Income Recognition

The key objective in the given case is to extend tax advice with regards to the taxpayer (VFA) in relation to the year ending June 30, 2018. The critical issues that need to addressed are as following.

1) The revenues obtained from TCA airways as part of pilot training contract would be recognised on accrual basis or cash basis.

2) With regards to the proceeds from the sale of land, it needs to be highlighted whether the same would be capital receipts or revenue receipts.

3) The possible tax deduction of the solicitor and court fees incurred by VFA in relation to build a large training facility with reference to s. 8-1 ITAA 1997.

4) The tax implications of the sale of land which was intended to expand the operations to training of commercial pilots and had to be closed later.

5) To ascertain whether the cash incentives for entering the lease can be treated as assessable income under s. 6-5 or s 6-10. The same needs to also be performed for the rent free use of the new facility by Chandler Airport Corporation for a period of one year.

6) The tax deductibility of the annual lease payments made with regards to the special flight simulator procured from Flight Services Ltd in the light of s. 8-1 ITAA 1997 or any other clause.

7) The tax deductibility of the payment for restrictive covenant to the tune of $ 350,000 for a period of four years.

8) The assessability of the compensation payment to the tune of $ 750,000 that has been provided by FlyHigh on account of cancellation of the service agreement which would have brought in assessable income for VFA over the next four years.

9) The appropriate taxation treatment of the following expenses need to be considered with reference to Income Tax Assessment Act 1997 (ITAA 1997) and also Fringe Benefit Tax Assessment Act 1986 (FBTAA 1986).

• Bank Charges
• Car Expenses
• Education Expenses
• Entertainment
• Furniture
• Marketing Costs
• Telephone
• Travel Expenses

The deductibility of the above expenses and potential liability for the company ought to be highlighted.

The income derived from ordinary income sources are termed as ordinary income and contributes to assessable income as per s.6-5 ITAA 1997. As per tax ruling TR 92/7, assessable income would include various income such as employment income, business income, investment income and income from personal exertion (Reuters, 2017).

In accordance with tax ruling TR 98/1, a taxpayer has a choice with regards to choosing an appropriate means for income recognition in the form of accrual (earnings) basis or cash (receipts) basis. The taxpayer has the choice but the same should be exhibited in a manner that presents the most accurate representation of the income. TR 98/1 highlights that the receipts or cash method is preferable in instances where the income is derived on providing services or where income is the result of skill possessed by the underlying income. On the other hand, trading income or income from manufacturing operations is preferred to be recorded on the earnings method (Barkoczy, 2017).

Business Expenses

However, as indicated in Carden v FCT (1938) 63 CLR 108, the decision with regards to appropriate basis for income recognition should not be based on rigid rule and must be driven by the underlying circumstances of the business. In this regards, the size of the business plays a crucial role and typically when the size of a business expands and there is use of other employees for revenue generation, then the appropriate basis to be deployed is accrual basis as indicated in the verdict of the Henderson v. Federal Commissioner of Taxation (1970) 119 CLR case (Sadiq et. al., 2015).

General deduction is available for business expenses under s. 8-1 ITAA 1997. As per ss. 8(1) ITAA 1997, the necessary positive limb for claiming tax deduction for outgoings or losses is that the underlying outgoing or expenditure must have been incurred with regards to producing assessable income and there should be sufficient nexus between the outgoing and the assessable income production (Woellner, 2015). Further, there are three negative limbs in relation to ss. 8-1(2) that are outlined as follows (Krever, 2017).

• The expenditure cannot be capital in nature and has to be revenue. In case of capital expenditure no deduction can be availed.
• The expenditure should be business expenditure and must not domestic expenditure since no deduction is available for private expenditure.
• The expenditure should be done for assessable income and any expenditure incurred for producing tax exempt income or non-assessable income would not be able to claim deduction under this section.

