Taxation Law: Accounting Method And Tax Deductions

Part 1

Required 1:

Issue

Frank wishes to know whether he should file return on cash or accrual basis

Law

In terms of Australian law, a business entity can maintain its book of accounts under cash or accrual basis depending on threshold limit specified under the act and amended from time to time. Further, the law also specifies that it shall be at the disposal of the business to report its accounts under accrual or cash when threshold is not met as per the convenience.

In terms of Australian Tax Office, the threshold specified for small business to maintain their book on cash or accrual basis for 2017-2018 has been AUD 10 Million while for 2016-17 the threshold was AUD 10Million. (Tax changes for small businesses 2016/17 year end, 2017)

Some of the factors that are generally chosen responsible for choosing a particular method of accounting are:

• Ease of business,
• Managerial competency,
• Managing Taxes
• Impact on Margin and Operations.

Reference to Tax Rulings

To substantiate further, the stand of maintaining books of accounts one needs to look at various tax rulings where the said matter has been dealt with at length and which is binding on tax authorities. The following judgements are crucial for determining whether the books shall be maintained under cash or accrual basis:

• Arthur Murray Principle;
• Carden Case;
• Henderson Vs FCT;
• Dunn Vs FCT;
• Firstenberg Vs FCT.
• TR98/1.

Arthur Murray Principle

Principle Established: The timing of realisation of income in the assessable income of a taxpayer shall be dependent on whether it is a statutory income or ordinary income. If the income is statutory income, the same is included in the assessable income at the time specified in the relevant provisions of the ITAA, 1997 dealing with such income. While, for ordinary income the same is included in assessable income, when it is derived unless driven by a specific provision under the Act.

Further, if the income is business income the same is dependent on the fact whether business return income on a cash or accrual basis. If Business, uses cash basis the same is recognised on receipt. Further, for accrual basis, the same is recognised when recoverable debt is established.(HBA Encompass Pty Ltd, 2014)

CardenCase  (The Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia L (1938) 63 CLR 108 (C)

Principle Established: It shall be a taxpayer who shall determine the income which is derived by adopting method of accounting for income whether cash or accrual. The method that tax payer adopt for accounting of income for tax purpose shall be appropriate as per circumstance i.e. the method chosen must be in alignment with situattion. The method of accounting adopted by the taxpayer shall be appropriate if it give a substantially correct reflex of the income. It means what income has come to the home of the tax payer in realised form or in a realisable form during the year.(Commonwealth of Australia)

Thus, in Carden case it has been established that method chosen should give a correct reflex of income. Further, it has been held by Dixon J for non-trading income there should be something coming in or there must be a receipt to establish realisable or immediately realisable form.  

Part 2 – Required 1

Henderson Vs FCT(1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596 and Henderson v. FCT69 ATC 4049; (1969) 1 ATR 133.

Principle Established: Under the said case, it was decided that appropriateness of the method of accounting used by the taxpayer shall be a discussion point or decisive factor or the sole method/test for determining which method of accounting to be used. Further, only one method of accounting is appropriate to each item and there shall be no choice available to the taxpayer.(Commonwealth of Australia).

FCTVs. DUNN 11 89 ATC 4141 at 4144; (1989) 20 ATR 356 at 358

Principle Established:Underthe said case, it wasdecided that while deciding which method is appropriate in determining the income chargeable to tax on needs to looks at the accounting principles adopted, method of maintaining books by the taxpayer, occupational circumstances, the methodology of carrying on of business and evidence as to accounting principle and practice shall be relevant.(Commonwealth of Australia).Further, the assessable income shall be decided on the basis of above basis. If an organisation follows accrual basis return shall be filed on the basis of same.

Firstenberg Vs FCT (1976) 27 FLR 34 at 58; 76 ATC 4141 at 4155; (1976) 6 ATR 297 at 314

Principle Established:In the said case, it was decided that when there are circumstance and conditions under which one cannot predict which method is appropriate, earning method shall prevail over other methods unless it is burdensome, artificial.(Commonwealth of Australia)

TR 98/1

In the said ruling, it was decided that in relation to income derived by an individual solely from his application of knowledge/ skill as a part of business carried on by the tax payer. The said income shall be taxable on receipt basis not on the basis of earning method. Further, it has been stated that aforesaid advise shall not hold good if income comes from reliance on staff and machinery.(Commonwealth of Australia)

Present Case (Analysis)

In the present case, Frank Lloyd is rendering personal service as architect to companies, individuals etc. His work primarily, concerned with building designs and specifications. During year 2016-17, he had a small client base with a turnover not exceeding AUD 10 Million and provided services involving knowledge and application of skill. Thus, the income from the same shall be taxable on receipt basis as laid down in TR98/1. Further, as laid down in Carden’s case for non-trading income there must be realisation. Thus income shall be recognised on receipt basis.[since no details of maintenance of books of account has been given, the same has not been commented but if one look as  GST requirements it shall be assumed that books of accounts have been maintained under cash basis. Accordingly, by relying on other aforesaid case laws it can be stated that since the books of accounts are also in cash method, receipt return can be adopted].

