BULAW5916 | Taxation Law & Practice | Two Basis For Recognising Income
Part 1
On 1 July 2016 Frank Lloyd commenced business as an architect. He operated as a sole proprietor from a converted garage at the rear of his residence. Much of his work consisted of preparing building designs and specifications for local council building permits but he quickly gained a reputation for quality drawings prepared within tight timeframes. By the end of 2016/17 he had a small client base of local builders and private referrals and billings (fees) of $75,000.
During the year (2016/17) Frank submitted a design as part of a national competition for
‘The Citadel’, the centrepiece of an ambitious urban redevelopment. His visionary design and revolutionary use of local materials left the judging panel speechless with admiration and, to national acclaim, he was awarded the prize and commissioned to build the structure. Immediately he borrowed $1 million, rented premises in Main Terrace, acquired state of the art equipment and employed six draughtsmen and two administrative staff. During 2017/18 his billings were $2.5 million.
Required 1:
Should Frank return on a cash or accrual basis in 2016/17 and 2017/18?
You must refer to appropriate case law. Your answer must include (but should not be limited to) a discussion of the following:
- What factors affect the choice of a cash or accrual basis?
- Does Frank have a choice of the basis he adopts?
- Does the Commissioner of Taxation have a right to insist on a particular basis?
- Should Frank’s basis be the same in both years?
- Given the present availability of accounting software packages, in your view, is the traditional criteria for the cash/accrual distinction still relevant?
Part 2
Ruby Engineering Pty Ltd [Ruby] was incorporated in 1990 and produced engine components used in the Australian car industry. In 2016 the business and company assets were sold to Diamond Ltd. Under the terms of the agreement, Ruby remained liable for any claims arising before 2016. The company used the funds to invest in real estate and shares.
During the year ended 30 June 2018 Ruby incurred the following expenses:
Required 2:
Advise the directors of Ruby Pty Ltd of the tax deductibility of the above amounts. You must make reference to appropriate authorities and legislation.
- Ruby has owned and rented a residential property since 2008. Rental income for the current year is $35,000. During the year the company replaced the old kitchen fittings, including cupboards that had deteriorated through water damage and wear and tear. The new cupboards were of the same type as the old ones and the kitchen layout was not altered substantially. The cost was $8,500.
- In another of the rental properties a visitor to the tenants slipped on the steps and sustained injuries requiring medical attention. She claims one of the steps was loose and commenced legal proceedings against the partnership alleging her injuries were caused by the poor condition of the building. Ruby incurred legal expenses to date of $7,000 and the action has not been settled at 30 June.
- In March 2015 the company owned sold a batch of parts that were subsequently found to be defective. The purchaser, an Australian car manufacturer lodged a claim for damages in the Federal Court. The claim was settled in November 2017 and the company paid an amount of $750,000 to the car manufacturer.
- The directors of Ruby were concerned about the claim in (c) and the effect it had on the year’s reported profit. They resolved to set aside a small amount of funds annually to meet any future claims. Accordingly, an amount of $100,000 was set aside in a provision in the accounts for the year ended 30 June.
- In August 2017 the directors of Ruby decided to investigate the possibility of re-entering the car parts manufacturing industry using a new type of alloy. An amount of $220,000 was paid to consultants investigating the proposal but, due to uncertainty in the motor vehicle industry, the directors decided not to proceed at the time.
Required 2
Advise the partners and directors of Ruby Pty Ltd of the tax deductibility of the above amounts. You must make reference to appropriate authorities and legislation.
Answer:
1. Income Recognition Basis
There are two basis for recognising income that are available to a taxpayer which are the cash basis and accrual basis. In line with tax ruling TR 98/1, the taxpayer has the choice to select one of these methods based on which method would present a more accurate picture of the income of the taxpayer. In cash method, the income recognition takes place when the cash payment is received without any consideration to product or service being provided to customer or client. In earnings method, the income recognition takes place only when the underlying product or service has been provided without any consideration to cash receipts (CCH, 2013).
Factors that decide the suitable basis
In order to exhibit the choice provided, the following aspects need consideration.
