Part 1
Choice of income recognition
With regards to derivation of income, there does arise instances when the time period between providing the promised products or services to the customer and the receipt of payment from the client tend to be patterned in such a way that these two events take place in different tax year. In such instances, a choice is provided to the taxpayer to choose whether to report earnings on cash basis or accrual basis considering as to which method would allow a more accurate description of the taxpayer’s income as has been indicated in TR 98/1 (ATO, 2018 a).
The choice regarding the income recognition is influenced by certain factors that are as outlined below.
1) Income source nature
There is a pivotal link between the method of income recognition chosen and the manner in which the assessable income is derived by the taxpayer. In this regards, tax ruling TR 98/1 highlights the preference towards accrual method when the underlying earnings are derived from business related to trading or manufacturing. Similarly, in case of income being derived as a result of individual skill or implied knowledge, then it is preferred that the cash method is chosen. A case law which endorses this approach is Carden v FCT (1938) 63 CLR 108 in which it is hinted by Dixon J that income recognition in the context of non-trading income should be carried out in way that ensures that tax payment to government is linked to something valuable being obtained by the taxpayer (Sadiq, et.al., 2016).
2) Business & Taxpayer related circumstances
It is noteworthy that the income source potentially provides a preference towards a method and does not make the decision conclusive which is in line with the commentary provided by Dixon J in Carden v FCT case where he clearly outlines that the choice of appropriate method must not be derived on account of any rigid rule but must consider the underlying situation circumstances to arrive at a conclusion. This approach suggested by Dixon J is reiterated by Javies J during the commentary in FCT v Dunn (1989) 85 ALR 244 case where he highlights that choice need not be based on any legal principle but rather derived from circumstances surrounding the business and taxpayer (Kreyer, 2016).
3) Investment in business and attained size
The method related to income derivation must factor in the size of the business and the underlying capital investment. This aspect can be highlighted by the Henderson v. Federal Commissioner of Taxation (1970) 119 CLR case. Initially, the taxpayer (i.e. Henderson) used the cash method for income recognition as the income was derived on account of skill possessed by Henderson. However, in the next year, his business was on a growth trajectory fuelled by business investments and hired employees. Henderson decided to alter the income recognition method to accrual method as the growth of business made this method more suitable to capture income. This switch in method was upheld by the court (Kreyer, 2016).
Required 1:
It is apparent that the choice to select one of the two methods rests with the taxpayer and the same cannot be dictated by the Tax Commissioner. However, it is imperative to note that the choice available to the taxpayer must be used suitably and therefore if the Tax Commissioner feels that the method used by taxpayer is not justified by the various factors identified above, then an objection may be raised and the Tax Commissioner may insist on a particular method. In such a circumstance, the taxpayer may concur with the Tax Commissioner or take the matter to court for resolution (Barkoczy, 2015).
2016-2017 – The scenario given clearly highlights that Frank is working as an architect and therefore his earnings are the result of his skill. Also, the business size is quite small since most of the work is performed by Frank only. Besides, the use of hired employee is also absent. Hence, as per the various case laws and tax rulings cited above, cash method seems appropriate for Frank.
2017-2018 – After Frank has won the national award for design, he has taken an office on rent, made investments of $ 1 million in the business along with hiring employees to assist him in designing and also related administrative tasks. Considering the investments and growth in business (receipts in excess of 2 million), Frank must switch to the accrual basis in line with the decision highlighted in FCT vs Henderson case where there were comparable circumstances.
The real time monitoring of cash inflow and outflow has seen significant improvement with the introduction of modern accounting software packages. Even though the use of these software is on the rise but still the distinction between cash and accrual remains relevant. This is because the need of these two methods is linked to instances when the time period between providing the promised products or services to the customer and the receipt of payment from the client tend to be patterned in such a way that these two events take place in different tax year. In such a scenario, an obvious question which arises is that income needs to be computed on cash or accrual basis and in answering this, accounting software is of limited use only since it is more useful for cash flow management (CCH, 2013).
