allowances and trading stock requirements; and • reducing their compliance costs. In ITAA 1997 s 328-110, an eligible small business is one that in the current year carries on a business and either: • carried on a business in the previous income year to the current income year and had an aggregated turnover for the previous year of less than $2 million; and/or • the aggregated turnover for the current income year is likely to be less than $2 million. However, it is not considered to be a small business entity if the aggregated turnover for the two previous income years was $2 million or more: ITAA 1997 s 328-110(3). ITAA 1997 s 328-115 provides that aggregated turnover is the sum of the relevant annual turnovers of the business, a business connected with the taxpayer and an affiliate of the taxpayer during the income year. ITAA 1997 s 328-120(1) provides that ‘an entity’s annual turnover for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business’. Section 328-120(5) provides further that if an entity does not carry on business for the whole of an income year, the annual turnover must be worked out using a reasonable estimate of what the entity’s annual turnover for the income year would be if the entity carried on business for the whole of the income year. The various concessions available to eligible small businesses are listed in ITAA 1997 s 328-10. In addition to the eligibility requirement

as to aggregated annual turnover, above, some of the concessions listed below have additional specific conditions that must also be satisfied. [page 52] Table 3-1: Small Business Concessions

Item

Concession

Relevant provision of the legislation

1

CGT 15 year asset exemption Subdivision 152-B ITAA 1997

2

CGT 50% active asset reduction

Subdivision 152-C ITAA 1997

3

CGT retirement exemption

Subdivision 152-D ITAA 1997

4

CGT rollover

Subdivision 152-E ITAA 1997

5

Simpler depreciation rules

Subdivision 328-D ITAA 1997

6

Simplified trading stock rules Subdivision 328-E ITAA 1997

7

Deducting certain prepaid expenses immediately

Sections 82KZM and 82KZMD ITAA 1936

8

Accounting for GST on a cash basis

Section 29-40 GST Act 1999

9

Annual apportionment of input tax credits for acquisitions and importations that are partly creditable

Section 131-5 GST Act 1999

10

Paying GST by quarterly instalments

Section 162-5 GST Act 1999

11

FBT car parking exemption

Section 58GA FBTAA 1986

12

PAYG instalments based on GDP-adjusted notional tax

Section 45-130, Sch 1 TAA 1953

Question 1 ITAA 1997 s 6-5 (4) provides that: … 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. Why is it so important to determine exactly when income is derived?

Answer Plan This is an essay type question that requires the student to reflect on the importance of understanding the words of the tax legislation. [page 53]

Answer 3-22 It is important to determine exactly when income was derived because: • A taxpayer is assessed taxation on income each year. For most taxpayers in Australia the financial year for income tax, ITAA 1997 s 995, ‘means a period of 12 months beginning on 1 July’. Therefore it is important to know in which income year income needs to be included for the purpose of assessment. • Income tax rates for individual taxpayers are progressive. This means that if income is understated in one income year, then the actual rate of taxation assessed could be lower than the actual rate that should have been charged. This means that the Australian Government could lose revenue. • It is important to ensure that income is taxed in the correct period because otherwise taxpayers could manipulate when to declare

income in order to lower their tax liability. For example, a taxpayer could attempt to minimise income in a year where they had a one- off capital gain by moving other income to a different tax year. Alternatively, a taxpayer could move income into a year where there would otherwise have been tax losses, in order to take advantage of those losses.

Examiner’s comments 3-23 When answering this question, students need to understand the legislation and practical consequences of the legislation.

Keep in Mind 3-24 Students need to keep in mind that even though the taxpayers can choose between cash and accruals when determining their assessable income for tax, that income needs to be declared to the ATO on a consistent basis that reflects the actual assessable income of a taxpayer in any tax year. Students need to be aware that income tax is levied annually. Students also need to reflect on the fact that Australia’s progressive personal tax rates give taxpayers’ financial advantages in ‘evening’ out income from year to year.

Question 2 (adapted from TR 1998/1) Bob is the sole shareholder, director and employee of a company, Bob’s Crop Spraying Pty Ltd. Bob’s company owns and operates a Cessna aircraft for spraying crops and pastures with either fertilisers or pesticides. The business charges farmers on an hourly basis for the use of the aircraft and for Bob’s time in flying the aircraft. Bob charges $400 an hour of [page 54] which around $50 per hour would be for his labour. The business also charges farmers for the spray being used. The only way a farmer can engage the aircraft is together with

Bob as the pilot as he lets no one else fly because the aircraft is his major asset. The company maintains simple books of account and records income when it is received. Most clients pay cash on completion of a job. Bob gives credit rarely and only in special circumstances. Bob keeps virtually no supplies of fertiliser or pesticides on hand and orders them for specific jobs. He does have a small fuel and oil store in his hangar. Should Bob return his income for tax on the receipts or earnings basis?

Answer Plan This is a difficult problem style question.

Answer 3-25 Issue: Is the cash receipts or the earning/accruals basis the most appropriate basis for returning the taxable income of Bob’s Crop Spraying Pty Ltd? Law and Application: ITAA 1997 s 6-5 states that assessable income is ordinary income that ‘you have derived’. This leaves it open for taxpayers to determine whether or not the receipts or earnings basis is the most appropriate method of accounting for tax purposes. In the case of Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 Gibbs J held (at 428): … 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.

TR 1998/1 lists a number of factors that need to be considered when determining the appropriate method of accounting for tax purposes. They include: • Size of the business — Generally, for a small business the receipts method is the appropriate method. This is a small, one-man business where the owner, with his aircraft, generates the income of the business.

•

Circulating capital and consumables — The more reliant the business is on circulating capital and consumables, that is, the turnover of trading stock or manufacturing, the more likely that the earnings method would be the most appropriate method. In this case Bob keeps ‘virtually no supplies’ and only has a small stock of fuel and oil for his aircraft. [page 55]

•

Capital items — The more reliant a business is on the use of capital items, for example, expensive equipment, to produce income, the more likely that the earnings method would be the most appropriate method. Bob’s business is totally reliant on his aircraft for his business. The greater portion of his income is from the hire of his aircraft rather than his labour in flying. • Credit policy and debt recovery — A taxpayer that regularly extends credit to customers and clients and has formal procedures for the extension of credit and debt recovery would be more likely to use the earnings method as the appropriate method. Bob rarely extends credit and appears to have no formal procedures for extending credit. • Books of account — Where books of account are kept, the way they are kept, that is, using either the receipts or earnings method, is considered a relevant but not determinative factor to the question of when income is to be recognised. Bob keeps simple books of account and records income on a receipts basis. Conclusion: Bob runs a small business, is not reliant on circulating capital, rarely extends credit and keeps his accounts on a receipts basis. However, Bob does earn the majority of his income from the use of capital equipment, that is, his aircraft. This would suggest that he should keep his books on an earnings basis. However, when you weigh up the other factors it would appear that for the size and nature of the business operation that the receipts basis would be the correct basis.

Examiner’s Comments 3-26 When answering this question, students need to recognise that the relevant legislation does not provide sufficient guidance in order for a taxpayer to determine the appropriate accounting method to use when preparing their account for taxation purposes.

Keep in Mind 3-27 Students need to keep in mind that the relevant Tax Ruling lists a number of factors to consider when determining the appropriate method of accounting for tax purposes. Students need to apply all of the relevant factors listed in the ruling to the facts given for the problem scenario. All the factors then need to be weighed up by the student to determine which accounting method is appropriate.

Question 3 Shah & Co is an accounting partnership with eight partners, 15 employed salaried accountants and 20 support and secretarial staff. The partnership has offices in Parramatta, Penrith and Campbelltown. Although it is involved in some long-term projects, most of its turnover is represented by [page 56] work that takes less than three months to complete. Up to and including the year ended 30 June 2013 the partnership submitted its income tax returns on the receipts basis and the Taxation Commissioner assessed them on this basis. However, due to the increasingly complex nature of their activities, the partnership has decided to submit its return for the current year on an earnings basis. Answer the following: (a) Must the Commissioner accept the altered basis for returning income? What are the relevant considerations? (b) For tax purposes, in which income year are fees of $150,000, which were earned but not received prior to 30 June 2013, regarded as having been derived?

Answer Plan This is a problem style question of moderate difficulty.

Answer 3-28 (a) Issue: Is cash or accruals accounting the most appropriate method for returning the income of Shah & Co? Law and Application: Students should mention and apply: ITAA 1997 s 6-5 which states that assessable income is ordinary income that ‘you have derived’. This leaves it open for taxpayers to determine the most appropriate method of accounting for tax purposes. In the case of Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 Gibbs J held (at 428): … 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.

In Henderson v Federal Commissioner of Taxation (1970) 119 CLR 612 the High Court held that it is appropriate for large professional firms to use the accruals method of accounting. However, it was acceptable for small professional practices to use the cash basis. In this case the business is a professional practice, an accounting partnership. Also, the practice employs 35 staff and has eight partners operating in three offices, so it is not a small business. However, the business could not be classed as a large business either, so the method selected must be one that gives a substantially correct reflex of the taxpayer’s true income. TR 98/1 states that one of the factors to consider would be the size of the business, because the more reliant the business is on employees to [page 57]

generate income, the more likely that the earnings method would be the most appropriate method. Therefore, as Shah & Co is a professional practice with more staff earning income as opposed to principals, that is partners, earning income, the accruals or earnings method would be the most appropriate. (b) In Henderson v Federal Commissioner of Taxation (1970) 119 CLR 612 Barwick CJ stated, further, that when changing from cash to accruals method, ‘the uncollected fees earned in a prior year cannot be included in the assessable income of the next year. They are simply untaxed earnings’. In this case, the $150,000 earned but not received prior to 30 June 2013 is simply ‘untaxed earnings’. The $150,000 is considered to have been derived in the year ended 30 June 2013.

Examiner’s Comments 3-29 When answering this question, students need to be aware of the ‘on point’ case that should be referred to in the answer. An ‘on point case is a case with similar facts to the facts given to the students in the problem.

Keep in Mind 3-30 Students need to keep in mind that when legislation does not fully answer a question then cases and/or Tax Rulings need to be applied. When applying a case to a problem students should display their understanding of the case by giving the decision of the court and the reasons for the decision. Students should then apply the reasons given by the court to the fact scenario in the problem question as appropriate.

Question 4 (adapted from TR 1997/7)

Thilla is a solicitor operating her own practice as a sole practitioner. She employs a secretary, receptionist and a para-legal. Thilla takes sole responsibility for the practice, and all documents and letters are personally signed by her. She returns her income on a cash receipts basis. In June 2015 she receives invoices for a number of expenses which she pays in July 2015. The expenses include telephone, stationery, motor vehicle expenses and the office contents insurance bill. The insurance bill covers the period from 1 July 2015–30 June 2016. In which income tax year are the expenses paid in July 2015 deductible?

Answer Plan This is a problem style question of moderate difficulty. [page 58]

Answer 3-31 Issue: Are the expenses paid in July 2016 deductible in the 2015 or 2016 tax year? Law and Application: According to ITAA 1997 s 8-1(1)(a) allowable outgoings of taxpayers may be deducted from assessable income when they are incurred in gaining or producing assessable income. As the word incurred is not defined in the legislation, one must look to TR 1997/7 (para 5) where it states that ‘you incur an outgoing at the time you owe a present money debt that you cannot escape’. Paragraph 6(a) states that ‘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’. The ruling allows taxpayers who use a cash receipts based accounting system a deduction for a loss or outgoing that has not necessarily been paid a deduction as long as the loss or outgoing has actually been ‘incurred’. In this case even though Thilla operates on a cash receipts basis, she may still be entitled to a deduction in the 2015 tax year for payments made in the 2016 tax year. In order to obtain the

deduction, the amount paid must be ‘definitively committed in the year of income’. As the bills were received in June 2015 the telephone, stationery and motor vehicle expenses would have been incurred prior to the end of the financial year and would therefore, be deductible. The insurance bill on the other hand, even though received in June 2015, relates to the following income tax year. ITAA 1936 s 82KZL provides that expenditure for loan interest, rents, lease payments and insurances are taken to be incurred ‘during the period to which the payment relates’. As the payment is for insurance and relates to the 2016 tax year it would not be deductible in 2015, but would be deductible in 2016.