1) The first pivotal factor is the income source type through which taxpayer earns assessable income. Some basic indicators are presented by TR 98/1 which advises that for trading or manufacturing based business, the preferred method would be accrual basis. However, the cash basis would be preferred when the income is non-trading or linked to skill of the taxpayer (Woellner, 2014). This assessment is provided support based on cases such as Ca
rden v FCT (1938) 63 CLR 108. It is advocated in the verdict of the given case law that for tax to be levied on non-trading income, it Is imperative that the taxpayer should obtain something of value on which tax becomes justified which could be cash only, therefore indicating preference for cash basis in such scenario (Deutsch, Freizer, Fullerton, Hanley & Snape, 2016).
2) The second key factor corresponds to the circumstances related to the business or income production coupled with scenario of taxpayer. It has been indicated in the Carden v FCT case that the decision to choose the appropriate bias should be a flexible decision not derived from any rigid thumb rule or legal principle. Instead, the underlying circumstances should dictate the choice. Support to this observation has been extended in FCT v Dunn (1989) 85 ALR 244 case when Javies J pointed that the requisite basis should be linked to the prevailing business circumstances along with taxpayer rather than any legal rule (Barkoczy, 2015).
3) The third key factor relates to the extent of investment coupled with business size which is also pivotal. The Henderson v. Federal Commissioner of Taxation (1970) 119 CLR provides testimony in this regards. In this case, Henderson was the taxpayer who computed income on cash basis in one year. However, the next year he chose the accrual basis owing to the increase in business and the significant investment put owing to which he started using hired labour for assisting him which previously was not done. The change in basis from receipt to accrual was upheld by the honourable court (Sadiq et. al., 2016).
Right to Insist
The Tax Commissioner cannot insist that the taxpayer must report the earnings using a particular basis only. However, once the returns filing is completed, the Tax Commissioner can consider the various factors outlined above to highlight if the basis used presents the most accurate description of income or not. If the Tax Commissioner considers otherwise, then an objection may be raised and the taxpayer may need to revise the basis. However, if the taxpayer considers that the basis originally used is suitable, then the same may be justified in the court of law which would decide the appropriate basis (Krever, 2016).
Suitable Choice for Frank
Tax year 2016-2017 – On the basis of provided facts, it may be concluded that Frank is deriving income based on his skill since he is working as an architect. The size of the business is quite small and all the work is carried out by Frank. Taking into consideration the various factors, cash method is the requisite choice for deriving income (CCH, 2013).
Tax year 2017-2018 – One of the crucial events in this year has been his national award. Encouraged by the same, he has taken loan and invested the same into hiring a place and setting business. The size of business has significantly enhanced considered client payments in excess of $ 1 million. Also, hired labour is used to assist Frank is performing his job along with rendering administrative support. Referring to the FCT vs Henderson case, Frank needs to change in favour of accrual basis (Woellner, 2014).
Distinction between Cash/Accrual
Over the years, there has been introduction of accounting software packages which has altered the way in which record keeping and transaction tracking is done. Since these systems tend to monitor cash on a real time basis, hence the distinction between cash and accrual basis is blurring. However, with regards to tax purposes, the distinction between cash and accrual basis is necessary. This is because there does arise circumstances when the delivery of products or service to the customers and receipt of payment do fall in different tax years. As a result, there is a choice which the taxpayer needs to make with regards to whether derive revenues on cash or accrual basis. In this regards, the accounting packages offer limited help as without the distinction between the two methods, filing tax returns for businesses would be quite difficult (Deutsch, Freizer, Fullerton, Hanley & Snape, 2016).
2. The implications of the given transactions have been explained as follows.
(a) As per TR97/23 and the given facts, it may be concluded that the given expenses in regards to replacement of kitchen fittings would be termed as repair. Evidence in this regards can be offered by replacement being undertaken only after damage has been done. Further, the objective is to restore the earlier efficiency and not to improve the same (Krever, 2016).
Also, another key aspect that the repair expense has been undertaken with regards to rental property and hence potential tax deduction may be claimed under the following two sections.
1) Section 25-10 – Provides immediate tax deduction for repairs pertaining to depreciating assets provided the assets are part of property engaged in assessable income generation. Another key requirement is that the repair expenses must not be capital (Barkoczy, 2015).
2) Section 8-1 - Provides immediate tax deduction for repairs providing sufficient link of the repairs to assessable income generation. However, the underlying expenditure must not possess a capital nature or deduction cannot be availed under this section.