The discussion with regards to availability of tax deduction on the various transactions that have been outlined in context of Ruby Pty Ltd (“taxpayer”) is indicated below.
Part 2
(a) The difference between repair and maintenance (including improvement) is highlighted in accordance with TR 97/23 and includes the following (ATO, 2018 b)
- The objective of repair work is to restore the efficiency without altering the underlying character. This differs from maintenance where the objective is to improve efficiency by change of character.
- While maintenance is carried out to prevent damages when it has just commenced, repair is usually carried out much later i.e. when significant damage has occurred.
In the scenario given, the expense related to kitchen fittings are repairs since they have commenced only after significant damage has taken place. Also, these have been implemented without altering the efficiency and also the layout has been largely kept the same. Besides, it is known that the given property in question is used for assessable income generation.
Possible tax deduction for the repairs can be availed under s. 25-10 ITAA 1997 or s. 8-1 ITAA 1997 (Austlli, 2018 a). As per s. 25-10, any repairs in relation to any depreciable asset belonging to any assessable income generating property would have tax deductions provided the repair expenditure does not assume a capital nature. As per s. 8-1, any particular loss or outgoing in the production of assessable income can be deducted for tax purpose (Austlli, 2018 b). However, ss.8-1(2) prohibits the deduction of any expenditure that is not revenue but capital.
In relation to kitchen fittings a crucial aspect that needs to be highlights is that most of the components are permanent fixtures (eg. Cupboard, sink, pumbings) and therefore instead of being considered as separate depreciable assets, they are considered as an integral part of the overall property assets. This implies that expenses related to repair of kitchen fittings would be considered as capital expenditure related to restoring the value of the property and hence would reflect in the asset cost base as per s. 110-25 ITAA 1997. This stance is also supported by the discussion indicated in TR 97/23. On account of the repair expenditure being capital, the taxpayer would not be able to claim any tax deduction in relation to the repair expenses (ATO, 2018 b).
(b) As per s. 8-1, any particular loss or outgoing in the production of assessable income can be deducted for tax purpose. However, ss.8-1(2) prohibits the deduction of any expenditure that is not revenue but capital (CCH, 2013).
In line with the above rule, it is essential to determine as to whether the legal expense would be capital in nature or not. For shedding light in this regard, reference must be made to the British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 case. During the proceedings of this case, a simple test was outlined whereby the capital expenditure can be identified with the presence of an enduring advantage. On the other hand, revenue expenditure would not lead to an advantage have is enduring (Austlli, 2018 c).
Required 2:
Considering the involvement of the taxpayer in real estate business and having rental property under management, occurrence of negligence related claims is a common phenomenon associated with the business. The advantage derived from the legal expenses is limited in nature as it would help in saving payment of damages in a particular year. The legal expenses do not provide any potential benefit once the case of settled and therefore tax deduction under s. 8-1 can be availed by Ruby Pty Ltd (Sadiq, et.al., 2016).
(c) As per s. 8-1, any particular loss or outgoing in the production of assessable income can be deducted for tax purpose (Austlli, 2018 b). However, ss.8-1(2) prohibits the deduction of any expenditure that is not revenue but capital.
The key question on which the decision to provide tax deduction hinges is whether the underlying outgoing would be termed as capital or revenue. A useful case which can be referred in the given scenario is Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33. Reading the verdict of the case, Dixon J highlighted that the nature of the expenditure incurred by the taxpayer can be identified by analysis the attributes related to the advantage which arises from the outgoing. If the underlying benefit or advantage continues for a sustained period of time, then the expenditure would be capital. In contract, if the advantage has impact limited to the given tax year or time period, then the expenditure is often categorised as revenue (Austlli, 2018 c).
Ruby Pty previously was engaged in business related to manufacturing of engines. In that business, it would have been common occurrence whereby faulty parts were supplied to a client which would have led to claims arising thus requiring settlement. This expense quite closely is related to the act of producing income by manufacturing engines. Besides, the advantage derived from paying the claims to the tune of $ 750,000 is not long term which implies that expenditure on claims is revenue and hence tax deduction can be availed by taxpayer (Sadiq, et.al., 2016).