A key concern with regards to expenditure or outgoing is to determine the underlying nature of the same which is of special information to s. 8-1 deduction and also other sections which provide deduction only belonging to revenue nature. A suitable case law for indicating the difference between the two is Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case. In this particular case, Dixon J highlighted a test to differentiate between the two which focused on the advantage produced from the underlying outgoing (Deutsch et. al., 2015). If the advantage that is procured from the outgoing has an enduring effect, then the underlying expenditure would be capital in nature. However, if the advantage would be realised in the current tax year and would not be long term, then the expenditure would be revenue. A similar stance has also been assumed in the Carden v FCT (1938) 63 CLR 108 case (Coleman, 2015).  For instance, any payment related to restrictive covenant would be capital expenditure and not revenue expenditure as the underlying positive effect in terms of lower competition is not limited to the current tax period but tends to extend in the future and hence the nature of the advantage would be termed as enduring (Gilders et. al., 2016).

With regards to capital expenses, deduction can be availed in accordance with s. 40-880 ITAA 1997 where any business related capital expense can be deducted completely over a five year period with equal deductions applicable every year (Krever, 2017).

Sale of Land

It is noteworthy that when there is a sale of assets, then the underlying proceeds are capital in nature and exempted from tax. However, any capital gains that are obtained in the process would be taxed in accordance with Capital Gains Tax (CGT). The CGT needs to be charged on the capital gains which are required to be computed once a CGT event takes place as per s. 104-5 ITAA 1997. A prominent CGT event is A1 event which is triggered whenever there is a disposal of any asset.  In accordance with this the capital gains can be computed by subtracted the asset cost base from the proceeds realised on asset case (Reuters, 2016).

The cost base of the asset is determined in accordance with s. 110-25 ITAA 1997. As per ss. 110-25(1) ITAA 1997, there are five elements which tend to contribute to the asset cost base as highlighted below (Barkoczy, 2017).

1. 110-25(2) – The price for which the asset has been purchased.
2. 110-25(3) – The incidental costs which are related to either the asset purchase or sale and are necessary.
3. 110-25(3) – The ownership costs for the asset including the payment of certain taxes along with the payment of interest on any loan assumed for the asset purchase.
4. 110-25(4) – The capital costs in regards to the preservation or enhancement of asset value.
5. 110-25(5) – The capital costs incurred by the taxpayer in relation to the title preservation of the asset.

The capital gains thus determined considering the cost base and sales proceeds can further be reduced through the application of discount method or indexation method. The discount method is outlined in s. 115-25 ITAA 1997 and offers 50% discount on the capital gains provided these are long term. For long term capital gains, it is imperative that the underlying asset has been held for a period of more than one year. However, this discount cannot be availed by companies and restricted only to individuals and small businesses. Hence, the only alternative remains in the form of indexation method which is applicable only for assets purchased prior to September 1999. Finally, the capital gains remaining after this would be levied CGT at the rate of 30% (Sadiq et. al., 2015).

Fringe benefits are those benefits that are extended to the employees by the employers and are provided not in form of cash besides being personal in nature. The legislation for the tax treatment of these benefits is Fringe Benefit Tax Assessment Act 1986 (FBTAA 1986). The discussion on the key aspects is indicated below (Gilders et. al., 2016).

• One of the most common fringe benefits is car fringe benefits which as per s. 7 FBTAA 1986 arise when the employer owned car is provided to employee for personal usage. The extent of fringe benefit can be determined as per s. 9 statutory formula which is indicated below (Coleman, 2015).

Further, the taxable value of the benefit is obtained by multiplying the above value with the gross factor which depends on the underlying year and whether the underlying item would have GST applicable or not. Also, the FBT burden on the employer is computed by multiplying the taxable value with the FBT rate which may vary annually (Woellner, 2015).