Examiner’s Comments 3-32 When answering this question, students need to be careful to distinguish between the tax accounting rules that apply to receipts and the tax accounting rules that apply to payments as these are not the same. The law in this area allows taxpayers to account for receipts on a cash basis, yet still account for payments on an accruals basis, but only when the taxpayer ‘owes a present money debt’ that they cannot escape.

Keep in Mind 3-33 Students need to keep in mind that rules relating to the deductibility of outgoings are very specific unlike the rules for receipts, which ‘leave it open to the taxpayer’ whether or not they use cash or accruals. When applying the tax rules to payments, students need to carefully distinguish between outgoings that are a ‘present money debt’ before the end of the tax year, and so, deductible, and payments that relate to after the tax year, and so, not deductible.

[page 59]

Chapter 4

Assessable Income

Key Issues 4-1 The income tax legislation, Income Tax Assessment Act 1997 (Cth) (ITAA 1997) s 3-5, provides that income tax is payable for each year by each individual and company, and by some other entities. In order to calculate the amount of income tax payable, a taxpayer first has to determine their taxable income. The taxable income of a taxpayer is the assessable income of the taxpayer less the allowable deductions of the taxpayer. ITAA 1997 s 4-15(1) Taxable Income = Assessable income – deductions This chapter deals with the ‘assessable income’ part of the above formula. Chapters 6 and 7 will deal with the allowable deductions part of taxable income. ITAA 1997 s 6-1(1) provides that assessable income consists of ordinary income and statutory income. The key issues in this chapter are: • distinguishing between ordinary income and statutory income; • ordinary income; • ordinary income from employment; • ordinary income from business; • ordinary income from property; and • statutory income.

Distinguishing between ordinary income and statutory income 4-2 Assessable income consists of ordinary income and statutory income. Ordinary income is defined in the legislation as income according to ordinary concepts. ITAA 1997 s 6-5(1) states ‘Your assessable income includes income according to ordinary concepts, which is called ordinary income’. The term ‘ordinary concepts’ is explained in case law. Statutory income on the other hand is income that is not ordinary income and is specifically provided for in the legislation. ITAA 1997 s 6-10(1) provides that ‘assessable income also includes some amounts that are not ordinary income’. ITAA 1997 s 6-10(2) further provides that ‘[a]mounts that are not ordinary income, but are included [page 60] in your assessable income, are called statutory income’. The practical effect of these provisions is that ordinary income takes precedence over statutory income. That is, unless income is classed as ordinary income, it will only be included as income for the purposes of taxation, if it is statutory income. Statutory income is found in the income tax legislation, mainly ITAA 1997 Div 15. However, other important classes of statutory income are found scattered throughout the legislation.

Ordinary income 4-3 ITAA 1997 s 6-5(1) provides that ‘Your assessable income includes income according to ordinary concepts, which is called ordinary income’. This definition of ‘ordinary income’ is not particularly useful because what is considered ‘ordinary income’ in the

hands of one taxpayer could be extraordinary in the hands of another taxpayer. For example, an established golfing professional expects to win prizes of money at golf tournaments. On the other hand, an amateur golfer who works in another profession, say teaching, would be surprised to win money at a golf tournament. The prize money received by the professional golfer would be classed as ordinary income and form part of the golfer’s assessable income. The prize money received by the amateur golfer could be considered receipts from a hobby and not assessable. The characteristics of what constitutes ordinary income were considered in Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540. Up until July 1940, Dixon was employed as a clerk by shipping agents Macdonald, Hamilton & Co. In 1939 his employer had notified staff that they ‘would endeavour to make up the difference between their present rate of wages and the amount they will receive from the Navy or Military authorities’ should they enlist to serve in the war effort. Dixon did volunteer, and served in the Australian Imperial Forces in Australia and overseas from July 1940–December 1945. The case was unusual in that the issue was whether the payment of £104, made by Dixon’s former employer to Dixon to make up his military pay to the level of his civilian pay, was assessable income. The majority decision of Dixon CJ and Williams J held that in determining what income is, the character of income must be conceived. They held (at 558) that: Because the £104 was an expected periodical payment arising out of circumstances which attended the war service undertaken by the taxpayer and because it formed part of the receipts upon which he depended for the regular expenditure upon himself and his dependants and was paid to him for that purpose, it appears to us to have the character of income.

The characteristics of income can thus be summarised as being: • for services rendered; • periodical; [page 61]

• expected; and • relied upon. These characteristics of income need not all be present for a receipt to be characterised as income. Each situation/case rests on its own facts and the factual circumstances of each case must be examined. For example, if the above characteristics are applied to the case of the professional golfer and the amateur golfer in the above example, it can be seen why the prize money received by the professional golfer would be characterised as income and the prize money received by the amateur would not be characterised as income.

Ordinary income from employment 4-4 The most important characteristic for income from employment is that the income received has a nexus with employment or a service rendered. For example, it is uncontroversial to assert that salary earned by an employee from their employment is ordinary income. Salary earned has a direct nexus to the service of work rendered to the employer by the employee. Salary also has the four characteristics of income: it is for services rendered; it is periodical; it is expected; and it is relied upon by the employee. Situations arise where the characterisation of a receipt may not be so straightforward. Some of these situations are: • non-cash receipts; • receipts that could be considered a gift; • prizes and unexpected payments; and • receipts that could be the receipt of capital.

Non-cash receipts 4-5 ITAA 1997 s 15-2, a statutory income section, states that, for an individual, any receipt in respect of a service rendered is income, and that this is so ‘whether the things were provided in money or any other form’. In other words the receipt need not be money. However, the section provides that the amount to be declared as income by the taxpayer is ‘the value to you’, that is, the subjective value of the receipt

in the hands of the taxpayer. Money received would be valued at the face value of the money received. However, for goods or allowances received the value would have to be subjectively assessed for the individual taxpayer. For example a bottle of wine given to an employee as a ‘tip’ may have no value to the employee if the employee does not drink alcohol. However, the same bottle of wine would have a value to an employee who enjoys drinking wine. The Income Tax Assessment Act 1936 (Cth) (ITAA 1936) s 21A(1), a statutory income section for businesses, states that ‘in determining the income derived by a taxpayer, a non-cash business benefit that is not [page 62] convertible to cash shall be treated as if it were convertible to cash’. Clearly then, non-cash receipts for business are considered assessable income. The section also provides that non-cash business benefits of a business are to be brought to account as income ‘at its arm’s length value reduced by the recipient’s contribution’ if any. In other words non-cash business benefits are treated as assessable income on an objective arm’s length value.

Receipts that could be considered a gift 4-6 Taxpayers may sometimes receive voluntary, not legally binding payments as money or in other forms and then one has to determine whether the receipt by the taxpayer is income or a gift. For example, a waiter in a restaurant will receive tips from satisfied customers. These tips or gratuities are not legally required to be made. However, they are made and because they are made for a service rendered, they will be considered as income: see ITAA 1997 s 15-2 below. Alternatively, if a parent gives a child a birthday gift of a sum of money, this is considered as a non-assessable receipt because there is no nexus to service. The amount is a gift, because it is made because of the personal relationship between a parent and a child.

In the case of Scott v Federal Commissioner of Taxation (1966) 117 CLR 514 Mr Scott was a solicitor who received a substantial gift of money, £10,000, from a client, Mrs Freestone. The High Court had to decide whether the gift was made for services rendered by Mr Scott, and income, or whether the payment was a ‘true gift’. The facts of the case were that Mr Scott acted for Mrs Freestone after the death of her husband. Before the death of Mr Freestone in 1958, Mr Scott and Mr Freestone ‘were associated in various business enterprises’. After his death Mr Scott acted for Mrs Freestone in the administration of the estate which was large and complex. In order to pay the assessed death duties of £94,000, parcels of real estate had to be sold. Mr Scott succeeded in having land at ‘Greenacres’ situated in a green belt, rereleased from restrictions and so able to be advantageously sold. The land in question, 82 acres, had been valued at £15,500 for probate. However, after the restrictions on the land were lifted, 48 acres of the land were sold for £170,023. After the sale of the land had settled, the taxpayer and Mrs Freestone were in his car on a ‘mission’ when Mrs Freestone informed the taxpayer that she intended to make some gifts to relatives and friends and that she ‘proposed to give him £10,000’. The taxpayer was astounded as it was ‘entirely unexpected’. Cheques for the gifts to the taxpayer and others were made out in the car. Some months after the gift the taxpayer rendered an account to Mrs Freestone for his professional costs of £895, which was duly paid. [page 63] Windeyer J held (at 528) that the gift was not given as ‘remuneration or recompense for services rendered’ and so did not form any part of assessable income. The factors considered in coming to this conclusion were: • the personal relationship or friendship between the donor and the donee; • Scott being paid for his professional services;

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the gift was made outside of the office and was made along with a number of other gifts at the same time; and • the gift was out of all proportion to the service rendered by Scott. 4-7 In the case of Commissioner of Taxation v Harris [1980] FCA 60 the Federal Court, by majority, held that an ex gratia cash payment made to retired officers and other former employees was not income. The bank had made five lump sum payments, yearly, to retired bank officers, from 1975–79. Harris received his first payment of $450 in 1977. The payments were motivated to assisting retired employees whose pensions were being eroded by inflation. The amount of $450 was held not to be income because: … when it was received, it was not known by the taxpayer to be one of a series of periodical payments. The payment was a gift which was not income in the hands of the taxpayer.

The case of Brown v Commissioner of Taxation [2002] FCA 318 considered whether benefits, a home unit, furniture and related benefits to the value of $1 million, were income of the taxpayer or a mere gift. The Federal Court held (at [47]) that in the present case the unit and related benefits were not provided to Mr Brown because of friendship, nor had he been appropriately remunerated for the service he had rendered. The benefits, although voluntarily given, were in fact a reward for services rendered and, therefore, held to be income.

Prizes and unexpected payments 4-8 If the prize, voluntary or unexpected payment has a connection with service, then it is ordinary income. In the case of Laidler v Perry [1965] 2 All ER 121 a Christmas bonus, given as a gift voucher, to all employees and former employees was held to be ordinary income. This is because the benefit was held to arise out of employment and did not arise out of anything else. 4-9 Prizes received by professional athletes are clearly ordinary income. The Australian Tax Office (ATO) has promulgated TR 1999/17, ‘Income Tax: Sportspeople — Receipts and Other Benefits Obtained from Involvement in Sport’. The ruling discusses benefits received by individuals from involvement in sport. The ruling:

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includes all benefits received — salary, wages, allowances, prizes be they in the form of cash or kind, for example, a holiday or motor vehicle; [page 64]

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applies to individuals who receive benefits through their involvement in sport, either as a participant or an official such as a referee or coach; • does not discuss whether a sportsperson is an employee or whether amounts received come within the scope of the PAYG system; and • does not distinguish between an amateur or professional sportsperson as these distinctions are not determinative for income tax purposes. The ruling (at paras 9–14) states that a payment or other benefit received by a sportsperson is assessable if it is: • a payment received from, or in respect of employment; • payments or other benefits received for, in respect of or in connection with services provided; and • amounts of a revenue nature or other benefits received, including prizes or awards, from carrying on a business of participating in sport. This includes exploitation of personal skills in a commercial way for the purpose of gaining reward. Some payments to sportspeople may be made in the absence of any legal obligation and such payments are called voluntary payments. Voluntary payments can be a series of payments, for example, a grant or an occasional payment such as an award or prize. The fact that a payment is voluntary does not mean that it cannot be assessable income. 4-10 The receipt of a series of voluntary payments, such as a grant, will be assessable income if it has the following characteristics (TR99/17 para 12):

(i)

It is made under an agreement or arrangement to provide financial support in the form of periodical, regular or recurrent payments; (ii) It is received in circumstances where the sportsperson has an expectation of receiving the regular payment and is able to rely on the regular payment for their regular expenditure; or (iii) It is part of periodic, regular or recurrent payments made in substitution of income.

Expenses of sports are not allowable deductions against voluntary payments as these expenses do not relate to the voluntary payment received. The receipt of an occasional payment, such as a prize or award, will be determined to be assessable income on a case-by-case basis. The occasional payment will be considered assessable income if paid to the sportsperson in relation to an activity that can be considered employment or the conduct of a business. The occasional payment will not be considered assessable income if they are in the nature of a ‘windfall gain’. This includes receipts incidental to a pastime or a hobby or received on purely personal grounds. 4-11 In Kelly v Federal Commissioner of Taxation (1985) 85 ATC 4283 the Supreme Court of Western Australia considered whether the receipt of $20,000, received by Kelly from a television station for being voted [page 65] the ‘best and fairest player’ in the Western Australia National Football League in 1978, was income. Franklyn J held the amount was income even though the amount was not paid by his employer. Franklyn held (at 4289): Here the payment is directly related to the performance by the recipient of his duty as an employee of the club which performance itself secures the votes of the umpires and results in the payment.

