Taxation Of Bloomingdale Florists Pty Ltd And Matchstick Ltd – Case Study

Question 1

The computation of taxable income and resultant tax liability of Bloomingdale Florists Pty Ltd is provided in the table below as per the Income Tax Assessment Act 1997.

Calculation of tax liability of Bloomingdale Florists Pty. Ltd:

Tax liability of Bloomingdale Florists Pty. Ltd at the rate 30% corporate tax rate is (141800 x 30%) =$42,540 for the year ended on 30^th June, 2018.

Explanations:

• Long leave service paid: According to subdivision 83-B of Income Tax Assessment Act 1997 (ITAA 1997) long service leave is allowed only on payment basis. Provision for such long service leave payment is not allowed as deduction.
• ITAA 1997 provides that bad debt is to be deducted in computing taxable income. As per sec. 25.35 of ITAA 1997, amount written off as bad from ordinary course of business is to be deducted in computing taxable income.
• Only expenditures incurred to conduct the day to day affairs of an organization are allowed as deduction. Replacement cost of wooden windows by steel windows are capital expenditures hence, disallowed for taxable purpose.
• Gifts to hospital is allowed however, gifts to Paramatta Eels League is disallowed for taxable purpose.
• $10,000 allowed as capital allowance is deducted accordingly for ascertaining taxable income of the company.
• Use of LIFO method is not allowed for taxable purpose. Thus, excess of closing stock value as per LIFO method has to be adjusted to the accounting profit. Thus, $8,000, i.e. $60,000 less by $52,000 is added to the accounting profit for determination of taxable profit.
• Borrowing cost is a capital cost and not allowed to be deducted for computing taxable income of business (sec. 25.25 of ITAA 1997). Such cost is to be amortized over the period of borrowing. Thus, the entire borrowing cost is to be added to the accounting profit and only the amortization cost for the period is to be deducted from revenue for computing taxable income of business.
• Retail sales on credit is revenue for the purpose of income tax. However, in case there is significant doubt in respect of final recovery of credit sales then necessary provision shall be made in the books of accounts. In case bad debt is incurred on such sales then it has to be deducted from gross revenue to calculate the taxable income of business. Income from credit retail sales is already included in accounting income hence, there is no adjustments to be made for the credit retail sales amount.     
• Franked dividend is fully exempt for income tax purposes in the country under the ITAA 1997. The portion of dividend which is not franked shall be considered for income tax purposes. Hence, the dividend which is not franked shall be included in computing taxable income. In addition dividend received from foreign companies are taxable as per s6-5 of ITAA 1997. Having received dividend from foreign company it is to be included in computing taxable income of the company.  
• Directors’ salaries and remunerations are eligible expenses to the extent the same is reasonable. In case the Commissioner of Taxation finds directors’ salaries exceeding the reasonable limits then the excess amount of directors’ salaries will be added back to the accounting profit. In this case the reasonable limit of directors’ salary is $40,000 as per Tax Commissioner. Hence, the excess amount of directors’ salary shall be added to the accounting profit.  
• Losses carried forward from previous income year / years are allowed to be set off against the taxable income of current income year. Hence, the unabsorbed loss of previous year will be deducted from gross taxable income of the company to compute taxable income for the current year.

In order to understand the tax implications of the various transactions in the scenario provided in the case study, IRAC (Issue, Rules, Application and Conclusion) model has been used. Accordingly, the facts of the case is dissected below for the readers.

Issue:

1. The income tax liability of Matchsticks Limited for receiving $1,000,000 as compensation for cancellation of a major contract by one of the customers of Matchsticks Limited is to be explained using appropriate provisions of Income Tax Assessment Act 1997 (ITAA 1997) and appropriate case laws.
2. Also the tax liability of Matchsticks Limited for profit of $10,000,000 on sale of a land realized in the current year is to be explained as per ITAA 1997.    

