Factors to consider
With regards to income earned, there arises a situation when the income earning takes place in a separate tax year in comparison to the cash receipts. In this condition, it is imperative that appropriate method for computing and reporting income needs to be chosen by the taxpayer so as to faithfully represent assessable income under s. 6(5) ITAA 1997 (Gilders, et. al., 2016).
One of the choices available in this regards is called the “receipts” method which has been outlined in the subsection 6-5(4) ITAA 1997. In accordance with this method, the actual or constructive receipt of the cash is considered for recognising income. The other choice available to the taxpayer is the earnings method as per which income derivation depends on income being earned (Krever, 2017). This typically happens when a recoverable debt is created on account of services or product provided. As per TR 98/1, the underlying taxpayer can choose any of the above methods for reporting income which as per taxpayer presents a more accurate view of the income based on the underlying circumstances related to income and also the taxpayer (Sadiq, et. al., 2016).
TR 98/1 highlights that some of the income sources are usually recognised using the receipts method and are listed below (Barkcozy, 2017).
- Income that is derived by an employee
- Non-business income which an individual derives on account of underlying knowledge or skill
- Business income derived from service business where the underlying skill or knowledge of the taxpayer is involved.
Further, income that is derived either from trading or manufacturing is recognised using the earnings method (Methercott, Richardson & Devos, 2016).
However, it is noteworthy that the courts have not relied on any general rules but have taken the case facts and circumstances into consideration in deciding the suitable method of deriving income. One of the cases that merits discussion is “The Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108” (also called as Carden’s Case).
In this particular case, a medical practitioner derived income based on only cash receipts and hence only included those amounts as income which was actually received during the year thus ignoring the money that was earned but not received during the year. In this case Dixon J highlighted that the exact choice of method would be dependent on the underlying circumstance of the profession and the receipts and must not be determined by any rigid rule. Further, in relation of non-trading income recognition, this case is often cited particularly the commentary by Dixon J where he cited that there should be something that must come in for tax to be applied on. Therefore, in case of non-trading income, the receipts method is usually applied.
Right to Insist – Tax Commissioner
Another relevant case is Henderson v. Federal Commissioner of Taxation (1970) 119 CLR 612 from which it can be highlighted that the basis can be changed between years. The taxpayer Henderson initially recorded revenue on cash basis for the services provided but due to growth in business made a shift to accrual basis. The court held that the accrual method would be applied only for the current year owing to the increased size of business, investment and use of hired manpower.
The Tax Commissioner can insist on a particular basis if it is felt that the income of the taxpayer is better represented with that method. However, this can be only done after the income tax return has been filed not prior to filing the return. This needs to be done after considered various circumstances along with the nature and size of business. This has been highlighted in Henderson v FCT case since taxpayer can use different basis for income representation but the same should be based on underlying rationale and must not be arbitrary or with malicious intent.
Considering that Frank is an architect who derives income based on skill, hence as per TR98/1 and Carden case, the receipts basis would be suitable for 2016/2017 when the business is in nascent stages. However, as highlighted in the Henderson v FCT case, when there was a growth in business, the basis was altered to accrual basis from cash basis since it captured the business income in a better way (Gilders, et. al., 2016). A similar change would also be advised in case of Frank who has also seen significant growth in business and has invested $ 1 million in the business, thus shifting to an accrual basis where revenues and expenses are recognised on accrual basis.
The relevancy of the income basis continues to remain despite the availability of accounting software since these are essentially linked to the underlying nature of the business along with the circumstances. For instance, a business taking non-refundable advance payments for providing service should use receipts method while a business taking fully refundable advance payments should be better off using earnings method. In this example, even though the entries in the software package may be the same but still the recognition basis differs based on which tax payable would alter.
The objective is to highlight the potential tax deduction available for each of the following outflows or expenses with reference to suitable legislation and case law.
Relevant Basis for Frank
(a) An expense of $8,500 has been incurred in replacing old kitchen fittings for a residential property owned by the company that has been rented since 2008.
As per tax ruling TR 97/23, repair is aimed at efficiency restoration of the underlying property part being repaired. In repair, the character of the part essentially remains the same and hence typically includes expense for restoring the previous form, condition or appearance. Therefore, a repair only aims to replace or correct any part which already exists but has already worn out thus demanding restoration work to be done (Krever, 2017).
With regards to deduction for repairs, s.25-10 ITAA 1997 is relevant. As per s. 25-10(1), any expense on repair of premises or any depreciating asset is tax deductible provided the underlying asset is held only for production of assessable income. Also, in accordance with s. 25-10(3), repair deduction under this section is available only for operating expenditure and not for capital expenditure (Woellner, 2014). Further, deduction for repairs is also permissible under s.8(1) provided the nexus with income production can be sufficiently established and also the outgoings is not capital expenditure as per s. 8-1(2) ITAA 1997. However, repair expenses are deductible only under one of the above two sections and cannot be deducted twice (Reuters, 2017).
As per IT 242, there are certain assets which are permanent fixtures such as kitchen cupboards, sinks, kitchen plumbings, built in stove, which are essential building fixtures and thereby no depreciation can be claimed on same. Further, TR 97/23 highlights that expenses incurred for replacing the in-built furniture, stove, refrigerator are capital expenditures and therefore non-deductible under s. 25-10 and also s.8-1. The given repairs to kitchen fittings and cupboards would be capital in nature based on the above discussion. As a result, the current expenses would not be deductible immediately and therefore the complete amount may be deducted over the five year period under s. 40-880 (Woellner, 2014).