The High Court decision in Commissioner of Taxation v Stone [2005] HCA 21, considered whether the taxpayer had turned her athletic talent to account for money and if so, whether the receipts of prize money, government grants, appearance fees and sponsorship

payments constitute assessable income? Joanna Stone was a senior constable in the Queensland police service and a competitor in women’s national and international javelin throwing events. [She] submitted that she was not conducting a business … the evidence showed that the taxpayer’s motivation was her desire to excel, to represent her country and win medals, not to make money. (at [49])

In order to determine whether her receipts from her sporting activities were assessable income, the High Court undertook (at [19]) ‘a wide survey and exact scrutiny of the taxpayer’s activities’. The court held (at [54]) that: Taken as a whole, the athletic activities of the taxpayer during the 1998–1999 year constituted the conduct of a business. She wanted to compete at the highest level. To do that cost money — for equipment, training, travel, accommodation. She sought sponsorship … she agreed to accept grants … and … her pursuit of excellence, if successful, necessarily entailed the receipt of prizes, increased grants, and the opportunity to obtain more generous sponsorship arrangements.

Receipts that could be the receipt of capital 4-12 There are circumstances when a receipt, particularly in a lump sum, could be characterised as a capital receipt rather than a receipt of income. For example, a one-off receipt to compensate an author for the sale of copyright to his/her work could be a capital receipt. However, if the author regularly sold the copyright then the receipt could be characterised as income. The case of Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 had to determine whether a receipt by the taxpayer was for personal exertion or a capital receipt. In this case, the taxpayer, the wife of a notorious train robber, was paid for selling her story to a newspaper. The taxpayer also sold some photographs and entered into a 60-day restrictive covenant not to sell the story further. The court held that the receipt was assessable income because: • her knowledge was not considered property as it was not acquired through the conduct of a business, nor was any copyright attached to the knowledge; [page 66]

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the 60-day restrictive covenant was considered part of the service agreement; and • the taxpayer had merely provided a service. In the case of Bennett v Federal Commissioner of Taxation (1947) 75 CLR 480 the High Court had to determine whether compensation of £12,055 payable in instalments for entering into a new contract with less status and less pay was capital or income. The High Court held that the payments were not compensation for loss of income, but were payments for removal of contractual rights, compensation for giving up control of the company. The receipt was thus, held to be capital. The United Kingdom case of Higgs v Olivier [1952] Ch 311 considered whether £15,000 paid to the taxpayer, Olivier, to not perform in films for a certain period was income or capital. The restrictive covenant to ‘not perform’ was entered into as a separate agreement to the service contract entered into to perform in a film. The court held that: • the payment could not be regarded as a reward for service; • the restrictive covenant was not related to the service contract; and • there was at that time no evidence that such payments, restrictive covenants, were an ordinary incident of vocation as an actor. In the Australian case of Reuter v Federal Commissioner of Taxation (1993) 24 ATR 527 the taxpayer was paid $8 million by the merchant bank Rothwells to covenant that he would not claim a success fee for the takeover of Fairfax against Bond Media. It was held by Hill J, in the Federal Court, that the receipt was closely connected to the services provided by the taxpayer to Rothwells Ltd and was therefore ordinary income. Fees received by a taxpayer for entering a new employment arrangement can be characterised as capital or income, depending on the facts of each case. For example, in Jarrold v Boustead (1963) 41 TC 701, a sign-on fee paid to the taxpayer as compensation for giving up his amateur status was held to be a capital receipt. On the other hand, in Pickford v Federal Commissioner of Taxation (1998) 40 ATR 1078 a

one-off payment of $20,000 to the taxpayer by a new employer was held to be income. This is because the payment was made to compensate the taxpayer for share options given up with the current employer when taking up the new employment.

Ordinary income from business 4-13 Income from business is regarded as a category of income from personal exertion and therefore regarded as ordinary income and assessable under ITAA 1997 s 6-5.

Other relevant legislation 4-14 ITAA 1997 s 15-15(1) states that assessable income includes profit arising from a profit-making undertaking or plan. [page 67] ITAA 1997 s 15-15(2), however, states that it is not applicable to profit arising from: • ordinary business income covered under ITAA 1997 s 6-5; and • the sale of property acquired after 20 September 1985 as these profits are subject to Capital Gains Tax (CGT). ITAA 1997 s 995-1 provides a definition of ‘business’ as including ‘any profession, trade, employment, vocation or calling, but does not include occupation as employee’. ITAA 1997 Div 35 deals with the deferral of losses from noncommercial business activities. The object of Div 35 s 35-5(1) is to improve the integrity of the taxation system by preventing losses from non-commercial activities that are carried on as a business by individuals (alone or in partnership) being offset against other assessable income. An activity subject to this Division is one where, in the year of income, the sum of the taxable income, the reportable fringe benefits, reportable superannuation contributions and net investment

losses is less than $250,000, and any one of the tests set out below for the income year is satisfied: • the assessable income from the activity is at least $20,000 (s 3530); • the relevant activity made a profit in at least three of the past five years (s 35-35); • real property used in the activity had a reduced cost base, or market value of at least at $500,000 (s 35-40); or • other assets, including depreciable equipment, trading stock, leased assets and trademarks or patent rights, valued at least $100,000 (s 35-45). 4-15 Factors considered by the courts when determining whether or not an activity constitutes carrying on a business include: • profit-making intention; • scale of activities; • commercial approach to activity; • system and organisation employed; • whether or not the methods used in the activity are characteristic of the particular line of business; • sustained and frequent activity; and • the type of activity and the type of taxpayer. Although the factors would be considered, not all the factors need to be present as each case is determined on its own facts. In the case of Ferguson v Federal Commissioner of Taxation (1979) 9 ATR 873 the taxpayer, a navy officer, leased five cows with the intention of establishing a herd. The activity made losses. The court held that the taxpayer was carrying on a business through a manager because he had: • a purpose of profit-making; • repetition and regularity; [page 68]

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organisation and a businesslike approach with appropriate record-keeping; • having a full-time job held not to be inconsistent with carrying on a business; • the size of the operation and capital are relevant considerations but must be looked at in context of the activity; and • the activities were more than a preparation to begin a future business. In Federal Commissioner of Taxation v Walker (1985) 16 ATR 331 the taxpayer, a real estate agent, was held to be conducting a business of goat breeding despite the fact that he only owned one goat. The court applied the criteria, for determining whether there is a business, established in Ferguson. In Thomas v Federal Commissioner of Taxation (1972) 3 ATR 165 considered a small farm of 7.5 acres, owned and run by a barrister. The farm had been planted with trees for timber, macadamia nuts and avocados. Held by the High Court to be a business. What was decisive in this case 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 a hobby. A number of cases illustrate that carrying on a business can be found even if carried on in a small scale. If the above cases were decided today, they would still be held to be carrying on a business. However, the small size of the activity means the losses from the activities would be subject to ITAA 1997 Div 35. The losses from the activities would therefore, not be deductible against other income of the taxpayers. 4-16 The courts have also had to determine whether or not the activity of gambling constitutes a business activity. Professional bookmakers and casino operators are clearly running a business because of the scale of their operations and the fact that they can manage the odds of winning. Individual gamblers are unlikely to be considered in the business of gambling because such activities are inherently recreational in nature. In Trautwein v Federal Commissioner of Taxation (No 2) (1936) 56

CLR 196 the taxpayer owned a stud farm and raced and leased horses. He was also involved in frequent and systematic betting using an agent to place bets and wagering large sums. The High Court held that the taxpayer’s gambling activities were part of his racehorse business and therefore ordinary income. In a subsequent case, gambling was held not to be a business even though associated with horse breeding. In Martin v Federal Commissioner of Taxation (1953) 90 CLR 470 the taxpayer owned and bred racehorses, and he was also an hotelier and farmer. He regularly bet in a systematic manner and his accountant kept records. It was held by the High Court that the taxpayer was not conducting a business but pursuing a recreational pastime. [page 69] Gambling has also been held not to be a business if there is a lack of systematic approach to the activity. In Evans v Federal Commissioner of Taxation (1989) 20 ATR 922 the taxpayer earned over $800,000 in gambling wins over five years. The Federal Court held that the taxpayer was not conducting a business but was lucky. There was a lack of systematic approach, bets were not placed with a bookmaker and he often bet on long-odds bets. Gambling by a taxpayer with no other source of income was also held not to be a business. In Babka v Federal Commissioner of Taxation (1989) 20 ATR 1251 the taxpayer, after retirement, spent a lot of time gambling on horses, cards and casinos. The Federal Court held that, even though the taxpayer had no other income, kept records and utilised a betting system, he was not in the business of gambling. 4-17 It is important to determine when a business commenced, because expenses incurred preliminary to starting a business are not deductible. In Softwood Pulp and Paper v Federal Commissioner of Taxation (1976) 7 ATR 101 costs in producing a feasibility study to establish a

paper mill were held to be non-deductible because no production had occurred nor had a decision been made to carry on a business. 4-18 Receipts are normal business proceeds, and so assessable income of a business, when they are a product of: • a transaction that is part of the ordinary business activity; or • a transaction that is an ordinary incident of the business activities. In Memorex Pty Ltd v Federal Commissioner of Taxation (1987) 19 ATR 553 the taxpayer sold and leased computer equipment and advised on the design of computer systems. During the income year, the taxpayer had receipts from the sale of leased equipment. These receipts were not a significant component of the taxpayer’s business and were returned as capital receipts. The Full Federal Court held the receipts were assessable income of the taxpayer because they: • showed a nexus with the core business activity; and • were of a sufficient magnitude, frequency and regularity to be judged as a normal incident of the business activities.

Non-cash business benefits 4-19 If a business benefit is truly income in nature, then under ITAA 1936 s 21A treats the benefit as being: • convertible to cash; and • requiring the benefit be brought to account at arms-length value (less any contribution by the recipient), but • does not apply to non-deductible entertainment or a benefit valued at less than $300. [page 70]

Isolated business transactions 4-20

When a business undertakes an isolated transaction, the

difficulty is whether to characterise the proceeds as ordinary income, statutory income under ITAA 1997 s 15-15 or as a capital receipt. In the early case of Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation (1950) 81 CLR 188 the proceeds from an isolated transaction were held to be capital. After 1924 the taxpayer sold land that had previously been used for mining for 60 years. The land was subdivided, roads and railway station built, land granted to schools, churches and for parks. The High Court held sale to be ‘a mere realisation’ of an asset and not a business. Further, they held that there cannot be a business or profit-making scheme by selling alone. The opposite decision was made in the case of Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 150 CLR 355. Fishermen owned shares in a company that owned beachfront property. The company shares were sold by the fishermen to land developers. The new shareholders, property developers, extensively developed the land and sold it at a substantial profit. By majority the High Court held that the company had embarked on a profit-making scheme. According to the majority ‘the development and sale was so extensive that it had the characteristics of a business’. In Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 the taxpayer assigned the right to a future interest income stream, on an $80 million loan to a subsidiary (Myer Finance), to Citibank in exchange for receiving a lump sum of $45 million. The High Court in finding that the $45 million was assessable income, held: • First strand — A gross profit derived in the course of a business enterprise that is subsidiary or incidental to the taxpayer’s ordinary business activities acquires an income character similar to profits from ordinary business activities. This is called the ‘broad approach’ to characterisation of business activities. The requirements of the first strand are: – there was a business operation or commercial transaction; – there was a profit-making intention upon entering the transaction; and – the profit was made by means consistent with the original intention: see the Westfield decision below.

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Second strand — on the basis of the compensation doctrine it was held that Myer had exchanged a future income stream (the interest payments over 7.25 years) into present income in the form of a lump sum. This is the ‘narrow approach’ to the characterisation of the receipt. In Westfield Ltd v Federal Commissioner of Taxation (1991) 21 ATR 1398 the taxpayer was in the business of designing, constructing, leasing and managing shopping centres. In the normal course of their business the taxpayer acquired land with the purpose of designing, building and [page 71] leasing a shopping centre on the site. After acquiring the land, the taxpayer determined not to proceed with the development. They subsequently sold land acquired for the development at profit. The High Court in finding that the receipt from the sale of land was a capital receipt, held that: • purchase and sale of land was not part of a profit-making scheme; and • where a transaction is outside the scope of the business, there must exist at the time of entry into the scheme a purpose of profitmaking by the very means by which the profit was made.

