Factors taken into consideration
In the earnings method, income recognition considers only that income for which the seller or service provider has fulfilled the contractual obligations and hence would derive payments. The actual receipt of the payment is not crucial. In sharp contrast, receipts method requires that the underlying cash must be received irrespective of whether the contractual obligations towards the client have been discharged or not.
1) The primary factor is the nature of the income source. This is important since based on the type of source of income, the appropriate method to be used for recognising income is impacted. This has been highlighted in the Carden vs FCT case (i.e. Commissioner of Taxes (South Australia) v. The Executor Trustee and Agency Company of South Australia Limited (1938) 63 CLR 108) where Dixon J highlighted that in relation to non-trading income, it is imperative that something of value ought to be realised for liability of tax to arise, thereby indicating towards receipts method for such businesses (Barkcozy, 2015).
Further, the tax ruling TR98/1 also provides basic pointers with regards to appropriate method for different income sources. In regards to income drawn as an employee and any income which relates to the skill or knowledge that the taxpayer possesses, then in such cases the receipts method is more suitable (Wollner, 2014). On the contrary, in case of businesses carrying on trading or manufacturing activities, the earnings method would be given preference over cash receipts.
2) It is noteworthy that the above advice regarding the application of a particular income recognition method should not be considered rigidly as has been pointed to by Dixon J in Carden’s case where he opines that the underlying business circumstances must be necessarily considered before deciding the suitable for recognition and the same should not be decided based on any rigid rule. Hence, it can be concluded that while the nature of the business does provide a pointer to a suitable method but the same may be altered by specific circumstances related to a given business and need to be considered.
3) Yet another factor to be taken into consideration is the business size. The importance of this factor has been emphasized in the verdict of Henderson v. Federal Commissioner of Taxation (1970) 119 CLR case. In this case, the taxpayer was derived income based on underlying knowledge and thus was using the receipts method of income recognition for one year (Wollner, 2014). However, by next time, the taxpayer made significant in the business which resulted in explosive growth of the same As a result, the taxpayer Henderson altered the appropriate income recognition method to earnings and this was acknowledged in the court of law as well.
Choice in basis
With regards to income, at times circumstances arise when there is mismatch in the year of cash receipt and the earning of income. In such cases, as highlighted in TR 98/1, the taxpayer would exhibit choice in deciding between the two possible methods of recognising income namely receipts method and earnings method. This choice is exhibited by taxpayer so that in accordance with the factors highlighted in the previous section, the taxpayer can choose the method which leads to faithful representation of the income earned. Therefore, Frank also has this choice.
Right possessed by Tax Commissioner
No objection can be raised by the Tax Commissioner before the taxpayer files the returns. Only after the returns have been filed and the Tax Commissioner considers it not suitable in light of the underlying circumstances and income source, then only he/she may insist on modifying the same according to the more preferred method in that circumstance. The taxpayer can accept this or reject the same. In case of rejection of the opinion of the Tax Commissioner, judicial intervention would take place to decide which of the two income recognition methods would be more suited to the situation at hand (Gilders, Taylor, Walpole, Burton, & Ciro, 2016).
Basis for Frank
In the given case, it is known that Frank is an architect by profession and hence it is appropriate to consider that income for Frank would be derived on account of his knowledge and skill. As a result, the correct method for income recognition to be used in 2016/2017 would be the receipts method as per the discussion highlighted in TR 98/1 along with the Carden case (Gilders, Taylor, Walpole, Burton, & Ciro, 2016). It is also known that after winning the prize for his work, there is significant business growth and hence sizable business investments have been done by Frank besides appointing assistants for help and related office work. Under this situation, the more suitable method of income recognition for Frank would be earnings basis for 2017/2018. This is in line with the verdict in the Henderson v FCT case where the scenarios were comparable to the given case.
Relevancy of Cash/Accrual Distinction
There are some who argue that in the age of advanced accounting software, the distinction between cash and accrual method may be blurring. However, this is far from true considering that the distinction is required so as to determine as to which receipts or earnings would be realised as income in the given year. This takes into consideration a host of subjective factors and is not concerned with the computation or timing which is what the software primarily aids in. For instance, if there is a business selling manufactured goods and it receives an advance payment for a particular consignment at the time of booking, then it needs to be determined as to whether the income should take the advance received into consideration or not.
The tax deduction of various transactions enacted by Ruby Pty Ltd is discussed as follows.
(a) In the given case, repairs have been done to the kitchen fittings considering the fact that the underlying character has not been altered and the damage was already incurred by the fittings. The key aspects tend to comply with the features of repair as outlined in TR 97/23. With regards to outgoings as repair, tax deduction is possible under one of the two sections namely s.8-1 or s.25-10 (Wollner, 2014).