A crucial aspect related to kitchen fittings is that most of these exist as permanent fixtures. Suitable examples could be plumbing, cupboard, sink etc. Owing to this nature, the kitchen fittings are not considered a separate depreciable asset but essentially part of the overall rental property which is a capital asset. Thus, any repairs expenses are essentially repairs on the house and thereby are included in the property cost base as per s. 110-25 ITAA 1997 (Sadiq et. al., 2016). Considering this, it is apparent that repair expenditure in the given context is capital owing to which no tax deduction can be availed by Ruby Pty Ltd.
(b) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the repairs to assessable income generation. However, the underlying expenditure must not possess a capital nature or deduction cannot be availed under this section (CCH, 2013).
Considering the above, the pivotal aspect is to highlight the nature of the legal expense incurred. A relevant case which can provided assistance is British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 case. The presiding judge indicated that capital expenditure can be differentiated from revenue expenditure since the former would lead to obtaining an “enduring advantage”. Also, the expenses under revenue expenditure are typically those who are usual business expenses (Deutsch, Freizer, Fullerton, Hanley & Snape, 2016).
It would be appropriate to highlight that in the business of real estate, the owner have to often face claims based on negligence and these are common business aspects. Further, through incurring the legal expenses, Ruby Pty would not derive any enduring advantage expected to provide benefit over multiple years (Woellner, 2014). Therefore, the legal expenses would be revenue owing to which s. 8-1 ITAA 1997 can provide tax deduction to Ruby Pty Ltd.
(c) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the repairs to assessable income generation. However, the underlying expenditure must not possess a capital nature or deduction cannot be availed under this section (Barkoczy, 2015).
Again the key issue is to determine if the claims would constitute capital or revenue expense. Assistance in this quest can be obtained by referring to Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case law. A useful observation made by Dixon J in this case was that the expenditure type can be determined by focusing on the type of advantage that the underlying expense aims to provide. If this advantage stretches across multiple years, then the expenditure would be capital or less revenue (CCH, 2013).
The taxpayer was earlier involved in engine and related parts manufacturing. In this business, it is a common practice that defective parts are supplied to the customers resulting in legal claims to be settled. The payment of claim amount does provide an advantage which stretches over the years which is concerned with the reputation. As a result, the given expenditure would be capital and non-deductible under s. 8-1. However, considering that it is a business expenditure, phased deduction over a five year period is permissible under s. 40-880 ITAA 1997.
(d) Only when the incurring of an expense has taken place can deduction under s.8-1 be considered. Tax ruling TR 97/7 explains this aspect in detail. In accordance with this tax ruling, the word ”incurred” does not represent occurring of actual cash flows to the expense item. But there needs to be reasonable and credible assurance that the cash outflow would occur along with the accurate estimate of the underlying amount (Krever, 2016). With regards to the claims for the faulty components, it is known that the outflow would arise but no reasonable estimation is possible in regards with the true magnitude of the claim along with the time when the same would occur. The lack of reliability in estimating the claim amount is apparent from the provision amount and the actual claims awarded by the court. Hence, no tax deduction for claim related provisions is permissible under s. 8-1 ITAA 1997.
(e) Section 8-1 provides immediate tax deduction for repairs providing sufficient link of the repairs to assessable income generation. However, the underlying expenditure must not possess a capital nature or deduction cannot be availed under this section. The expense on market research is clearly capital as the underlying advantage being derived would extend into future years in the form of profits obtained from business or losses saved (Deutsch, Freizer, Fullerton, Hanley & Snape, 2016). Hence, the given amount spent on consultant would not be tax deductible for Ruby Pty Ltd as per s. 8-1.
An alternative to s. 8-1 can be provided in the form of s. 40-800 ITAA 1997 which provides deduction for capital expenditure related to business. As per s. 40-800(2A), capital business expenditure related to future business is also provided tax deduction over five equal annual deductions. Further, despite the taxpayer not going ahead with the project, the expenditure can still be claimed for tax deduction under this section (Woellner, 2014)
Thus, annual tax deduction for Ruby Pty Ltd arising on account of s. 40-880 would be 220000/5 or $ 44,000 and this tax deduction would be available for 5 year period so that complete amount is deducted for tax purposes (CCH, 2013).
References
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.
Deutsch, R., Freizer, M., Fullerton, I., Hanley, P., & Snape, T. (2016) Australian tax handbook. 8th ed. Pymont: Thomson Reuters.
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
Woellner, R (2014), Australian taxation law 2014 7th ed. North Ryde: CCH Australia
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