Ordinary income from property 4-21 ITAA 1936 s 6, the definitions section, defines ‘income from property’ or ‘income derived from property’ as all income not being income from personal exertion. Income from property, like business income, is ordinary income under ITAA 1997 s 6-5. Types of income from property include:

Interest

4-22 Interest represents income from money. Interest from traditional securities is recognised when it is paid. Interest from ‘qualifying securities’ is recognised using accruals basis.

Income from real property 4-23 Rent is income for the use of property. It is usually paid periodically, but is also income even if paid in a lump sum. Leases are also income from the use of property. Lease premiums can be paid to induce a party to enter a lease.

Lease premiums 4-24 A lease premium is normally capital and taxed under the CGT provisions. However, a lease premium can be income when: • the taxpayer is in the business of receiving lease premiums (Kosciusko Thredbo Pty Ltd v Federal Commissioner of Taxation (1983) 15 ATR 165); or • where the lease premium is really a substitute for rent.

Income from shares 4-25 Dividends are income from shares and are not classed as ordinary income. ITAA 1936 s 44 declares dividends received as statutory income.

Royalties 4-26 A royalty is a payment calculated on the basis of usage of intellectual property or the quantity/value of a substance taken, such as coal from a mine. Royalties, like dividends, are assessable as statutory [page 72] income under ITAA 1997 s 15-20 unless they are ordinary income. In other words a professional author who makes his ordinary living from

royalties would have the royalties treated as ordinary income. On the other hand, a teacher who happens to write a book and receive royalties would be considered as earning statutory income.

Annuities 4-27 An annuity is a regular stream of payments that occur at regular intervals. There are two types of annuity: 1. fixed term; or 2. life. The annuity normally comprises part interest income and part return of capital. This is set out by ITAA 1936 s 27H, which recognises the capital component of a royalty payment.

Statutory income 4-28 Division 15 of ITAA 1997 sets out some items that are included in assessable income, not including ordinary income, in the table below. Table 4-1: Some Items of Assessable Income

ITAA 1997 section

Operative provision

15-2

Your assessable income includes the value to you of all allowances, gratuities, compensation, benefits, bonuses and premiums provided to you in respect in respect of, or for or in relation directly or indirectly to, any employment of or service rendered by you. This is so whether the things were provided in money or any other form.

15-3

Assessable income includes any amounts received under any arrangement entered into for the purposes of inducing you to resume working for or providing services to an entity.

15-5

Assessable income includes an accrued leave transfer payment that you receive.

15-10

Assessable income includes any bounties or subsidies received in relation to carrying on a business that is not assessable under ordinary income.

15-15

Assessable income includes profit arising from the carrying on or carrying out of a profit-making undertaking or plan, unless the profit is assessable as ordinary income.

15-20

Assessable income includes amounts received by way of royalty, unless the royalty is assessable as ordinary income.

15-22

Payments made to a copyright collecting society. [page 73]

15-23

Payments of resale royalties by a resale royalty collecting society.

15-25

Amounts received for lease obligations to repair received as a lessor or former lessor of premises, unless the receipt is assessable as ordinary income.

15-30

Amounts received by way of insurance or indemnity for the loss of assessable income, unless the amount is not assessable as ordinary income.

15-35

Amounts received under the Taxation (Interest on Overpayments and Early Payments) Act 1983 (Cth).

15-40

Amounts received for providing mining, quarrying or prospecting information or geothermal information, unless the receipt as assessable as ordinary income.

15-45

Amounts received under forestry agreements.

15-46

Amounts received under forestry managed investment schemes.

15-50

Work in progress amounts received.

15-55

A benefit provided by a life insurance company under certain funeral policies, unless the receipt is assessable as ordinary income.

15-65

Amounts received as sugar industry exit grants under the program known as the Sugar Industry Reform Program.

15-70

Reimbursed car expenses received.

15-75

Amounts received by way of a bonus on a life insurance policy.

When examining Div 15, it becomes clear that amounts received as statutory income under this Division are usually only considered as statutory income unless they are ordinary income. The practical effect of this is, for example, if an author receives royalty payments for books written in the course of their normal enterprise, then those royalties are treated as ordinary income. However, if a mountain climber received royalties for writing a book of their exploits, then the royalty receipt could be considered as statutory income under ITAA 1997 s 15-20.

Question 1 Alice is a full-time university student who works part-time in a pizza restaurant. During the year she has receipts as follows: (a) income from working in the pizza restaurant $25,000; (b) tips from customers of $500 cash; (c) at Christmas time, a bottle of expensive Scotch worth $250, from a regular customer. Alice does not drink spirits and gave the bottle to her father; (d) a Christmas gift from her grandparents of $15,000; and [page 74] (e) a monthly outing with the owner of the restaurant. Each month the owner takes all staff to a dinner on a night when the restaurant is closed. The owner spends around $600 on the meals that Alice consumed. Alice enjoys these occasions and sees them

as a reward for her hard work. What is Alice’s assessable income for the year?

Answer Plan This is a problem question of moderate difficulty because students need to analyse a number of different receipts and characterise those receipts in the hands of Alice, the taxpayer.

Answer 4-29 Issue: Are the receipts of cash, goods and meals assessable income in Alice’s hands? Law and Application: (a) ITAA 1997 s 6-5 provides that assessable income includes income according to ordinary concepts. In the case of Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540, the majority held that ordinary income had the characteristics of being for services rendered, periodical, expected and relied upon. In this case salary is for services rendered, is periodical, expected and relied upon, therefore the salary is ordinary income. Alice would have to declare $25,000 as income. (b) ITAA 1997 s 15-2, a statutory income section, provides that any receipt in respect of service is income. As the tips have a nexus with service, they are assessable income and would have to be declared at a value of $600. (c) ITAA 1997 s 15-2, a statutory income section, provides that any receipt in respect of service is income even when the receipt is not in the form of money. In this case the bottle of scotch does have a nexus with Alice’s service and so would be income. ITAA 1997 s 15-2 states that when a receipt is not in the form of money, then the receipt is valued for tax at the subjective value of the taxpayer. As Alice does not drink spirits and she gave the bottle of scotch to

her father, the value to Alice is zero. (d) ITAA 1997 s 15-2 provides that for a receipt to be income there must be a nexus to service provided by the taxpayer. Further the case of Scott v Federal Commissioner of Taxation (1966) 117 CLR 514 held that if a gift was not given for service, but rather because of the personal relationship between the parties, then the gift was not income. In this case Alice received the money not because of service but because of her personal relationship. The $15,000 is therefore not assessable income. [page 75] (e) ITAA 1997 s 15-2, a statutory income section, provides that any receipt in respect of service is income even when the receipt is not in the form of money. In this case the provision of dinners does have a nexus with Alice’s service and so would be income. ITAA 1997 s 15-2 states that when a receipt is not in the form of money, then the receipt is valued for tax at the subjective value of the taxpayer. As Alice does attend and enjoy the dinners the value for tax purposes would be $600. The total of Alice’s assessable income would therefore be; Salary Tips of cash Bottle of scotch Gift from grandparents Dinners from employer Total Assessable income

$25,000 $500 Nil Nil $600 $26,100

Examiner’s Comments 4-30

Students should recognise that receipts, whether in cash or any

other form, will be income if they have a nexus with employment or service rendered.

Keep in Mind 4-31 Students need to keep in mind that receipts of a non-cash nature are income if there is a nexus with service. It is important to note that any non-cash receipts, whether or not they are convertible to cash, are income. However, the value of non-cash receipts in the hands of an individual is, for tax purposes, the subjective value of the non-cash receipt: ITAA 1997 s 15-2. It is important to distinguish between noncash receipts in the hands of an individual for providing a service, and non-cash receipts in the hands of a business. This is because, under ITAA 1936 s 21A, non-cash business receipts are valued objectively, at an arm’s length value.

Question 2 Catherine is a book editor and she is employed at a major legal publishing house. In her spare time she writes short stories. Catherine has never submitted any of her work for publication, as she writes for her own pleasure. One day Catherine notices that there is a national short story competition with a first prize of $50,000. She decides to enter the competition and on the same day, feeling lucky, she buys a lottery ticket. Catherine wins $10,000 second prize in the lottery and she wins the short story competition. Discuss the assessability of these receipts.

[page 76]

Answer Plan This is an easy problem style question.

Answer 4-32 Issue: Are the prize receipts assessable income or chance winnings? Law and Application: ITAA 1997 s 15-2 provides that receipts that have a nexus to service will be statutory income. In this case the $50,000 for winning the short story prize was based on the quality of the story written by Catherine. Even though luck may have played a part in winning the competition, the reason Catherine won the money was that she had written the best story. Therefore, this receipt would be regarded as assessable income. The $10,000 lottery win was not connected to service. In the case of Evans v Federal Commissioner of Taxation (1989) 20 ATR 922 the Federal Court held that the receipts from gambling were not assessable income as the taxpayer was merely ‘lucky’. In this case Catherine was also lucky. Therefore the prize for winning the short story competition would be regarded as statutory income, but the lottery win would not be assessable income.

Examiner’s Comments 4-33 Students need to distinguish between winnings attributable to chance and winnings attributable to skill. Students could have approached the answer by first considering whether or not the receipts were ordinary income per ITAA 1997 s 6-5 and whether or not the receipts had the characteristics of ordinary income as per Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540.

Keep in Mind 4-34 Students should always keep in mind that although a receipt may not be ordinary income, it may well be a form of statutory income.

Question 3 Following on from the previous question; after Catherine won the short story competition she was approached by a publisher of fiction, not her current employer, to sign a book publishing contract. Catherine signed the contract and the publisher published her winning story and other stories that she had written. The book had some success and Catherine received royalties of $8000. Were the royalty receipts assessable income in Catherine’s hands?

[page 77]

Answer Plan This is an easy problem style question.

Answer 4-35

Issue: Is the royalty receipt assessable income?

Law and Application: ITAA 1997 s 6-5 provides that ordinary income is assessable income. Income from a business is considered ordinary income. In Ferguson v Federal Commissioner of Taxation (1979) 9 ATR 873 the court held that the taxpayer was carrying on a business because: • he had a purpose of profit-making. In this case Catherine did not have a profit making purpose; • there was repetition and regularity. In this case Catherine may have written regularly but had never before published any work; • he demonstrated organisation and a businesslike approach with appropriate record-keeping. Catherine had no businesslike approach as she wrote in her spare time. There is no information as to her keeping any records; • a full-time job was held not to be inconsistent with carrying on a

business. Catherine has a full-time job; • the size of the operation and capital are relevant considerations but must be looked at in context of the activity. Catherine is writing on her own and has only had one book published as the result of her winning the short story competition; and • the activities were more than a preparation to begin a future business. It appears that Catherine is not writing for business purposes or professionally but writing for her pleasure. Catherine would not be considered to be conducting a business of writing books. However, ITAA 1997 s 15-20 provides that royalties are assessable as statutory income unless they are ordinary income. As Catherine has a royalty receipt it would be assessable as statutory income. Catherine does not make her living as an author as she is a book editor and not a professional author, and therefore the royalty is not assessable as ordinary income under ITAA 1997 s 6-5.

Examiner’s Comments 4-36 The examiner is looking to whether students can distinguish between statutory income and ordinary income here. [page 78]

Keep in Mind 4-37 Students should keep in mind that if a receipt is not dealt with under one section of the ITAA, in this case ITAA 1997 s 6-5 ordinary income, then it may be dealt with under another section. Students should also consider whether or not a receipt is ordinary income, before considering whether or not the receipt is statutory income. This is because ITAA 1997 s 6-10 has the effect that, unless income is classed

as ordinary income, it will only be included as income for the purposes of taxation, if it is statutory income.

Question 4 Following on from Question 2, after Catherine won the short story competition she was approached by a publisher of fiction, not her current employer, to sign a book publishing contract. Catherine signed the contract and was paid a $20,000 lump sum payment for the copyright to her work. Was the receipt assessable income in Catherine’s hands?

Answer Plan This is an easy problem style question.