Deduction under s. 8-1 is permissible only when requisite nexus can be developed between the expense incurred and the production of assessable income. An additional required of general deduction under s. 8-1 is that the outgoing must not have a capital nature. Further, tax deduction under s. 25-10(1) can be availed in case of depreciable assets provided these form part of property used for generation of assessable income (Wollner, 2014). An addition requirement according to s. 25-10(3) is that the underlying expenditure on repair must not be capital (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
With regards to kitchen fittings, most of these exist in permanent fixture form particularly sink, cupboard, stove, plumbing and hence are non-depreciable assets in accordance with IT 242. Further, tax ruling TR 97/23 states that the underlying expenditure that taxpayer incurs for the permanent fixtures replacement will be capital in nature. Owing to this $ 8,500 expenditure being capital, it would not be deductible for tax purpose under s. 8-1 or s. 25-10 (CCH, 2013).
(b) Deduction under s. 8-1 is permissible only when requisite nexus can be developed between the expense incurred and the production of assessable income. An additional required of general deduction under s. 8-1 is that the outgoing must not have a capital nature (Krever, 2016).
Thus, the crucial aspect which decides the deduction of the legal expenses for tax purpose would be the underlying nature and essential character of this expense. A case law which merits discussion under the given scenario is British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205. In this case, the judge highlighted a way to segregate capital expenditure from revenue expenditure. Any expense or outgoing would be termed as being capital expenditure only if the underlying advantage gained from the outgoing would have ab effect that would be enduring or long lasting. Further, any outgoing which is incurred during the carrying of the business activity would be considered to be revenue in nature (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
The underlying legal expense has been incurred during the business of rental property where negligence claims often crop up for which legal expenses are incurred. Besides, whenever the case is settled, there would be only one time advantage and no enduring benefit is expected to be derived. Owing to the above, tax deduction for the legal expense would be available to the company under the aegis of s. 8-1 ITAA 1997 (Barkcozy, 2015).
(c) Deduction under s. 8-1 is permissible only when requisite nexus can be developed between the expense incurred and the production of assessable income. An additional required of general deduction under s. 8-1 is that the outgoing must not have a capital nature.
Thus, the key question emerges as to whether this expense would be revenue or capital in nature. In a bid to answer the same, consideration needs to be given to Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 33 case where Dixon J highlighted that the nature of a given outgoing can be deciphered by considering the nature of advantage that the outgoing is providing (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016). With regards to revenue expenditure, the advantage is reflected in the present year financial statements but for capital expenditure, the influence is seen in the future years as well and not limited to the present.
Making the requisite payment for the claim on faulty parts is essentially a part of the regular business activity where the customers would make claims if faulty products are supplied to them. Further, the money involved in the settling of these claims would not provide any long term advantage to the business but it would be limited only to the current year when settlement takes place. As a result, the underlying outgoing of $ 750,000 on the claim amount would be deductible under s. 8-1 since sufficient nexus with the previous business exists and also the expenditure is revenue (Gilders, Taylor, Walpole, Burton, & Ciro, 2016).
(d) In order for general deduction under s. 8-1, a necessary condition is that the outgoing must have been incurred. It is noteworthy that incurred does not necessarily means paid but only implies that the given circumstance provide significant assurance of the outgoing occurring in the particular tax year besides providing an accurate estimation of the amount expected (Deutsch, Freizer, Fullerton, Hanley, & Snape, 2016).
For the given facts, s. 8-1 would not lead to any tax deduction since with regards to the claim for which provision is being made at that time neither could have the settlement year being predicted and also a reasonable estimation of the claims could not have been made. This is apparent from the vast difference in the provisions and the actual claim amount. Hence, no outgoing has been incurred through provisioning to the extent of $ 100,000 and hence tax deduction cannot be availed on the same under the aegis of s. 8-1 (Sdiq, 2016).
(e) Deduction under s. 8-1 is permissible only when requisite nexus can be developed between the expense incurred and the production of assessable income. An additional required of general deduction under s. 8-1 is that the outgoing must not have a capital nature. The cost related to market research spent in this transaction would not be revenue expenditure as per the test highlighted in the British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 (Gilders, Taylor, Walpole, Burton, & Ciro, 2016). The advantage accrued from the market research would not be limited to the current year and hence s.8-1 cannot provide tax deduction on the $ 220,000 paid to the consultant.
However, it is noteworthy that the given expenditure is a business expenditure related to start up and hence deduction in a phased manner needs to be explored as per s. 40-880 ITAA 1997 (Barkcozy, 2015). Any capital expenditure such as market research, business structure advisory which is related to future business can be tax deductible over a 5 year period in accordance with s. 40-880(2A), The fact whether the future business actually is established and yields assessable income is immaterial (Gilders, Taylor, Walpole, Burton, & Ciro, 2016). Thus, for the given scenario, annual expenditure to the extent of $ 44,000 (i.e.$220,000/5) can be availed by Ruby Pty Ltd for a 5 year period
References
Barkcozy, 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.
Gilders, F., Taylor, J., Walpole, M., Burton, M. & Ciro, T. (2016) Understanding taxation law 2016. 9th ed. Sydney: LexisNexis/Butterworths.
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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