There are essentially two methods available for recognising income namely earnings method and receipt method. In the former method, income is recognised when the good or service has been provided while in the latter method, focus is on cash receipt without consideration to the income being earned or not. The various factors to be considered to choose the appropriate method are emphasised below.
1) Income source type
A crucial aspect for determining the appropriate the relevant choice for income recognition is related to the income source. As per Carden case (Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108), Dixon J pointed that non-trading income recognition must involve realisation of any valuable on which the business ought to pay taxes. This implies that for non-trading income source, receipts method ought to be more suitable. This has been substantiated by tax ruling TR 98/1 which outlines that for income derived through employment or any business where the emphasis is on the knowledge or skill of the taxpayer for earning income, then the receipts method would be more suitable. On the contrary, in case of manufacturing or trading businesses, earnings method is preferable (Woellner, 2014).
2) Underlying circumstances associated with business/employment
It has been advocated in the Carden case by Dixon J that the relevant method of income recognition is not a question of law and must not be decided on the basis of any rigid principle. This line of thought has also been endorsed in the FCT v Dunn (1989) 85 ALR 244, 252 where Davies J has highlighted the following (Krever, 2016).
“On the other hand, the question was not entirely one of law. The issue was the appropriate means of computing the income derived by the taxpayer. The circumstances of his occupation, how it was carried on and what records and books were kept were matters to be taken into account, and evidence as to accounting principles and practice was relevant. All these are matters of fact.”
Therefore, it is essential that the underlying circumstances have to be considered before reaching a conclusion about the suitable income recognition method.
3) Business size
The underlying business size is a key factor for determination of income recognition method as identified in the Henderson v. Federal Commissioner of Taxation (1970) 119 CLR case (Sadiq, et.al., 2016). As per this case, the taxpayer altered the income recognition method to earnings from receipt method used in the previous year. The main reason for this change was that the taxpayer had grown the business significantly and hired several employees and thereby considered the earnings method more apt. Thus, the higher use of capital expenditure and hired employees tends to shift the balance in favour of earnings method.
Income recognition basis choice
The need for two different methods of income recognition arises due to intrinsic mismatch between the receipt of cash and the providing of services or goods. In accordance with tax ruling TR 98/1, a choice is given to the taxpayer in relation to choosing the method of income recognition (Barkoczy, 2015). This choice must be exhibited by the taxpayer in a manner so as to ensure that a faithful representation of the income is presented to the tax department. Hence, Frank can also exhibit this choice based on the factors highlighted in the previous section.
The Tax Commissioner may disagree with the income tax returns filed by the given taxpayer with regards to choosing a method if the same is suitable under the given scenario. The taxpayer may not agree with the assessment of the Tax Commissioner and in such case may approach for relief from higher authorities such as court. However, before the filing of returns, the Tax Commissioner cannot insist that a particular method be used and the choice is available to the taxpayer.
The facts presented clearly highlight that the income earned by Frank is based on his skill as an architect. Thus, for the tax year 2016/2017, the suitable basis would be receipts basis which has also been supported by TR 98/1 and also Carden case (ATO, 2018). Further, the case facts clearly highlight that after winning the national award, Frank has hired an office, two assistants, other employees to help him and made significant capital investments to the tune of $ 1 million in the business. In line with the Henderson v FCT case, the suitable income recognition method would now be altered to earnings method since the business has made significant capital investments and is using hired employee (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016). Further, the business can change the income basis as the underlying circumstances demand so as has also been highlighted in Henderson v FCT case where also the income recognition basis was different in two consecutive years (Krever, 2016).
It is essential to note that the distinction between cash and accrual basis is relevant owing to the mismatch of the timings of being eligible to receive the payment and actual receipt of payment. Since the tax year tends to end on June 30 of every year, thus it is possible that these two events may not lie in the same year with one preceding the other. With the use of accounting software while it is possible to monitor the cash flows due and received and hence update the systems but it is not possible to determine when the tax on a given income would be paid. This essentially rests on a variety of factors based on which one method ought to be chosen and the distinction between the two cannot be done away with.
(a) Kitchen fittings have been repaired with the cost of $ 8,500. The expense is on repair is confirmed since there is restoration of the previous character without any improvement. Also, the repair work was initiated only when the damage was already present. Therefore, it would be suitable to term the given expense as repair in accordance with tax ruling TR 97/23. For repairs in regards to rental properties, general deduction is permissible under s. 8-1 while statutory deduction under s. 25-10 ITAA 1997 (Woellner, 2014).
For an expense or outgoing to be tax deductible as per s. 8-1 ITAA 1997, it is required that the outgoing must be closely linked to the assessable income generation. Further, s. 8-1(2) highlights that tax deduction is limited only to revenue expenditure and does not include capital expenditure. Also, for depreciable assets which are present in the property engaged in assessable income production, s. 25-10(1) provides for immediate tax deduction provided the repairs are not capital in nature (Sadiq, et.al., 2016).