Answer 4-38

Issue: Is the lump sum receipt income or capital?

Law and Application: In the case of Brent v Federal Commissioner of Taxation (1971) 125 CLR 418 the court had to determine whether a receipt by the taxpayer was for personal exertion and thus income or a capital receipt. In this case, the taxpayer, the wife of a notorious train robber, was paid for selling her story to a newspaper. The court held that the receipt was assessable income because her knowledge was not considered property as it was not acquired through the conduct of a business, nor was any copyright attached to the knowledge. In this case Catherine is selling property, her copyright, for a lump sum. Therefore, the receipt of $20,000 is a receipt of capital and not income.

Examiner’s Comments 4-39 This question requires students to use a case and instead of applying the outcome of the case to the problem scenario they need to

distinguish the case to the problem. In this problem the taxpayer did sell property and so the receipt was held to be a capital receipt; this is the opposite of the decided case. In the decided case the taxpayer was found not to be selling property and so the receipt was held to be income. [page 79]

Keep in Mind 4-40 Students should keep in mind that had Catherine been in the business of writing books and selling her copyright, then the lump sum receipts would have been assessable ordinary income.

Question 5 Pearl is a full-time employee of the Victorian Police Force and a world-class high jumper. Pearl competed successfully in national and international competitions, including being selected for the Olympics team and winning a gold medal at the Asia Cup Athletics Competition in April this year. Pearl earned the following receipts: (a) $80,000 from her police salary; (b) $40,000 in cash as prize money from sporting events; (c) $20,000 in government grants to assist with training; (d) $25,000 from her appearance fees at motivational and sports seminars; and (e) $10,000 in sporting goods from a major sponsor. Explain with reference to decided cases and legislation the assessability for Pearl of the five receipts.

Answer Plan This is a straightforward problem style question. Although the question has five parts, each part is straightforward, even though different law applies to the parts.

Answer 4-41 Issue: Are the receipts of cash and goods by Pearl ordinary income, statutory income or gifts? Law and Application: (a) ITAA 1997 s 6-5 provides that assessable income includes income according to ordinary concepts. In the case of Federal Commissioner of Taxation v Dixon (1952) 86 CLR 540, the majority held that ordinary income had the characteristics of being for services rendered, periodical, expected and relied upon. In this case salary is for services rendered, is periodical, expected and relied upon, therefore the salary is ordinary income. (b) ITAA 1997 s 15-2 provides that any receipt in respect of service rendered is income. The cash received from competing in sporting events has clearly been granted to Pearl for her sporting efforts and not from luck and so is statutory income. However, in the case of Commissioner of Taxation v Stone [2005] HCA 21, a case with facts [page 80] similar to those above, the High Court had to determine whether Stone’s receipts from her sporting activities were income from conducting a business. The High Court held that Stone’s activities, taken as a whole, were the conduct of a business. Therefore all of the receipts from her sporting activities were ordinary income from conducting a business under ITAA 1997 s 6-5. Therefore, in this case Pearl’s receipts of prize money are ordinary income. (c) As per part (b) above, because the $20,000 of government grants are related to Pearl’s sporting activities, that is, her business as a sportswoman, the government grants are also ordinary income. (d) As per part (b) above, because the $20,000 of appearance fees are related to Pearl’s sporting activities, that is, her business as a

sportswoman, the appearance fees are also ordinary income. (e) As per part (b) above the sporting goods received are related to Pearl’s sporting activities. However, the goods are not cash and may not be cash convertible. ITAA 1936 s 21A states a non-cash business benefit is treated as though it were convertible to cash and it must be brought to account at its arm’s length value. Because the goods are received as a direct result of Pearl’s sporting activities, then they would be assessable under ITAA 1936 s 21A at a value of $10,000.

Examiner’s Comments 4-42 All receipts, of cash or of goods, need to be examined and characterised in the hands of the taxpayer receiving the money or goods. It is the characteristics of the individual taxpayer which will be determinative in deciding whether or not a receipt is income, and the type of income.

Keep in Mind 4-43 Students need to keep in mind the nexus between a receipt and the provision of service. If a receipt can be characterised as either, from a providing personal service or from the conduct of a business, then the receipt is probably income. Students also need to keep in mind that once the receipt has been characterised, then the relevant law will come into operation. Receipts with a nexus to the provision of personal services will either be ordinary income under ITAA 1997 s 6-5 or statutory income under ITAA 1997 s 15-2. Receipts with a nexus to the conduct of a business will either be ordinary income under ITAA 1997 s 6-5 or statutory income under ITAA 1936 s 21A. [page 81]

Question 6 During the financial year Lorraine received the following amounts: (a) salary of $50,000; (b) winnings from horse race betting $60,000; (c) gifts of cash for her 50th birthday $1000; (d) proceeds from the sale of two paintings which Lorraine painted to pass time over the Christmas holidays $500; and (e) a rental property from which she received $250 per week for 52 weeks of the year. Calculate Lorraine’s assessable income and tax payable (excluding the Medicare levy) for the year ended 30 June 2015.

Answer Plan This is a calculation type question that requires the students to examine the characteristics of the different receipts in the hands of the taxpayer. The question also requires students to go back to Chapter 1 and apply the relevant tax tables.

Answer 4-44 (a) The $50,000 salary is ordinary income as it is cash, a real gain and flows from personal services: ITAA 1997 s 6-5. (b) Even though the earnings are cash and a real gain as they are chance gambling winnings, they are typically not ordinary income, especially when the gambling does not involve any element of skill and is purely due to luck: Babka v Federal Commissioner of Taxation (1989) 20 ATR 1251. (c) Even though the gift is cash and a real gain, there is no nexus with any service and therefore is clearly not assessable as ordinary income. The gift was personal in nature: Scott v Federal Commissioner of Taxation (1966) 117 CLR 514. (d) As the painting did not involve a material commitment of capital

and/or time, Lorraine does not have a genuine profit intention and only involves the occasional sale. These activities are therefore likely to constitute a hobby and therefore not ordinary income: Thomas v Federal Commissioner of Taxation (1972) 3 ATR 165. (e) Rent is ordinary income as it is cash, a real gain, flows from property and is regular: ITAA 1997 s 6-5. Total assessable income = $50,000 + $13,750 = $63,750. Tax payable: 3572 + ((63,750 – 37,000) × 0.325 = $12,265.75 [page 82]

Examiner’s Comments 4-45 All the receipts need to be examined and characterised in the hands of the taxpayer, even those receipts that are held not to be income. It is the characteristics of the individual taxpayer which will be determinative in deciding whether or not a receipt is income.

Keep in Mind 4-46 Students need to keep in mind that even though many receipts are not income, all receipts need to be examined.

Question 7 Belinda Blue is a large lady, who is an employed account executive with a major retail store. In her spare time Belinda is an avid amateur golfer who also designs and makes women’s golf clothes in larger sizes. Even though Belinda is an enthusiastic golfer, entering all the amateur events she can, she is not very good at the sport. However, she does have a flair for clothing design and she takes her golf clothes to all the events she participates in and sells the clothes she has made to other lady golfers. Belinda takes clothing orders from the golfing ladies and makes clothes to measure. Belinda attended a clothes design course at her local TAFE. She also had a small catalogue of her designs printed and she hands out copies of the catalogue at all the golfing tournaments that

she attends. Belinda is feeling confident that her clothing line will be a big success. During the financial year she attended 48 golfing competitions. She won one tournament during the year and received prize money of $500. She also sold Belinda Blue clothing to the value of $45,000. Discuss the assessability of the above receipts.

Answer Plan This is a difficult problem type question because students are required to consider receipts with different characteristics.

Answer 4-47 Issue: Are the receipts from the golfing prize and sale of clothes business income or a hobby? Law and Application: Under ITAA 1997 s 995 ‘business’ is defined broadly as ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’. In this case the prize money and the receipts from selling clothes could be characterised as business income. [page 83] In Ferguson v Federal Commissioner of Taxation the Federal Court held that the taxpayer was carrying on a business after considering a number of factors: (a) Profit making intention In this case it appears that Belinda did believe that her clothes line ‘would be a big success’ and so she had a profit-making intention. However, with respect to her golf playing, Belinda only won one prize and was aware that she was not ‘very good at the sport’ even though she enjoyed playing. So, here there was no profit-making intention.

Repetition and regularity In this case Belinda attended 48 golfing (b) events and so displayed repetition and regularity. (c) Organisation and a businesslike approach In this case Belinda took a TAFE course and had a clothes catalogue printed and so displayed the beginnings of a businesslike approach to the clothing sales. However, she did not take on golf lessons to improve her playing of the game. (d) Having other income does not preclude other activities from being a business In this case Belinda’s other employment would not preclude her from having a business. (e) Size of the operation In this case her regular sales and building up of a clientele would indicate a commercial activity. However, only one golf prize appears to be a product of luck rather than skill. (f) Activities were more than preparation for a business In this case attending TAFE appears to be preparation for a business. However, printing a catalogue and attending so many golfing tournaments indicates a business has begun. In Thomas v Federal Commissioner of Taxation the court held that the activity was a business because the farming activity ‘was more than a recreational activity pursued for mainly leisure purposes’. In this case the activity of making and selling clothes was more than a leisure activity. The golf playing, however, retained the character of a leisure activity. Conclusion: It appears that even though Belinda is an avid golfer, she only plays for her pleasure and so the $500 would be a receipt from a hobby. However, her activity in selling clothes has the characteristics of a business activity and would most likely be business income. Other cases students could consider would be: • Federal Commissioner of Taxation v Walker — apply the same characteristics as in Ferguson’s case. • Stone v Federal Commissioner of Taxation — students could distinguish Stone’s sporting activities that were held to be a business activity despite the lack of a profit motive from Belinda’s sporting activities.

[page 84]

Examiner’s Comments 4-48 The issue of distinguishing between receipts that are receipts from a hobby and receipts from a business activity can be difficult. This is because determining when a personal passion becomes a business is not clear as the transition happens incrementally. A talent for designing and making clothes can remain a lifelong hobby. However, when that hobby begins to display the characteristics of a business will happen over time. ITAA 1997 Div 35 deals with this issue by defining receipts from non-commercial activities by establishing a monetary scale of activity indicators.

Keep in Mind 4-49 Students need to keep in mind that the first task in answering a problem question is to determine the legal issue. This task is vital as it determines the law that will be applied to the particular problem. If the issue is incorrect, then students will be directed to inappropriate law for the facts of the particular problem.

Question 8 Julia owns a luxury car rental business out of premises that she purchased 25 years ago, for $200,000, from which to operate her business. Recently, the neighbourhood where she conducts her business has become a fashionable residential area. The value of the land where Julia operates the business has risen so that it is now worth much more as a development site than as a business site. Julia enters into negotiations with a number of property developers and sells her land for $4.5 million. After selling her land, she moves her business to another location. Are the receipts from the sale of land assessable income in Julia’s hands?

Answer Plan This is a moderately difficult problem style question.

Answer 4-50

Issue: Are the receipts from the sale of land income or capital?

Law and Application: In Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 the High Court held: • First strand — A gross profit derived in the course of a business enterprise that is subsidiary or incidental to the taxpayer’s ordinary business activities acquires an income character similar to profits from ordinary business activities. This is called the ‘broad approach’ to characterisation of business activities. In applying the broad approach to this question, the profit derived by Julia from selling [page 85] her land was not ‘subsidiary or incidental’ to her ordinary activities of leasing luxury cars. • Second strand — On the basis of the compensation doctrine, it was held that Myer had exchanged a future income stream (the interest payments over 7.25 years) into present income in the form of a lump sum. This is the ‘narrow approach’ to the characterisation of the receipt. In applying the narrow approach, the compensation doctrine, to this question Julia exchanged one capital asset, land, for compensation, a lump sum payment. In conclusion then, the profit was not earned during the course of Julia’s ordinary business and she exchanged one capital asset for a lump sum, therefore the receipt is capital.

Examiner’s Comments 4-51 This is a problem of moderate difficulty because it was open to students to answer this question by applying different cases in order to achieve the same conclusion. Students could have applied the cases of Scottish Australian Mining Co Ltd v Federal Commissioner of Taxation (1950) 81 CLR 188, Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199, and/or Westfield Ltd v Federal Commissioner of Taxation (1991) 21 ATR 1398.

Keep in Mind 4-52 Students should keep in mind that using general principles from a case can obviate the need for students to find and apply cases that are on point with the problem they have been given.