(d) One of the requirements for general deduction of expense under s. 8-1 is for the expense to be incurred. Incurred in the context of this section does not mean that payment for the same should have been made. But TR 97/7 highlights that a key requirement for expense incurring is that reasonable estimation of the cash outflow must be possible along with reasonable assurance regarding the cashflow to occur (ATO, 2018 c).
Required 3.
Based on the given scenario, considering the potential of claims to be paid for faulty engine parts supply , the company has made provisions to the extent of $ 100,000. It is evident from the comparison of the actual amount and the provisional amount that the company at the time of providing the provision was not in a situation to potentially estimate the extent of claims that would arise. This implies that tax deduction to taxpayer will not be given in context of the provisions made for the claim amount (Kreyer, 2016).
(e) As per s. 8-1, any particular loss or outgoing in the production of assessable income can be deducted for tax purpose. However, ss.8-1(2) prohibits the deduction of any expenditure that is not revenue but capital. The amount in this case has been paid to the consultant in relation to market research the result of which would have an enduring advantage which would not be limited to the current year. As a result, the payment made to the consultant is a capital expenditure with no possible tax deduction under s. 8-1 (Austlli, 2018 b).
However, the amount paid to consultant does qualify as business expenses meant for future business. Section 40-800 ITAA 1997 would be useful here for providing tax deduction for business related capital expenditure. Unlike s. 8-1, the tax deduction under s. 40-800 would be available over a five year period in equal amounts. Besides, as per ss.40-880(2A), deductions are possible for future business related capital expenditure and the same is independent of the eventual decision of the taxpayer to start the business or not (Austlli, 2018 d).
Therefore, tax deduction per year (for five years) = 220000/5 which amounts to $ 44,000
References
ATO (2018 a). TR 98/1, Income Tax: determination of income, receipts versus earnings. Retrieved from: https://www.ato.gov.au/law/view/document?DocID=TXR/TR981/NAT/ATO/00001&PiT=99991231235958[Accessed 12 September 2018].
ATO (2018 b). Taxation Ruling, TR 97/23, Income tax: deductions for repairs. Retrieved from: https://www.ato.gov.au/law/view/document?docid=TXR/TR9723/nat/ato/00001[Accessed 12 September 2018].
ATO (2018 c). Taxation Ruling, TR 97/7, Income tax: section 8-1- meaning of ‘incurred’-timing of deductions. Retrieved from: https://www.ato.gov.au/law/view/document?Docid=TXR/TR977/NAT/ATO/00001 [Accessed 12 September 2018].
Austlli (2018 a) Income Tax Assessment Act 1997 –SECT 25.10. Retrieved from: https://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s25.10.html [Accessed 12 September 2018].
Austlli (2018 b) Income tax Assessment Act 1997 –SECT 8.1 General Deductions. Retrieved from: https://www8.austlii.edu.au/cgi-bin/viewdoc/au/legis/cth/consol_act/itaa1997240/s8.1.html [Accessed 12 September 2018].
Austlli (2018 c) Income tax Assessment Act 1997. Retrieved from: https://www8.austlii.edu.au/cgi-bin/viewdb/au/legis/cth/consol_act/itaa1997240/ [Accessed 12 September 2018].
Austlli (2018 d) Income Tax Assessment Act 1997 –SECT 40.880 General Deductions. Retrieved from: https://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1997240/s40.880.html [Accessed 12 September 2018].
Barkoczy, S. (2015) Foundation of Taxation Law 2017. 9th ed. Sydney: Oxford University Press.
CCH (2013), Australian Master Tax Guide 2013, 51st ed., Sydney: Wolters Kluwer.
Krever, R. (2016) Australian Taxation Law Cases 2017 2nd ed. Brisbane: THOMSON LAWBOOK Company.
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
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