It is noteworthy that kitchen fittings essentially refer to a host of permanent fixtures that are inbuilt into the property such as sink, plumbing, cupboard. These assets are therefore non-depreciable as highlighted in the decision of IT 242 (Krever, 2016). Any expenditure in relation to replacing these permanent fixtures would be regarded as capital expenditure in light of TR 97/23 (CCH, 2013). As the $ 8.500 expense is capital expenditure, hence no tax deduction can be availed by Ruby Pty Ltd despite the property being used for assessable income production.
(b) For an expense or outgoing to be tax deductible as per s. 8-1 ITAA 1997, it is required that the outgoing must be closely linked to the assessable income generation. Further, s. 8-1(2) highlights that tax deduction is limited only to revenue expenditure and does not include capital expenditure.
Based on the above, it is apparent that the deduction of the $ 7,000 expenses incurred for legal counsel would be tax deductible if it is revenue in nature. For distinguishing the revenue expenditure from capital expenditure, British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 case is useful as it highlighted a test to facilitate the same. For the expense or outgoing at hand to be regarded as capital expenditure, it is essential that the advantage derived through the incurred outflow should have an effect which is enduring and hence not limited to the year in which the outflow is recognised. Also, revenue expenditure are usually those which are incurred in the normal course of the business.
In case of rental property related business, claims regarding negligence are quite common and tend to be part of the business. Also, the legal expenses incurred are not leading to an enduring advantage since the impact would be limited only to the year in which the settlement is achieved. As a result, the legal expense of $ 7,000 is deductible for Ruby Pty Ltd in accordance with s. 8-1 of ITAA 1997 (Sadiq, et.al., 2016).
(c) For an expense or outgoing to be tax deductible as per s. 8-1 ITAA 1997, it is required that the outgoing must be closely linked to the assessable income generation. Further, s. 8-1(2) highlights that tax deduction is limited only to revenue expenditure and does not include capital expenditure (Barkoczy, 2015).
Again, the pertinent question relates to the nature of the expense. A useful case to be referred in this regards is Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 in which it was advocated by Dixon J that the outgoing nature is determined by analysing the advantage that is derived as a result of the outgoing. The advantage resulting from revenue expenditure would have effect that is limited to the current tax year whereas capital expenditure advantage would be reflected in several of the future years and hence not restricted to only the present time.
Considering that the previous business of the company was auto part manufacturing, hence the delivery of faulty faults and settling the resultant claims would also be part of normal course of business. Also, the advantage derived from the claim settlement is limited in its effect and would not provide any benefit to the company in the future years. Thus, it may be concluded that the outgoing of $ 750,000 relating to the settlement of the pending claim would be revenue expenditure and hence tax deductible as per section 8-1 of ITAA 1997 (Krever, 2016).
(d) Only when the expenditure or outgoing is incurred, can potential deduction for tax purpose be claimed as per s. 8-1. As per TR 97/7, the meaning of the word incurred does not imply that cash outflow has occurred but there must be a reasonable assurance for the payment of the same and also a sound estimation of the amount can be made (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
In thee given scenario, provision has been made to the extent of $ 100,000 for the claim. However, it is evident that there is no reliable estimation of the possible amount of claim which would need to be settled. Also, the timing of the same is uncertain since it is dependent on the proceedings of the legal system which tends to uncertain. Thus, no deduction under s. 8-1 is permissible for the provisions on future claim amount (CCH, 2013).
(e) For an expense or outgoing to be tax deductible as per s. 8-1 ITAA 1997, it is required that the outgoing must be closely linked to the assessable income generation. Further, s. 8-1(2) highlights that tax deduction is limited only to revenue expenditure and does not include capital expenditure. In the scenario presented in this case, the market research related cost are termed as capital expenditure owing to the enduring benefit which would arise on account of these as indicated in the Sun Newspaper v FCT case. Thus, tax deduction under s. 8-1 is not permissible for the amount that has been paid to the consultant (Sadiq, et.al., 2016).
It is clear that the market research expenditure is essentially an expenditure relating to future business and this is deductible for tax purposes under the aegis of .s 40-880(2A) ITAA 1997 (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016). This deduction is not impacted whether assessable income from business is obtained in the future or not but at the time of business expenditure, the intent for producing assessable income has to be present. This was present on part of Ruby Pty Ltd since it wanted to commence the auto part business. Therefore deduction over a five year period would arise with annual deduction amount of $ 44,000 (i.e.$220,000/5).
References
ATO (2018) TR 98/1, Income Tax: Determination of income; receipts versus earnings. [online] Available at: https://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR981/NAT/ATO/00001 [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.
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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