Imperative Factors for choice

In order to decide the appropriate method for computation of income, the taxpayer needs to consider the following outlined factors.

1) Nature of the source of income

The income source tends to have a significant influence on the method deployed for recognition of income. A relevant case law highlighting the same is Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108) (also known as Carden v FCT case) (Woellner, 2014). In this case, Dixon J brought to light that for a taxpayer deriving non-trading income, payment of tax would require obtaining something having value owing to which it makes sense to pay taxes to the government. This would be in the form of cash only and hence indirectly it can be suggested that receipts method is suitable for income derived through non-trading. Further details in this regards are provided by TR 98/1 which recommends earnings method for income derived from manufacturing or trading business (ATO, 2018 a).

2) Individual circumstances linked with the taxpayer

Dixon J in Carden v FCT has highlighted that the decision of choosing a particular income recognition method should not only be based on a rigid rule or legal principle but rather should be a flexible decision to be taken by the taxpayer after considering all the relevant circumstances. This viewpoint has also been expressed in FCT v Dunn (1989) 85 ALR 244 case. Davies J hints that the income recognition method is not a legal question. As a result, the occupational circumstances, nature of conduct in business, book keeping are all relevant parameters influencing the decision made by the taxpayer (Woellner, 2014).

3) Size of business and capital investment

The size of business along with the level of investment is also a critical parameter for making a choice of appropriate method of income recognition. This has been highlighted in Henderson v. Federal Commissioner of Taxation (1970) 119 CLR case law.  Henderson the taxpayer changed the method of recognising income from receipts to capital when he witnessed a significant expansion and investment in business. Thus, the taxpayer was of the opinion when the business was small, receipts method captured income better but later with increased size and employee count, earnings method was found more suitable and this was also endorsed by the court.

The key reason for the distinction in income recognition methods is because the act of performing contractual obligations by the seller or service provider does not coincide with the receipt of payment or cash. As a result, taxpayer needs to decide the appropriate basis for income recognition taking into consideration the host of factors mentioned above. As per TR 98/1, the taxpayer should choose the method which would capture the income of the taxpayer in a more accurate manner (ATO, 2018 a). 

Once the tax return is filed, it may be possible to have disagreement with the Tax Commissioner in relation to the method used for recognition of income. This is because while a choice has been indeed provided to the taxpayer but he/she is expected to exercise the same in a prudent manner.  The taxpayer may decide to concur with the Tax Commissioner and alter the basis for income recognition or alternately the court may provide the final verdict in such cases.

Choice in Income recognition basis

The source of income for Frank is his skill since he is an architect. With regards to income derived on account of underlying skill, the receipts method presents the appropriate choice as has also been endorsed by TR 98/1 and also Henderson v FCT. Under similar circumstances, the taxpayer Henderson also chose the receipts method for income recognition. Thus, Frank must choose this approach for 2016/2017 (ATO, 2018 a).

However, during the year 2017/2018, the manner in which the business is performed has undergone a significant change. Frank has hired an office and invested about $ 1 million coupled with using hired staff for serving his clients. The circumstances faced by Frank are quite comparable to those faced by Henderson where he decided to migrate from receipts method to earnings method. A similar decision is expected from Frank who should switch to earnings method of income recognition for the year 2017/2018 (CCH, 2013).

The key reason for the distinction in income recognition methods is because the act of performing contractual obligations by the seller or service provider does not coincide with the receipt of payment or cash. The tax year terminates on 30^th June but the receipt of cash and performance of contractual obligation may not lie in the same tax year. The accounting software use can enable better cash flow monitoring and computation but the recognition is still a subjective process as mentioned in the various case laws that have been cited in the above discussion (Barkoczy, 2015). Thus, the distinction between these two methods continues to be relevant even in the current era. 

The requisite tax treatment of the various outgoings that have been undertaken by the given taxpayer (Ruby Pty Ltd) has been explained as follows.

(a) In wake of the given information, it can be concluded that the expense related to replacement of the damaged kitchen fittings would be considered as repair in line with the discussion in TR 97/23 (ATO, 2018 b). Through repair there has been no improvement but rather restoration of the previous character and also expense was incurred only when actual damage to pipe fittings was already done. Considering that the given repairs pertain to a rental property, hence potential tax deduction may be claimed by the taxpayer in accordance with s. 8-1 (general deduction) or s. 25-10 (CCH, 2013).

Section 8-1, ITAA 1997 provides general deduction on any outgoings or expense that have a sufficient and direct nexus with the derivation of assessable income (Austlli, 2018 c). A negative limb highlighted in ss.8-1(2) relates to tax deduction not being available if the underlying expenditure is termed as capital and not revenue. Section 25-10 provides tax deduction in context of expenses of repairs provided these pertain to the property or depreciable asset occupying a part of this property which tends to contribute to assessable income generation. As per ss.25-10(3), the only restriction is that the expenditure should not be termed as capital.

In context of kitchen fittings, it is essential to highlight that majority of the components are in the form of fixtures that are permanent in nature. This includes plumbing, cupboard, sink, built-in stove and owing to these being part of the property itself, hence no depreciation is available on these assets as explained in IT 242 (ATO, 1964). Also, TR 97/23 underlines that since the kitchen fittings are part of the property, hence any repairs on these would form part of cost case of the asset as per s. 110-25 ITAA 1997. Owing to the classification of the repair expenditure as capital, Ruby Ltd would not be entitled to any tax deduction on the repair amount of $ 8,500.