Question 9 Using the fact scenario in Question 8 above, Julia makes most of her regular income from luxury car rental. However, every five to six years she updates her cars so that they are always reasonably current. Are the receipts from selling her luxury cars assessable income?

Answer Plan This is a relatively easy problem style question.

Answer 4-53 In the case of Memorex Pty Ltd v Federal Commissioner of Taxation (1987) 19 ATR 553 the taxpayer sold and leased computer equipment and advised on the design of computer systems. During the

income year, the taxpayer had receipts from the sale of leased equipment. [page 86] These receipts were not a significant component of the taxpayer’s business and were returned as capital receipts. The Full Federal Court held the receipts were assessable income of the taxpayer because they showed a nexus with the core business activity; and were of a sufficient magnitude, frequency and regularity to be judged as a normal incident of the business activities. In this case Julia’s car sales do have a nexus with her core business activity of luxury car rental. Julia also sells cars with sufficient frequency and regularity that the activity would be considered to be a normal incident of her business. Therefore, the receipts from selling the cars would be assessable income.

Examiner’s Comments 4-54 The Memorex case, used above, is the case that is on point with the problem and so provides a direct answer to the problem.

Keep in Mind 4-55 Students need to keep in mind that when answering problem questions their first source of law should be legislation and that case law should be applied when legislation does not exist on the point or the legislation has been interpreted by case law.

[page 87]

Chapter 5

Capital Gains and Losses

Key Issues 5-1 Capital gains tax (CGT) was introduced as a class of statutory income in Australia on 20 September 1985. The fundamentals of CGT, contained in the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) s 100-10, provide that CGT affects a taxpayer’s income tax liability because assessable income includes the net capital gain for the income year: ‘Your net capital gain is the total of your capital gains for the income year, reduced by certain capital losses you have made.’ This means that, when preparing their tax returns, taxpayers need to check whether they have made any capital gains or losses in the income year. Even though any capital losses made are not allowable as a deduction from assessable income, capital losses can be used to reduce capital gains in the current or subsequent income years. That is, capital losses can only be offset against capital gains and can be carried forward indefinitely. All the CGT provisions are in ITAA 1997 Pt 3: • Part 3-1 contains the general provisions. • Part 3-2 does not exist. • Part 3-3 deals with special scenarios the most important of these being: – Division 128 Effect of Death; and

– Division 152 Small Business Relief. 5-2 CGT only applies to assets acquired or deemed to have been acquired after 20 September 1985. This date is mentioned throughout the CGT provisions of the legislation, for example, s 100-25(1). CGT only applies to gains actually realised by the taxpayer. In other words, if a taxpayer holds shares that have increased in value, the taxpayer is not taxed on the increase in value, until that value is realised through the sale of the shares. Capital losses can only be offset against capital gains, though they may be carried forward indefinitely for offset. Capital losses are not allowed as a deduction against assessable income. Capital losses are never indexed for inflation as is the case for some capital gains. 5-3 For individuals, capital gains are taxed at the individual’s marginal rate in the year in which the CGT event happens. For companies, capital gains are taxed at the company rate of income tax. [page 88] Australian residents are subject to CGT on CGT assets located anywhere in the world. Non-residents will only be affected by CGT for certain Australian connected assets: ITAA 1997 Div 136. 5-4 The basic structure of the CGT regime is contained in s 100-15 and provides: Did a CGT event happen in the income year? • No — no CGT consequences • Yes — does an exemption apply? – Yes — no CGT consequences – No — do the capital proceeds exceed the cost base? o Yes — the excess is the capital gain o No — the deficit is the capital loss 5-5 The key issues dealt with in this chapter are: •

working out net capital gain;

• • • • • •

identifying CGT events; identifying CGT assets; exceptions and exemptions to CGT assets; small business CGT concessions; the main residence exemption; and calculating the capital gain or loss.

Working out net capital gain 5-6 The assessable income of a taxpayer includes the net capital gain of the taxpayer in an income year. In order to work out the net capital gain there are five steps that must be followed. These steps, set out in ITAA 1997 s 102-5, are: 1. Reduce the capital gains made during the income year by any capital losses made during the income year. 2. Apply any previously unapplied net capital losses from earlier years to reduce the amounts, if any, remaining after applying step 1. 3. Reduce by the discount percentage each amount of any capital gain remaining after applying step 2. The discount percentage is normally 50%. Discount capital gains are only available to individual taxpayers and only apply to assets held for more than 12 months. 4. If any of the capital gains qualify for any of the small business concessions then apply those concessions to each capital gain as appropriate. Small business concessions are dealt with below. 5. Add up the amounts of any capital gains remaining after applying step 4. This amount is the net capital gain for the income year. [page 89]

Identifying CGT events 5-7

There are 12 categories of CGT events and they are listed in

ITAA 1997 s 104-5. For each category of CGT event, Div 104 specifies: • the type of event and how to identify the event; • its timing; and • the amount of any capital gain or capital loss resulting from the event. 1. Event A1 — disposal of a CGT asset occurs when there is a disposal of a CGT asset defined in ITAA 1997 s 108-5. A disposal occurs if there is a change in ownership of the CGT asset. The time of the CGT event A1 is when the contract for the disposal is entered into or, in the absence of a contract, the time when the change of ownership took place. 2. Event B1 — use and enjoyment before title passes and occurs when the right to the use and enjoyment of a CGT asset passes to another entity and title in the asset will or may pass to the other entity at or before the end of the agreement. The time of the event is when the other entity first obtains the use and enjoyment of the asset. That is, B1 may bring forward the time of disposal. 3. Events C1–C3 — end of a CGT asset occurs in three scenarios: (i) Loss or destruction of a CGT asset (event C1). The time of the event is when compensation is first received for the loss or destruction, or if no compensation is received, when the loss is discovered or the destruction occurred. (ii) Cancellation, surrender, release, discharge or forfeiture of an intangible asset. The time of the event is when a contract is entered into that results in the asset ending, or if there is no contract, when the asset ends. (iii)End of an option to acquire shares. The time of the event is when the option ends. 4. Events D1–D4 — bringing into existence a CGT asset. These events occur as follows: • D1 — creating contractual or other rights; • D2 — creating an option; • D3 — granting a right to income from mining; and • D4 — entering into a conservation covenant over land. The time of the event is when the contract is entered into or

the right is created. Other CGT events dealt with in the legislation but not dealt with here are: 5. Events E1–E9 — trusts 6. Events F1–F5 — leases 7. Events G1–G3 — shares [page 90] 8. Events H1–H2 — special capital receipts 9. Events I1–I2 — Australian residency ends 10. Events J1–J4 — reversal of rollovers 11. Events K2–K12 — other CGT events 12. Events L1–L8 — consolidated groups

Identifying CGT assets 5-8 • • • •

Section 100-25(2) lists the most common CGT assets, which are:

land and buildings, for example, a holiday home; shares; units in a unit trust; collectables which cost over $500, for example, jewellery or an artwork. These assets are defined in s 108-10; and • personal use assets which cost over $10,000, for example, a boat. These are dealt with in ss 108-20–108-30. Section 100-25(3) lists other CGT assets which are not so well known, for example: • family home; • contractual rights; • goodwill; and • foreign currency.

Exceptions and exemptions to CGT assets 5-9

ITAA 1997 s 100-30(1) provides that:

Once a CGT event is identified as being applicable, it should then be established whether there is an exception or exemption that would reduce the capital gain or loss or allow it to be disregarded.

Most of the exceptions are in Div 104 and are noted beneath each of the different CGT events. Most of the possible exemptions are found in Div 118 which deals with the main residence exemption. The small business relief exemptions are included in Div 152. The most common exceptions are pre-CGT assets, that is, assets acquired before 20 September 1985: s 104-10(5). There are four categories of exemptions (s 100-30(2)): 1. exempt assets, for example, cars and the main residence exemption; 2. exempt or loss denying transactions, for example, compensation for personal injury or where a tenancy comes to an end; 3. anti-overlap provisions (that reduce capital gain by the amount that is otherwise assessable); and 4. small business relief. [page 91] Exempt assets include: • where the taxpayer disregards the capital gains and losses arising from cars, motor cycles and valour decorations (unless purchased) (s 118-5); • the capital gain or loss from the sale of collectables and personal use assets where they are acquired for a market value of $500 or less or are acquired as a personal use asset for $10,000 or less (s 118-10); • the family home (s 100-30(3)) — however, special rules apply if

part of the home has been rented out or if the home has been rented out for a period of time; and • capital gains or losses made from CGT assets used solely to produce exempt income or non-assessable non-exempt income are disregarded (s 118-12). Exempt or loss denying transactions have the effect that a capital gain or loss is disregarded if it is: • compensation received that relates directly for any wrong or injury suffered in employment or any personal injury (s 11837(1)); and • from gambling or competition prizes unless the taxpayer is in the business of gambling (s 118-37(1)(c)).

Small business CGT concessions 5-10 Small business relief from CGT is available to small business owners if certain conditions are met: ITAA 1997 Subdiv 152-A. The conditions are: • net value of assets less than $6 million; • annual turnover of less than $2 million; and • the asset must be an ‘active’ asset. The net value of small business entity assets is calculated by taking the market value of the assets and subtracting any liabilities of the entity relating to the asset and deducting any provisions of the entity relating to annual leave, long service leave, unearned income or tax liabilities: s 152-20(1). In working out the net value of the assets certain assets are disregarded. The assets to be disregarded include (s 152-20(2)): • shares, units or other interests (except debt) in another entity connected with the small business entity; • any assets used solely for the personal use and enjoyment of an individual; and • the market value of any dwelling used as a main residence; and • the right to any payments from an approved superannuation fund, approved deposit fund or life insurance of an individual.

An active asset is an asset, either tangible or intangible, that has been owned and either used, or held ready for use, in the course of carrying on a business, either alone or in partnership: s 152-40. [page 92] The CGT concessions available to qualifying owners of small businesses are all in respect of CGT events happening to active assets and are: • 15-year exemption which allows the qualifying individual to disregard any capital gain if the CGT asset was owned continuously for the 15-year period ending just before the CGT event (s 152-105); • 50% reduction which allows the qualifying individual to reduce the capital gain by 50%. This means that if the capital gain has already been able to be reduced by the discount percentage of 50%, the gain is further reduced by another 50% resulting in an effective discount of 75% (s 152-205); • retirement concession which allows a qualifying individual to disregard a capital gain, of up to $500,000, if the proceeds of the CGT event are used in connection with retirement. For individuals under the age of 55, the proceeds must be paid into a complying superannuation fund or a retirement savings account (s 152-305); and • roll-over relief which allows the qualifying individual to defer all or part of a capital gain for two years if you acquire a replacement asset or incur expenditure on making capital improvements to an existing asset (s 152-400). Owners of small businesses who qualify can apply as many concessions to which they are entitled until the capital gain is reduced to nil.

Main residence exemption

5-11 ITAA 1997 s 118-100 provides that a capital gain or loss as a result of a CGT event happening to a main residence is generally ignored if: • the taxpayer is an individual; and • the dwelling was the taxpayer’s residence through the whole of the ownership period. The meaning of a ‘dwelling’ is a unit of accommodation used primarily for residential accommodation. A unit of accommodation can be either a building, or contained in a building, a caravan, houseboat or other mobile home and any land under the accommodation: s 118-115. Land that is adjacent to a dwelling will attract the main residence exemption to the extent that the land is used primarily for private or domestic purposes in association with the dwelling: s 118-120. The maximum area of land that can qualify for the exemption is two hectares: s 118-120(3). The main residence exemption also applies to adjacent structures of a flat or home unit such as a garage or storeroom if the adjacent structure was used primarily for private or domestic purposes: s 118-120(5) and (6). In determining whether or not the residence is your main dwelling, the ATO will have regard to:1 [page 93] •

• • • • • •

the length of time the taxpayer lived in the residence, noting that there is no minimum time a person is required to live in a residence before it is considered their main residence; whether the family of the taxpayer lives in the residence; whether personal belongings have been moved into the residence; the address to which mail is delivered; the address on the electoral roll; the connection of services such as gas and electricity; and the intention in occupying the residence.