• As per s. 58X, FBTAA 1986, if the employer provides any electronic portable item (such as mobile, laptop) for office work, then the same is exempted from purview of FBT. However, if the bill of these devices is paid by the employer and part of the usage is private, then FBT may be levied on employer (Deutsch et. al., 2016).
• With regards to entertainment fringe benefits, FBT would be levied on the employer. However, deduction under s. 8-1 ITAA 1997 is available for employer for any expenses in relation to client and their associates but the expenses related to client are non-deductible. Further, for Christmas party, FBT would be levied on the employer if the minor benefit exemption does not apply (Coleman, 2015).

Restrictive Covenants

In accordance with tax ruling TR 95/35, the compensation receipts would be considered to have the same nature as the underlying loss that they are replacing. Hence, if the compensation receipts are provided for revenue receipts, then the income would be assessable else not (Krever, 2017).

Lease Incentives

The tax implications of cash and non-cash lease incentives are highlighted as per IT 2631.  In accordance with this any cash incentive would be treated as income for the taxpayer. This is also vindicated from the decision in the F.C. of T. v. Cooling 90 ATC 4472 case where it was highlighted that these incentives tend to result from the normal business activity of shifting premises and would be income in character. In relation to the non-cash incentive, if the same is convertible into cash, then the same would also be included in the assessable income of the taxpayer (Sadiq et. al., 2015).

The depreciation on various depreciable business assets can be computed using the prime cost method as indicated in s. 40-75 ITAA 1997. To the extent that the asset is used for generation of assessable income, deduction would be available to the taxpayer. However, no deduction for the personal use of asset is permissible (Coleman, 2015).

The taxpayer in this case is the company VFA which is providing services to various airlines in regards to training their pilots and the money received on account of the same would be considered as ordinary income as per s. 6-5. Thus, the proceeds from TCA Airways contract would be considered as ordinary income. Considering the size and scale of business, the relevant basis would be accrual basis, hence the complete cash receipts received in October of each year would not be recognised. The revenue for each year would be recognised to the extent that services have been provided to the TCA Airways and remaining revenues would remain unearned.  Further, the debtors to the extent that

The settlement amount to the tune of $ 750,000 obtained during the year from FlyHigh Ltd would be considered as ordinary income since the settlement amount has been received in exchange of the loss on the future ordinary income that could have been earned had the contract not been terminated.

The cash lease incentive offered by CAC in relation to shifting the base to their airport would be considered as ordinary income for VFA considering that this payment has been derived in the ordinary course of shifting business premises by the company. Additionally, the assessability of the non-cash benefit would also be considered as the rent free place would result in cash savings for the company to the extent of $ 100,000 over the given tax year.  Thus, both cash and non-cash incentives would contribute to the ordinary income.

Land had been acquired by the company for the purpose of expansion but was liquidated later when the permission for commercial flight testing was not provided. Considering that the taxpayer is a company, hence discount method is not available. Further, indexation method cannot be used as the land has been acquired on October 1, 2017.

Purchase cost of land = $ 6 million

Interest paid for holding period of 4 months from October 1, 2017 to January 31, 2018 = 0.9*6 million*(6.8/100)*(123/365) = $ 123,741

Hence, cost base of the land = $ 6,000,000 + $ 123,741 = $ 6,123,741

Selling price of the land = $ 6,850,000

Capital gains that are subject to CGT = (6850000 – 6123741) = $ 726,259

CGT obligation (assumed no previous CGT loss and no other transactions) = 0.3*726259 = $ 217,878

However, it is noteworthy that the proceeds of $ 6.85 million from land would not be taxable since it is capital in nature.

The tax treatment of various expenses is indicated as follows.