Objection from Tax Commissioner

(b) Section 8-1, ITAA 1997 provides general deduction on any outgoings or expense that have a sufficient and direct nexus with the derivation of assessable income. A negative limb highlighted in ss.8-1(2) relates to tax deduction not being available if the underlying expenditure is termed as capital and not revenue (Austlli, 2018 c).

In line with the above rule, the pivotal aspect in relation to the legal expenses is to classify it into capital or revenue expenditure. A test to achieve the same has been indicated by the honourable judge in the British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 case, Any outgoing may be classified as capital expenditure only when there is an enduring effect associated with the resulting advantage obtained through the outgoing. It implies that the gains of a capital expenditure must not be limited to the present but must continue in the future. On the contrary, revenue expenditure relates to those outgoings which are often realised in the normal business practices (Woellner, 2014).

For taxpayers having rental properties, negligence related claims do arise on account of some defect in the building and this is an integral component of this business. Besides, the legal expenses for settling of negligence claim is not resulted to yield any advantage with enduring effect owing to which it would be appropriate to term the given legal expense as revenue expenditure only. Ruby Ltd would be entitled for a tax deduction as per s. 8-1 to the tune of $ 7,000.

(c) Section 8-1, ITAA 1997 provides general deduction on any outgoings or expense that have a sufficient and direct nexus with the derivation of assessable income. A negative limb highlighted in ss.8-1(2) relates to tax deduction not being available if the underlying expenditure is termed as capital and not revenue. 

In this case also, the key issue is to highlight the expense type as revenue or capital. A relevant case which can provide some guidance in this endeavour is Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case. Dixon J presiding over the case indicated that the nature or character of the expense is ascertained by considering the features of the advantage derived on account of incurring the expense. The revenue expenditure related advantage could be expected to last for only the reference year unlike capital expenditure related advantage which would have a positive effect extending into future as well (CCH, 2013).

It is known that the company before entering into the real estate business was in the business of manufacturing of auto parts. In such a business, it would be expected that at times, the components provided to the customer would be faulty and the claims may arise in such cases which would need to be settled. The act of settlement of claim does not lead to any enduring benefit or advantage for the taxpayer. Hence, it is appropriate to conclude that the given outflow of $ 750,000 would be revenue expenditure and hence deductible under s. 8-1 for tax purposes by Ruby Ltd (Krever, 2016).

Frank’s choice

 (d)  A key requirement for the application of general deduction under the ambit of s.8-1 is that the outgoing has to be incurred for any consideration of tax deduction. The implications of incurred as in s.8-1 have been reflected in tax ruling TR 97/7 whereby it is imperative that even if the actual cash may not have been spent, an assurance should exist which should reasonably confirm the same coupled with the likely estimates of that amount (ATO, 2018e).

Considering the claim for faulty auto parts, a provision of $ 100,000 has been made. It may be fair to conclude that at the time of providing provisions the company could not provide any fair estimate of the amount of outgoings and the year in which this would happen. Taking these uncertainties into picture, it would be appropriate to conclude that tax deduction as per s. 8-1 is not permissible on provisioning (Krever, 2016).

 (e) Section 8-1, ITAA 1997 provides general deduction on any outgoings or expense that have a sufficient and direct nexus with the derivation of assessable income. A negative limb highlighted in ss.8-1(2) relates to tax deduction not being available if the underlying expenditure is termed as capital and not revenue. As per the verdict in Sun Newspaper v FCT case, the nature of expenditure can be determined by analysing the underlying advantage obtained. With regards to market research, clearly, the advantage would be of enduring nature owing to the relation of this with the opening of a business which would produce assessable income over a number of years. Hence, the expense on consultant is capital and non-deductible under the aegis of s. 8-1 ITAA 1997 (CCH, 2013).

The expense on consultant is never the less a business expense which is related to future business with the intention of producing assessable income. In this context, s. 40-880 is relevant which provides deduction for business related capital expenditure over five years in the form of equal annual amounts.  Further, ss.40-880(2A) ITAA 1997 provides tax deduction for expenditure related to start-up costs of business without any requirement that the business should necessarily be set up and assessable income derived (Austlli, 2018 d).

As a result, annual tax deduction for Ruby Ltd = 220000/5 = $ 44,000

The above amount can be deducted for tax purpose for a period of 5 years. 

References

ATO (1964). Taxation Ruling, IT 242, Income tax: depreciation on hot water installation, stove etc in income producing properties. Retrieved from: https://www.ato.gov.au/law/view/document?locid=%27ITR/IT242/NAT/ATO%27 [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].  

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].   

Austlli (2018c) 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].   

CCH (2013), Australian Master Tax Guide 2013, 51^st ed., Sydney: Wolters Kluwer.

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].  

Woellner, R (2014), Australian taxation law 2014 7^th ed. North Ryde: CCH Australia.

Krever, R. (2016) Australian Taxation Law Cases 2017 2^nd ed. Brisbane: THOMSON LAWBOOK Company.

Barkoczy, S. (2015) Foundation of Taxation Law 2017. 9^th ed. Sydney: Oxford University Press.

ATO (2018 e). 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].  

Law cases

British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205

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

FCT v Dunn (1989) 85 ALR 244

Henderson v. Federal Commissioner of Taxation (1970) 119 CLR

Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33