Further, for 2017-18 the turnover has increased and Frank has hired machinery and men to build the structure involving men and resources and he is relying on men and machinery to produce income. Further, during the year he has engaged himself in constructing the required structure it shall amount to trading income and the said should be chargeable to tax on earning basis as laid down in  TR 98/1 (Para 45 Point d)

Part 2 – Required 2

Further, factors that shall affect method chosen includes ease, tax impact in the respective year, accounting complexities, managerial excellence and circumstances involved. For Frank Lloyd, since he has hired two administrative personnel during 2017-18 accrual method shall be the chosen method

Conclusion

For 2016-17: Cash or Earning method can be adopted;

For 2017-18: Receipt method ;(On the basis of TR 98/1 Para 45 point d and Carden        Case)

Yes, Frank can adopt cash or earning method in 2016-17. For 2017-18, he has no choice.(On the basis of TR 98/1 Para 30)

The commissioner of taxation can insist on accrualbasis of returns when he finds that the tax impact on account of the same is substantial and the tax payer is trying to defer such income.

On the basis of ruling TR 98/1 Para31 and 32,Lloyd shall not use the same method in both year.as  there has been a significant change in circumstances and it shall be burdensome on the tax payer to follow the same and shall be impractical in the present circumstance. Thus, tax payer shall follow the different method

Yes, the system is still important as the same has bearing on taxes of an individual. The Tax impact may be preponed or postponed by following a particular method of tax accounting. Though, there are various software and both cash and accrual accounting has been integrated into one yet the difference is significant from tax point of view.

The tax for 2016-17 can be determined only when the details of receipt have been provided.

For 2017-18 , tax liability shall be decided from 2.5 Million deducted by expenses incurred for earning such income. Since detail of the same has not been provided tax cannot be determined.

Required 2(a):

Issue: Can expenditure incurred for replacing the fitting be deductible;

Rules& Analysis

In terms of Section 8-I(1) of Income Tax Assessment Act, 1997 a taxpayer can deduct expenses  from their income to the extent they have been incurred for earning the income or producing assessable income. The law Section 8-I(2)  further states that a loss or outgoing expense shall not be allowed to the extent it is capital in nature or for private or domestic use or the same has been expended towards earning the income which is exempt or the same has been prevented from deduction by a specific provision under the Act.

It may be further noted that under section 25-10 of ITAA 1997, taxpayer is entitled to deduction for repairs to premises or assets of depreciable nature..

Thus, the expenditure incurred by Ruby for repair may be claimed as expense by treating the same as of revenue nature. There also exists a nexus between the expenditure incurred and  revenue generation activity.Further, also, repair means remedying a defect in a property. The same has been held in the case of LurcottWakely and Wheeler (1911) 1 KB 905. Thus, the same may be tax deductible.

Conclusion

Since the said expenditure has been incurred for the repair of damage part of the assets and can be treated as revenue expenditure and the same may be deductible.

Required2(b)

Issue: Legal expense deductibility for legal expenses paid;

Rules and Analysis

In term of law referred in required 2 (a) ,  it can be seen that there exists a nexus between the expenditure incurred by Ruby and the revenue generating activity. Further, similar view has been held in case of the judgement of FCT v Snowden &Willson Pty Ltd (1958) 99 CLR 431. Also in law, expenses incurred with respect to settlement of disputes are claimable.

Conclusion

Thus the legal expense incurred is deductible as the said expenditure has nexus with revenue as tenant relative has incurred injury in the revenue generating asset of Ruby.

Required2(c)

Answer

Issue: Claim for damages deductibility

Rules and Analysis

In term of law referred in required 2(a), there exists no clear nexus between the said expenditure incurred by Ruby Ltd. and the generating of assessable income. Further, the said expenditure may be treated as capital loss of the Ruby Ltd. Further in terms of Section 26-5 of the ITAA, 1997 settlement for damages or penalty paid under the Australian law are however not tax deductible. However, a contradictory stand has been taken by authorities injudgement of Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 where in it has been held that expenditure relating to settlement of damage claim shall be tax deductible. Accordingly, the deduction of the same is debatable and to be on safe side the same may not be deducted.