• Solicitor and Court Fees ($380,000) – The given legal expense is capital in nature since the benefit derived from the same would have brought incremental income for the taxpayer over several years and hence the benefit would have been enduring. 100% deduction can be claimed under s. 24-440 ITAA over a five year period.
• Lease payment to Flight Services for simulator ($150,000) – Assuming that the given  expense is operating, tax deduction under s. 8-1 ITAA 1997 would be available since the given equipment is necessary for producing assessable income.
• Payment for restrictive covenant ($350,000) – Since the benefits derived for the business are enduring, hence the given expense would be termed as a capital expense for the company. Thus, 100% deduction can be claimed under s. 24-440 ITAA over a five year period.
• Bank charges – The card transaction fees would be revenue in nature and hence deduction under s. 8-1 ITAA 1997 is available as these are required for payments.
• Car expenses – Since personal use is allowed on the car, hence FBT liability would be computed on the company (Taxpayer) as per s. 9 FBTAA 1986. Further, for the operating expenses, deduction to the extent of 77% can be availed under s. 8-1 ITAA 1997 since it relates to production of assessable income.
• Education Expenses – These are requisite expenses for the business since it is imperative to train the staff and also the instructor. Hence, the nature of the business expense is revenue owing to which deduction as per s. 8-1 ITAA 1997 is permissible.
• Employee Remuneration – These are deductible revenue business costs and thereby deductible in accordance with s. 8-1 ITAA 1997.
• Lunches and Christmas – Depending on the availability of the minimum exemption rebate, FBT would be levied on the employer in relation to the entertainment and meal fringe benefits that are extended. However, the amount of spending would be deductible under s. 8-1 ITAA 1997 as the employees produce assessable income for taxpayer.
• Furniture – The expenditure on furniture would be capital in nature and hence non-deductible under s. 8-1 ITAA 1997. However, over the useful life depreciation would be charged on the same and this amount would be available for deduction from taxable income.
• Fuel and Airplane Maintenance cost –   These are essential costs for the company as airplane are required for training and fuel would be incurred. For these regular business expenses, deduction is available under s. 8-1 ITAA 1997.
• Marketing and advertising costs are also business expenses that are regularly incurred for attracting new clients and hence these are revenue expenses with deduction under s. 8-1 ITAA 1997.
• In relation to mobile phone provided to instructors, no FBT would be levied but depreciation on the same may be claimed over the useful life of the asset.
• Solicitor fees with regards to lease for Simulator would be a revenue expense and hence general deduction would apply for this case.
• The amount spent by the company on the travel and stay of Dale Wise would be deductible under s. 8-1 ITAA 1997 since it is an imperative expenditure related to training and production of assessable income through upgrading and entering new business avenues.

Conclusion

On the basis of the above discussion, the following recommendations may be offered.

• The ordinary income would be derived on accrual basis from the services offered to various airlines. Also, the cash and non-cash based lease incentives obtained from CAC for changing the base would be considered as ordinary income. Additionally, the compensation receipts from the settlement (i.e. $ 750,000) would be considered as ordinary income and thereby assessable in the given tax year.
• On the sale of land, while the proceeds would not be taxable but on account of capital gains, CGT liability to the tune of $217,878 would le levied. Further, the interest charges on loan are adjusted in the land cost base.
• Also, the company would have FBT liability arising from extension of lunches, Christmas party and car fringe benefits.
• The solicitor expenses related to settlement case along with payment of restrictive covenant proceeds would be capital expenditure and hence deduction would be available over a five year period.
• For furniture and mobile phone, depreciation related deduction may be permissible provided the same is used for business.
• The remaining expenses are considered as deductible expenses under s. 8-1 ITAA 1997 owing to there being a direct nexus between these expenses and assessable income production. Also, these expenses are revenue in nature.

References

Barkoczy, S. (2017) Foundation of Taxation Law 2017 (9^th ed.). North Ryde: CCH Publications.

Coleman, C. (2015) Australian Tax Analysis (4^th 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. 9^th ed.  Sydney: LexisNexis/Butterworths.

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

Reuters, T. (2017) Australian Tax Legislation 2017 (4^th ed.). Sydney. THOMSON REUTERS.

Sadiq, K., Coleman, C., Hanegbi, R., Jogarajan, S., Krever, R., Obst, W., & Ting, A. (2015) Principles of Taxation Law 2015 (7th ed.). Pymont: Thomson Reuters.

Woellner, R. (2015) Australian taxation law 2015 (8^th ed.). North Ryde: CCH Australia.