Rules:

Rule for compensation received:  

Compensation for damages received in the ordinary course of business is taxable income of a business as per div. 6 of ITAA 1997. The test is to determine whether a receipt of compensation is for loss of revenue or in the nature of capital receipt is to be decided by taking into consideration the facts of each case. In tax terminology compensation paid for termination of contracts by one party to the other party is referred to as Eligible Termination Payments. Eligible Termination Payments or ETPs as commonly referred is considered as ordinary income for taxable purpose as per div. 6 of ITAA 1997.

Australian Taxation Office (ATO) has mentioned in its website that receipt of compensation by a company from one of its customers for termination of contract is mainly to make good the losses of revenue to the company for termination of such contracts. Thus, such compensation is clearly revenue in nature and must be included as assessable income from business to compute the taxable income of a company.

Further s6-5 of ITAA 1997 provides that compensation to make good the loss of profit for an entity conducting business operations to earn profit will be considered as ordinary income of such entity. In case an entity received from another entity any compensation for breach of contract or termination of contract then such compensation is treated as taxable icon of the former entity as per s6-5 of the act.

Rule for profit on sale of capital asset:

An entity uses number of non-current assets to conduct the day to day business operations to earn revenue. Most of such non-current assets are depreciated over their useful lives and ITAA 1997 allows depreciation for taxation purpose. Sale of such assets would result in ordinary gain or loss to be adjusted to the business income for calculation taxable income of an entity. However, in case of sale of a non-current assets on which no depreciation is allowed or charged is a capital asset to the business even if used for day to day business affairs. Profit or gain from sale of such asset would result in capital gain or loss to an entity. Such resultant capital gain or loss shall be considered for calculation of income tax liability of an entity.

Application:    

As per the provision of s6-5 of ITAA 1997, receipt of compensation by a business organization for termination of contract is classified as Eligible Termination Payment (ETP). Such ETP is an ordinary income under div. 6 of ITAA 1997. Matchsticks Limited has received a compensation of $1,000,000 from Strike a Light Pty Ltd, one of the customers of the former, for termination of contract is an ordinary income as per s6-5 of ITAA 1997. Such receipt shall be considered for computing taxable income of Matchsticks Limited for the income tax year in which the same has been received.

Question 2

The fact that the company, i.e. Matchsticks Limited, is in the process of winding up its business due to lack of profit and cancellation of the major contract constituting 80% of the supply made by the company is not of any substance in determining the taxability of such amount in the period of its receipt. Hence, in the year in which the compensation has been received by the company from its customer for termination of contract, the amount of compensation shall be included in computing the taxable income of the recipient.        

Capital gain is considered for non-depreciated assets that are sold by a tax payer. The resultant gain or loss on such sale is termed as capital gain or capital loss. Matchsticks Limited has realized a profit of $10,000,000 from sale of land which is a capital gain in the year of sale. The company would be liable to pay capital gain tax on the amount of capital gain realized from sale of land. For income year ending on June 30, 2018 the profit of $10,000,000 realized from sale of land is a capital gain for the company. The ordinary income is taxed at different rate for a company whereas capital gain is taxed at a different rate. Thus, the income from ordinary business and capital gain of Matchsticks Limited shall be properly segregated to ensure collection of appropriate tax on ordinary income and income from capital gain for the tax year 2018. Ordinary income shall include the compensation of $1,000,000 received by the company and capital gain is the profit of $10,000,000 realized from sale of land in the year ending on June 30, 2018.

Conclusion:

Taking into consideration the discussion above, the following conclusions have been drawn:

Compensation of $1,000,000 received By Matchsticks Limited for termination of contract by one of its customers is ordinary income under s6-5 of ITAA 1997. Thus, the amount shall be included in computing taxable income of the company for the income year ending on June 30, 2018.

The sale of land by the company has resulted in capital gain to Matchsticks Limited. The company has realized a profit of $10,000,000 from sale of such land and thus, the entire amount of profit shall be considered as capital gain for calculating capital gain tax of the company for the income year ending on June 30, 2018.

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