As per s. 8(1), a deduction is available for an outgoing or loss provided sufficient nexus can be established between the outgoing and assessable income production. However, one of the negative limbs as highlighted in s. 8-1(2) relates to the outgoing not being capital or else deduction would not be available under s. 8(1) (Hodgson, Mortimer & Butler, 2016).
In light of the above, the key objective is to be determine whether the legal expenses in this case is revenue expenditure or capital expenditure. Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 highlighted the following three aspects so as to segregate capital expenditure from revenue expenditure (Woellner, 2014).
- The essential character of the advantage that would result from the outgoing
- The method of usage of the underlying advantage by the taxpayer
- The underlying means for obtaining the advantage
Relevancy of Cash/Accrual Criterion
Amongst the above, the first and the third aspects are not that critical as highlighted in Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case (CCH, 2013). Thus, the pivotal element is how the underlying advantage is used. In this regards, if the advantage extends to the current tax period only, then the expenditure is revenue. However, if the advantage would be enjoyed over several years, then the expenditure is capital.
In wake of the above discussion, it is apparent that the legal expenses in this scenario are revenue expenditure as they are normal business purposes related to rental property and the benefits would be limited to the present tax year. Hence, legal expenses are deductible in the current year under s. 8-1 (Methercott, Richardson & Devos, 2016).
As per s. 8(1), a deduction is available for an outgoing or loss provided sufficient nexus can be established between the outgoing and assessable income production. However, one of the negative limbs as highlighted in s. 8-1(2) relates to the outgoing not being capital or else deduction would not be available under s. 8(1) (Reuters, 2017).
A relevant test was outlined in the British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 where it was stated that the expenditure would be considered as capital expenditure when it is incurred for gaining an asset or an advantage which is expected to have enduring effect. Additionally, expenditure related to carrying on with business or assessable income production is typically termed as revenue in nature (Hodgson, Mortimer & Butler, 2016).
In the given scenario, the claim amount paid is not meant for gaining any advantage that would be ensuring but rather to settle a client claim. Also, considering the circumstances of the business, the given claim amount is part of routine business activity since if the part supplied are faulty, then claims on the same would be made. As a result, deduction would be available in this case for Ruby under s.8(1) (Coleman, 2015).
One of the pre-requisite for any deduction under s. 8-1 ITAA 1997 is that the underlying loss or outgoing needs to be “incurred”. The meaning of “incurred” has been outlined in tax ruling TR 97/7 as per which it is not essential that the amount should have been necessarily paid but it is imperative that in the given income year, the taxpayer should be definitively committed . Further, it is also imperative that a reasonable estimation of the potential liability should be possible (CCH, 2013).
Deduction of Expenses for Repairs
In the given case, it is apparent that tax deduction under s. 8-1 would not apply to the given case as no loss or outgoing has been incurred since the company is not aware as to in which year, the matter would be settled and cannot make a reasonable estimation of the liability amount (Woellner, 2014). Thus, till the time the court verdict comes, the outgoing would not have been deemed to be “incurred” and therefore no deduction possible for provisions.
As per s. 8(1), a deduction is available for an outgoing or loss provided sufficient nexus can be established between the outgoing and assessable income production. However, one of the negative limbs as highlighted in s. 8-1(2) relates to the outgoing not being capital or else deduction would not be available under s. 8(1) (Deutsch, et.al., 2016). In the given case, the nature of the expense would be capital (in accordance with Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33) since the market research is related to start-up of business whose expected benefits would be realised by the company over years (Sadiq, et. al., 2016).
In accordance with s. 40-880(2A) ITAA 1997, any capital expenditure which is related to future business can be deducted equally over a period of five years irrespective of whether the business is eventually started or not (Coleman, 2015). Also, this includes expenditure related to seeking advice for the operations or business structure. Thus, in line with s. 40-880(2A), 100% deduction of the market research costs can be availed by Ruby over a period of 5 years with annual deduction being (220000/5) or $ 44,000
References
Barkoczy, S. (2017) Foundation of Taxation Law 2017. 9th ed. Sydney: Oxford University Press.
CCH (2013), Australian Master Tax Guide 2013, 51st ed., Sydney: Wolters Kluwer.
Coleman, C. (2015) Australian Tax Analysis (4th ed.). Sydney: Thomson Reuters (Professional) Australia.
Deutsch, R., Freizer, M., Fullerton, I., Hanley, P., & Snape, T. (2016) Australian tax handbook. 8th ed. Pymont: Thomson Reuters.
Gilders, F., Taylor, J., Walpole, M., Burton, M. & Ciro, T. (2016) Understanding taxation law 2016. 9th ed. Sydney: LexisNexis/Butterworths.
Hodgson, H., Mortimer, C. & Butler, J. (2016) Tax Questions and Answers 2016 (6th ed.). Sydney: Thomson Reuters.
Krever, R. (2017) Australian Taxation Law Cases 2017 2nd ed. Brisbane: THOMSON LAWBOOK Company.
Nethercott, L., Richardson, G., & Devos, K. (2016) Australian Taxation Study Manual 2016. (8th ed.). Sydney: Oxford University Press.
Reuters, T. (2017) Australian Tax Legislation 2017 (4th ed.). Sydney. THOMSON REUTERS.
Sadiq, K, Coleman, C, Hanegbi, R, Jogarajan, S, Krever, R, Obst, W, & Ting, A (2016) , Principles of Taxation Law 2016, 8th ed., Pymont: Thomson Reuters.
Woellner, R (2014), Australian taxation law 2014 7th ed. North Ryde: CCH Australia.
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