Partial main residence exemption 5-12 A taxpayer is entitled to the main residence exemption if the dwelling was the taxpayer’s residence through the whole of the ownership period. However, a taxpayer may still be entitled to a full exemption from capital gains even though the dwelling was not the main residence for the entire period of ownership. There are special rules that apply that may entitle a taxpayer to a full or partial exemption in the following circumstances: • Even though a residence ceases to be a main residence once a taxpayer has moved out of the residence, the taxpayer can still choose to have the dwelling treated as a main residence for CGT purposes. If a taxpayer makes this choice, then no other dwelling can be treated as a main residence: s 118-145(1). • If the dwelling that was the main residence is used for the purposes of earning assessable income, it can be treated as the main residence for a maximum of six years. The taxpayer is also entitled to another period of six years each time the dwelling becomes and ceases to be the main residence: s 118-145(2). • If the vacated dwelling is not used for income producing purposes, that is, is left empty or is used as a vacation home, then the dwelling can be treated as a main dwelling indefinitely: s 118145(3). Calculate the partial exemption as follows (s 118-185): 1. The taxpayer must calculate the capital gain or loss from the CGT event relating to the main residence. 2. Take the capital gain or loss from the CGT Event × (non-main residence days/days in the ownership period). The example from the ITAA 1997 is as follows: You bought a house in July 1990 and moved in immediately. In July 1993, you moved out and began to rent it. You sold it in July 2000, making (apart from this subdivision) a gain of $10,000. You choose to treat the dwelling as your main residence under section 118-145 (about absences) for the first 6 of the 7 years during which you rented the house out. Under this section you will be taken to have made a capital gain of: $10,000 × 365/3650 = $1,000

[page 94]

Calculating capital gain or loss 5-13 The steps to be undertaken to determining the capital gain or loss of a taxpayer are set out in ITAA 1997 s 100-45. These steps are: 1. Work out the capital proceeds from the CGT event. (CGT events are listed in s 104-5 and the most common CGT event is event A1 the disposal of a CGT asset.) Capital Proceeds — ITAA 1997 s 116-20(1) states: The capital proceeds from a CGT event are the total of (a) The money you have received, or are entitled to receive, in respect of the event happening; and (b) The market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

2. Work out the cost base for the CGT asset (the cost base of a CGT asset is detailed in ss 110-25 and 110-35). 5-14 The cost base of a CGT asset consists of five elements: 1. First element – the money paid or property given in respect of acquiring the property (s 110-25(2)); 2. Second element – the incidental costs (see below) incurred to acquire or that relate to the CGT asset (s 110-25(3)); 3. Third element – the non-capital costs of ownership of the CGT asset (but only if the asset was acquired after 20 August 1991) including: • 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 that has been borrowed to refinance the money that was borrowed to acquire the asset; and • interest on money that was borrowed to finance the capital expenditure that was incurred to increase the asset’s value (s 110-25(4)). Note — under s 110-40(2) these non-capital costs of ownership

are not to be included as part of the cost base ‘to the extent that you have deducted or can deduct it’. In other words if the noncapital expenditure has been deducted or could have been deducted from income earned, the taxpayer is not entitled to include them as part of the cost base of the asset. 4. Fourth element – capital expenditure incurred to increase the value of the asset (s 110-25(5)). Note — the expenditure must be reflected in the state or nature of the asset at the time of the CGT event. 5. Fifth element – capital expenditure incurred to establish, preserve or defend the title over the asset, or a right over the asset (s 11025(6)). [page 95] 5-15 Under s 110-35(1), there are five incidental costs that may have been incurred to acquire a CGT asset or that relate to a CGT event. They are: 1. professional fees for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser. Any advice about the operation of this act is only included if it has been provided by a recognised tax adviser (s 110-35(2)); 2. costs of transfer (s 110-35(3)); 3. stamp duty or other similar duty (s 110-35(4)); 4. costs of advertising for either a seller or buyer (s 110-35(5)); and 5. costs of any valuation or apportionment (s 110-35(6)). 5-16 ITAA 1997 Div 115, Discount capital gains may apply when calculating the net capital gain of a taxpayer: A discount capital gain remaining after the application of any capital losses and net capital losses from previous years is reduced by the discount percentage when working out your net capital gain.

In order to be able to use the discount method a taxpayer must meet the conditions as follows: • the gain must be made by an individual, a complying

superannuation entity or trust or a life insurance company CGT event connected with a complying superannuation asset (s 11510); • the CGT event must have occurred after 11.45 am on 21 September 1999 (s 115-15); • the cost base of the asset must have been calculated without reference to indexation (see below) (s 115-20); and • the asset must have been owned for a minimum of 12 months before the CGT event (s 115-25). The discount percentage for individuals, including partners in a partnership, and trusts is 50%. The discount percentage for complying superannuation funds is 331/3%. 5-17 Indexed capital gains may apply to a CGT asset. Under s 11036, ‘The cost base of a CGT asset acquired at or before 11.45am … on 21 September 1999 also includes indexation of the elements of the cost base’ if the requirements of Div 114 are met. Indexation of the cost base is used for the purposes of working out the capital gain only if the taxpayer chooses to use indexation of the cost base: s 110-36(2). Because indexation does not take into account inflation after 30 September 1999, indexation is generally not now favoured as the 50% discount method may provide a better outcome for individual taxpayers. Indexation takes into account inflation up to September 1999. The ATO publishes the relevant Consumer Price Index figures to be used in calculating the indexed cost base of an asset.2 [page 96] Table 5-1: Quarterly CPI Figures for Indexation Method

The indexation factor to be applied to the relevant element of the cost base is calculated by taking the indexation factor for the quarter ending 30 September 1999 and dividing by the indexation fact for the quarter in which the outgoing was incurred. The indexation factor should be calculated to three decimal places. Taxpayers may be entitled to elect to use the discount or the indexation method of calculating their CGT if the asset was acquired prior to September 1999 and if the asset was held for more than 12 months. 5-18 The capital gain or loss from a CGT event is calculated as follows: • subtract the cost base from the capital proceeds; • if the proceeds exceed the cost base, the difference is the capital gain; and • if not, work out the reduced cost base for the asset. The reduced cost base of a CGT asset consists of the cost base of the asset minus the third element. ITAA 1997 s 110-55 sets out how to calculate the reduced cost base:

– –

if the reduced cost base exceeds the capital proceeds, the difference is the capital loss; and if the capital proceeds are less than the cost base but more than the reduced cost base, there is neither a capital gain nor a capital loss. [page 97]

Question 1 Explain when the capital gain made by a taxpayer from the sale of their main residence is exempt.

Answer Plan This question is a simple test of comprehension.

Answer 5-19 ITAA 1997 s 118-100 provides that the capital gain or capital loss arising from the sale of a main residence can be disregarded. The full exemption only applies if the taxpayer is an individual and the dwelling was the taxpayer’s main residence throughout the whole of the ownership period.

Examiner’s Comment 5-20 The examiner is looking to see whether the student can identify the relevant law and display understanding of how the law operates.

Keep in Mind 5-21 For all CGT questions it is vital that students consider the nature of the asset involved in the CGT event to determine whether the asset is exempt from CGT because of the type of asset involved. The student must also be alert to the time the asset was acquired as assets acquired prior to 20 September 1985 are exempt. CGT questions also involve an examination of the taxpayer to determine whether the taxpayer is entitled to CGT relief, that is, a small business owner. The time of the CGT event is also important to determine whether or not the taxpayer can elect to choose indexation of the cost base or the discount method of calculating the final capital gain or loss.

Question 2 On 25 September 2014 a fire broke out at the factory of Trucks ‘r’ Us (TRU) which destroyed the entire factory building. On 11 October 2014 TRU were contacted by the insurers, who confirmed that the building was covered under the policy for $1.5 million and settlement would occur early the following year. As TRU needed a new factory to be built before this time the owner, Christopher, sold his marital home in Bringelly which he had purchased to reside in during October 2009 for $500,000. The house sold for $2 million in November 2014. [page 98] On 25 January 2015 insurance proceeds of $1.5 million were received by TRU. (a) What CGT event occurred in relation to the destruction of the factory and on what date did the event occur? (b) Discuss the CGT implications, if any, for Christopher on the sale of his home.

Answer Plan This is a question that requires the student to recognise two different

types of CGT events and to recognise that a CGT event may not give rise to CGT consequences if exemptions apply.

Answer 5-22 (a) CGT event: loss or destruction of a CGT asset (event C1): ITAA 1997 s 104-20(1) CGT date: 25 January 2015 (b) A CGT event has occurred in relation to the disposal of Christopher’s home. An A1 disposal of CGT asset has occurred: ITAA 1997 s 10410(1). As the capital proceeds from the disposal ($2 million) are more than the asset’s cost base ($500,000), Christopher has made a capital gain: s 104-10(4). The capital gain can be disregarded as it has been Christopher’s main residence since purchase: ITAA 1997 Subdiv 118-100 Pt 3-1.

Examiner’s Comments 5-23 Students need to understand that different CGT events have different CGT dates depending on the particular event. Therefore, even though the factory was destroyed on the 25 September 2014, the date of the CGT event was the date the insurance proceeds were received, that is, 25 January 2015. Also, students need to be alert to the types of asset involved, as exemptions from CGT or partial exemptions may apply.

Keep in Mind 5-24 CGT events may occur but have no CGT consequences, for example, the disposal of a main residence that meets all of the requirements of the main residence exemption.

[page 99]

Question 3 On 1 October 2000, Harry and his wife Rachel bought an apartment in Sydney for $195,000. Harry and his wife used the apartment as their main residence until Harry received an offer to work in Melbourne. Harry and Rachel left Sydney for Melbourne on 1 October 2011. The apartment was rented out until the apartment was sold on 1 October 2015 for $475,000 to fund purchase of a new home in Melbourne for $850,000. Calculate for Harry and Rachel the CGT on the sale of their apartment. Your answer must include references to relevant tax law and or cases.

Answer Plan This is a problem type question that requires students to reflect on the operation of the main residence exemption.

Answer 5-25 Issue: Can Harry and Rachel apply the main residence exemption in full to the sale of their apartment? Law and Application: Harry and Rachel can use the main residence exemption for the entire time they used the house as their main residence and then for six years once the house became income producing: s 118-145(3). As the dwelling has been used as a main residence and then rented for a period of less than six years (four years), the dwelling would be taken to have been Harry and Rachel’s main residence for the whole of the period of ownership. Conclusion: Pursuant to the operation of the full main residence exemption there is no CGT liability for Harry and Rachel.

Examiner’s Comment 5-26 This question included some facts that were not relevant to the answer, for example, the price of the new home in Melbourne. The question requires students to be able to ascertain the relevant facts in answering the question, such as: • the fact that the taxpayers did not have a main residence after they vacated their dwelling in Sydney; and • the fact that the main residence was rented out for only four years, which is within the six-year period that a dwelling may be used to earn assessable income, per s 118-145(3), and still be entitled to the main residence exemption. [page 100]

Keep in Mind 5-27 Students need to keep in mind that even though the question was posed as a calculation type question, the answer did not require a calculation but a consideration of the main residence exemption. Students need to reflect on the question to determine whether or not a calculation is appropriate.

Question 4 (adapted from the ATO fact sheet)3 Peta bought a house on a hectare of land under a contract that was settled on 1 July 1995 and moved in immediately. On 1 July 1997 she moved out and began to rent the house. She chose not to treat the house as her main residence because she had married and her main residence had become her new marital home. A contract for the sale of the house was signed on 1 July 2015 and settled on 31 August 2015. Her capital gain on the sale, calculated without using the indexation method, was $500,000. Peta had no other CGT event for the year and CGT losses of $45,000 to carry forward.

Calculate Peta’s capital gain on the CGT event and her capital gain for the year using the discount method.

Answer Plan This is a calculation question that requires students to understand how the partial exemption for the main residence works and to understand how to apply the discount method.

Answer 5-28 As Peta lived in her home for two years of the 10 years she owned the home, she is entitled to a partial exemption for the period in which the home was her main residence. As she elected another home as her main residence when she left this home, she is not entitled to the sixyear exemption during the period she rented out the dwelling. The taxable capital gain from the CGT event (s 118-185) is: Total capital gain × (Non-main residence days/Days in ownership period) Non-main residence days = 8 years × 365 = 2920 Ownership period = 10 years × 365 = 3650 Taxable gain = $500,000 × (2920/3650) = $400,000 Peta’s capital gain for the year (s 102-5) = $400,000 – $45,000 = $355,000 [page 101] Applying the discount = $355,000 × 50% = $177,500

Peta is entitled to apply the discount to her net capital gain as she is an individual, she owned the asset for longer than 12 months, the CGT event happened after 21 September 1999 and the cost base of the asset was calculated without reference to indexation. See ITAA 1997 Div 115.