Conclusion

By taking a precautionary stand the same is disallowed.

Required2(d)

Issue: Deduction of provision for future claims

Rules and Analysis

In term of law referred in required 2(a) and answer stated inrequired 2(c), it is clearly applied when the said expenditure is not allowed when paid, the provision of the same shall also be not allowed.

Conclusion

Not allowable

Required2(e)

Issue: Deductibility of expenditure incurred towards feasibility studies.

Rules and Analysis

In term of law referred in required 2(a),  it is clearly implied that the said  expenditure incurred by Ruby Ltd  for feasibility study is capital in nature. Further, it has been held in case of Softwood Pulp and Paper Ltd v FCT 76 ATC 4439 that losses or expenditure incurred prior to set up of business or income producing activity shall not be allowed as tax deduction under Division 8. Accordingly, the directors of Ruby has re entered into in car parts manufacturing industry and has invested $2,20,000 but due to uncertainty the directors decided not to proceed so the expenses incurred has been disallowed as general deduction as the same is capital in nature

Conclusion

Not Allowable

References:

CCH Australia Limited. (2018). LINDSAY v. FEDERAL COMMISSIONER OF TAXATION, High Court of Australia, 14 December 1961. Retrieved September 9, 2018, from iknow.cch.com.au: https://iknow.cch.com.au/document/atagUio2679067sl706100838/lindsay-v-federal-commissioner-of-taxation-high-court-of-australia-14-december-1961

Cmmnwealth of Australia. (2018, September 3). Changes to company tax rates. Retrieved September 5, 2018, from www.ato.gov.au: https://www.ato.gov.au/Rates/Changes-to-company-tax-rates/

Commonwealth of Australia. (2017, june 30). Choosing an accounting method. Retrieved September 5, 2018, from www.ato.gov.au: https://www.ato.gov.au/Business/GST/Accounting-for-GST-in-your-business/Choosing-an-accounting-method/

Commonwealth of Australia. (n.d.). Deduction: legal expenses – landlord defending a damages claim in respect of injuries suffered by a third party on their rental property. Retrieved September 9, 2018, from https://law.ato.gov.au: https://law.ato.gov.au/atolaw/view.htm?docid=AID/AID2003484/00001

Commonwealth of Australia. (n.d.). Deductions and expenses: reimbursement to trust account of stolen trust monies. Retrieved September 9, 2018, from https://law.ato.gov.au: https://law.ato.gov.au/atolaw/view.htm?docid=%22AID%2FAID2010207%2F00001%22

Commonwealth Of Australia. (n.d.). Law Companion Rulin. Retrieved September 5, 2018, from gwww.ato.gov.au: https://www.ato.gov.au/law/view/document?DocID=COD/LCR2018D7/NAT/ATO/00001&PiT=99991231235958

Commonwealth of Australia. (n.d.). Taxation Ruling. Retrieved September 5, 2018, from www.ato.gov.au: https://www.ato.gov.au/law/view/document?DocID=TXR/TR981/NAT/ATO/00001&PiT=99991231235958#P49

Commonwealth of Australia. (n.d.). What’s new for small business. Retrieved September 9, 2018, from www.ato.gov.au: https://www.ato.gov.au/business/small-business-entity-concessions/what-s-new-for-small-business/

HBA Encompass Pty Ltd. (2014, September 18). Deferring Assessable Income. Retrieved September 9, 2018, from www.hbaencompass.com: https://www.hbaencompass.com.au/deferring-assessable-income/

Lowering the tax burden on enterprise. (n.d.). Retrieved September 9, 2018, from www.budget.gov.au: https://www.budget.gov.au/2016-17/content/glossies/tax_super/html/tax_super-04.htm

Tax changes for small businesses 2016/17 year end. (2017, September 21). Retrieved September 9, 2018, from thompsonsaustralia.com.au: https://thompsonsaustralia.com.au/tax-changes-for-small-businesses-201617-year-end/

TAXATION OF PAYMENTS OF DAMAGES AND COMPENSATION. (n.d.). Retrieved September 5, 2018, from www.deverslist.com.au: https://www.deverslist.com.au/Taxation%20of%20Payments%20of%20Damages%20and%20Compensation.pdf