Examiner’s Comment 5-29 Students needed to note that although the sale of the house did not settle until 31 August 2015, the CGT event, a sale, was an event A1 and therefore the time of the event was the date of the contract, that is, 1 July 2015. This affects both the period of ownership and the period of non-main residence days. Students also needed to be aware that if a taxpayer is entitled to use the discount method in order to calculate their net capital gain, the discount is applied after the application of any capital losses.

Keep in Mind 5-30 When answering CGT questions, students always need to be alert to the timing of the CGT event. Keep in mind the various dates and their CGT impact. For example, all CGT assets acquired before 20 September 1985 are CGT exempt; all CGT assets acquired before 21 September 1999 may be able to use the indexation method of calculating the cost base; and assets owned by an individual taxpayer for longer than 12 months may be entitled to use the discount method.

Question 5 Your client has provided to you a listing of the transactions she has undertaken throughout the financial year to assist you in completing her 2015 income tax return. Sale of a block of land for $1,000,000: She purchased the land as an investment in 1991. The purchase price was $250,000, plus $5000 in stamp duty, $10,000 in legal fees. To fund the purchase she took out a loan on which she paid interest totalling $32,000. During the period of ownership her council rates, water rates and insurance totalled $22,000. In

January 2005 a dispute occurred with a neighbour over the use of the land and legal fees incurred amounted to $5000 in resolving this dispute. Before putting the property on the market $27,500 was spent to remove a number of large dangerous pine trees that were on the land. Advertising, legal fees and agent’s fees on the sale of the land were $25,000. Sale of her 1000 shares in Rio Tinto for $50.85 per share: She paid brokerage of 2% on the sale. She initially purchased the shares for $3.50 per share in 1982. [page 102] Sale of a stamp collection she had purchased, from a private collector, in January 2015 for $60,000: She sold the collection at auction for $50,000. Auction fees totalled $5000 for the sale. Sale of a grand piano for $30,000: It was initially bought for $80,000 in 2000. Advise your client of the capital gains tax consequences of his transactions. Ignore indexation. Your answer must include references to relevant tax law and or cases.

Answer Plan This is a calculation question of moderate difficulty. This question tests students’ knowledge of the different types of CGT assets and their differing treatment when they are sold. Students must be careful to identify the type of CGT asset being sold and ensure that no exceptions or exemptions apply to those assets. This requires a careful reading of the question and great attention to detail.

Answer 5-31

All references to legislation refer to the ITAA 1997.

(a) Sale of land Land is a CGT asset: s 108-5. The sale of a CGT asset is a CGT event A1: s 104-10.

(b) Sale of shares Shares are a CGT asset s 108-5. The sale of a CGT asset is a CGT event A1: s 104-10. However, the sale is exempt from CGT as the asset was acquired before 20 September 1985: s 100-25 or s 104-10(5)(a) or Div 104 s 104-1. [page 103] (c) Sale of stamp collection

The loss on a collectable must be carried forward and offset against any future collectable gains: s 108-10(4). (d) Sale of grand piano The grand piano is a personal asset and a CGT asset: s 108-20(2). The sale of a CGT asset is a CGT event A1: s 104-10.

Proceeds on sale $30,000 Less: Cost base Purchase price 80,000 Capital loss $50,000

s 116-20 s 110-25(2)

Any loss made on personal use assets are disregarded: s 108-20. Conclusion: The only asset sold by your client that made a capital gain was the sale of the land. The losses that were made were on a collectable and a personal use asset. Losses on collectables can only be brought forward and deducted from gains made on collectables. Losses on personal use assets are disregarded and so cannot be carried forward. According to Div 115, because your client is an individual taxpayer and owned the land for more than 12 months and did not calculate the cost base using indexation, she is entitled to a discount of 50% on the gain after the application of any losses. As there were no capital losses that are able to be deducted, her capital gain is $311,750. Your client will have to return a capital gain in her tax return for the sale of the block of land of $311,750. She will also have $15,000 of collectable losses to carry forward and offset against future collectable gains if any.

Examiner’s Comments 5-32 This examiner will be looking for students to correctly identify the types of assets being sold and an understanding by students of the different treatment between CGT assets. Students need to be aware that collectables and personal use assets are treated differently and to [page 104] recognise that items not normally considered as CGT assets, like a grand piano, are in fact covered by CGT.

Keep in Mind 5-33 Students need to keep in mind the difference between a collectable and a personal use asset for CGT purposes. A personal use asset is only subject to CGT if it cost the taxpayer more than $10,000 and a collectable is only subject to CGT if it was acquired for over $500: s 100-25(2). Also, the rules relating to the losses on these assets is specific and students need to refer to their legislation for these specifics.

Question 6 Your client, an Australian resident but born in Greece, is selling up all of her Australian assets as she is retiring from her business as a hairdresser and moving home to Greece. Your client is 65 years old. The assets that she is selling include: (a) Her home, purchased in 1981 for $35,000 and now worth $800,000. This home was her main residence for the entire period of ownership. (b) Her motor vehicle which cost $28,000 in 2011 and is now worth around $10,000. (c) Her hairdressing business, a small business enterprise. She commenced the business herself and has found a buyer to take over the salon for $125,000. The sale price includes $65,000 for all of the salon equipment, which cost $75,000, and $60,000 for goodwill. (d) Her furniture for $5000. No single item being sold cost more than $2000. (e) Her paintings for $35,000. All of her paintings were purchased in second hand shops or markets and no single painting cost more than $500. The one exception was a painting she purchased direct from an artist for $1000. This painting is being sold for $5000. Advise your client of the CGT consequences of the above sales. Include appropriate legislative references to support your answer.

Answer Plan This is a problem question of moderate difficulty and requires students to be alert to the different types of assets and the different dates the assets were purchased. Students will need to refer to their legislation in order to answer this question.

Answer 5-34 All references to legislation in this answer refer to the ITAA 1997. (a) Pursuant to s 118-110 the capital gain in relation to a family home is exempt if the home was owned by an individual and was the [page 105] main residence throughout the ownership period. As this is the case here, there are no CGT consequences on the sale. Further, pursuant to s 104-5, as the home was purchased prior to 20 September 1985, the sale is a CGT exception and would not be liable to CGT. (b) Pursuant to s 118-5 a capital gain or loss made from a car is disregarded. Therefore the sale of the car would have no CGT consequences. (c) Pursuant to s 118-5 a CGT asset includes ‘any kind of property’ and to avoid doubt goodwill is specifically mentioned as a CGT asset. Therefore the sale of the business has CGT consequences. The sale of the assets used in the business was made at a capital loss of $10,000 and this loss can be offset against any capital gains made in the current year or into the future: s 100-55. The sale of the goodwill was for $60,000; as there was no cost base for the goodwill, the capital gain is $60,000. However, we were told that the business was a small business and that the client is 65 years old and retiring. In those circumstances, pursuant to Div 152, an eligible small business is entitled to certain CGT relief. Pursuant to s 152-5 an eligible small business is one with a net value of assets of less than $6 million and the CGT asset must be an active asset. In this case, the assets in the business are worth less than $6 million and the assets being sold are all active assets.

Also, s 152-300 provides that a taxpayer can disregard a capital gain happening to an asset of a small business ‘if the capital proceeds from the event are used in connection with your retirement’. The limit of this relief is ‘a lifetime limit of $500,000’: s 152-300 and therefore the CGT on the sale of the goodwill of the business can be disregarded. (d) Pursuant to s 108-20 furniture is a personal use asset, that is, an asset ‘kept mainly for personal use or enjoyment’. However, pursuant to s 118-10(3) a capital gain made from a personal use asset is disregarded if the first element of the cost base is $10,000 or less. As no single item of furniture cost more than $2000 and gain made would be disregarded. (e) Pursuant to s 108-10(2) a collectable is defined as artwork. Therefore the paintings are collectables. However, pursuant to s 118-10(1), the capital gain or loss made from collectables is disregarded if the first element of the cost base is $500 or less. In this case, as only one painting cost more than $500 there would be a capital gain on the sale of that painting of $4000.

Examiner’s Comments 5-35 The examiner is looking to see that students know how to use the ITAA, know how to apply the law in a ‘real world’ situation and understand the different CGT consequences attaching to the disposal of different types of assets. [page 106]

Keep in Mind 5-36 It is important for students to keep in mind that all disposals of assets are subject to the CGT rules even if the disposals are an exception or an exemption or special rules apply to the disposal. For example, an

exception is an asset that was purchased prior to 20 September 1985 and an exemption is a home or a personal use asset costing less than $10,000 or a car. Also, special rules apply to the disposal of active assets used in a small business.

Question 7 In 2001 your client purchased a holiday home unit by the sea for $350,000. The cost associated with purchasing the unit were legal fees of $400 and stamp duty of $1500. During the period of ownership the unit was used solely for family holidays. The cost of keeping the unit, strata levies, rates, insurance etc. amounted to a total of $27,000. On 25 December 2015 your client made a gift of the unit to her son for him to use as his family home. At the time of the gift the unit had a market value of $1,200,000. Your client had no other CGT events during the year and she had no CGT losses carried forward from a previous income year. Calculate the capital gain on the disposal of the unit. Advise your client how this will be treated in her tax return.

Answer Plan This is a straightforward CGT calculation question. The question also requires students to provide advice to the client.

Answer 5-37 Under s 100-45 the capital gain is calculated by subtracting the cost base of a CGT asset from the capital proceeds of the CGT event. In this case the CGT event is a disposal of a CGT asset, event A1. Section 116-30 provides that if no capital proceeds were received the taxpayer is taken to have received the market value of the CGT asset. This is called the market value substitution rule.

[page 107] The net capital gain made by my client will be included in her assessable income in the income year in which the gain was made: s 102-25. The net capital gain is net of any capital losses made or carried forward from a previous year. As the client had no capital losses, and because the client is an individual selling an asset that she has owned for more than 12 months (Div 115) she will be able to apply the discount percentage to the capital gain: s 102-5. This means that the client will have to include in her assessable income an amount of $821,100 × 50%, that is, $410,550.

Examiner’s Comments 5-38 Although the calculation here was straightforward, the examiner is looking for an understanding of the CGT rules around ‘market value substitution’. This requires students to read the legislation carefully to ensure that they are aware of the very particular and comprehensive rules that pertain to CGT events and transactions. The examiner is also reinforcing the fact that even though the disposal of an asset may be in the form of a gift, CGT will still apply and the taxpayer will be required to return the capital ‘gain’ in their income and that the ‘gain’ will be subject to income tax.

Keep in Mind 5-39 Students are to keep in mind that certain entities who have made capital gains may be entitled to apply a discount of 50% to their net capital gain. The conditions that a taxpayer must meet to be eligible to apply the discount are found in ITAA 1997 Div 115. Students should read and understand that all of the conditions must be met for a taxpayer to be entitled to the discount.

Question 8 (adapted from the ATO fact sheet)4 Tom bought a property for $150,000 under a contract dated 24 May 1991. Tom paid the deposit of $15,000 on the contract date and the remainder, $135,000 on 5 June 1991. On 20 July 1991 Tom paid the stamp duty of $5000 and on 5 August he paid legal fees of $2000. Tom sold the property on 15 October 2014 for $350,000. Solicitor’s fees on the sale were $1500 and the agent’s commission was $4000. Tom had no other CGT event during the year but he did have CGT losses carried forward of $100,000. Advise Tom as to whether he should use the indexation method or the discount method to calculate his capital gain.

[page 108]

Answer Plan This is a difficult calculation question which requires students to know how to apply indexation factors to the various elements of the cost base. Students need to remember that each element of the cost base needs to be indexed discretely.

Answer 5-40

Calculating the capital gain using the indexation method.

Tom should use the discount capital gain instead of the indexed capital gain as this provides Tom with a better result. [page 109]

Examiner’s Comments 5-41 Students need to take care that the correct indexation factors are used. Students should also be aware that as indexation ended in September 1999 the indexation fact for the quarter ended September 1999 should be used no matter how long after that date the asset was disposed of.

Keep in Mind 5-42 Keep in mind that when using the discount method, the discount is applied to the net capital gain of a taxpayer and not the capital gain pertaining to a single CGT event.

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