Taxation Law Assignment: Advising ABC Ltd On Income Tax Consequences

Purpose

Part 1:

There can be circumstances where the taxpayer regularly gets payment in the form of compensation when they suffer commercial or other types of losses. There is a golden rule associated to the taxability of compensation payment. The character involving a compensation payment will normally be reliant on what type of amount is received by the taxpayer (Burkhauser et al., 2015). This involves the payment which replaces, substitute or compensate the taxpayer for any type of loss of revenue items or the items which would have been received on the income account are usually considered as having the characteristics of income. In addition this, the payment which replaces, substitute or compensate the taxpayer for any type of loss, destruction or sterilisation of capital assets are normally believed to have the characteristics of capital in nature.

The golden rule of compensation principle further adds that if a taxpayer gets compensation payment which simply replaces the amount which would have been treated as ordinary income given the taxpayer had received the amount, then the amount will be considered as taxable ordinary income under the “sec 6-5 ITAA 1997” (Jacob, 2018). In addition to this, the compensation payment will be considered as statutory income if it is assessed and falls out of the “sec 6-5 ITAA 1997” then the amount received will be treated as taxable statutory income within the legislative provision of “sec 6-10 and sec 15-30 ITAA 1997”.

As the general rule, when a taxpayer gets an amount that is in connection with the termination of commercial contracts or the variation of contracts, that are of business or trading in nature which is made during the ordinary course of carrying the business then it is treated as having the characteristics of income (Paris, 2017). These receipts are considered to be compensation relating to the loss of profits within the contracts and such compensation payment subsequently takes the character of income. In other words, they are deemed to be paid as the substitution for lost income.

The amounts received by taxpayer associated to the loss of business profits arising out of the cancellation of trading contracts are normally considered to be having income nature. The taxpayers must denote that the loss or variation of such type of commercial contracts do not create an impact on the profit generating structure of business (Chardon et al., 2016). To support the statement reference to the case of “Heavy Minerals Pty Ltd v FC of T (1966)” can be made to better understand the taxability of compensation payment.   

Part 1- Advising the directors of ABC Ltd.

As eminent in the case of “Heavy Minerals Pty Ltd v FC of T (1966)” the decision of the high court stated that if the taxpayer company gets an amount in the form of compensation regarding the termination of business contracts of selling rutile should be treated as income or capital in nature (Feld et al., 2016). The decision of the judge stated that the amounts were having the character of income. The business of the taxpayer in the concerned case involved mining of rutile and dealing in rutile. The capital asset of the taxpayer were the mining lease and plant. Following when the contract was terminated the taxpayer still had its assets. The taxpayer company was considered free to mine the rutile and to sell given the company was able to locate a buyer.

As a result of collapse of rutile market, the clients negotiated the cancellation of contracts and paid the taxpayer company with a compensation amount that were around 221,000 pounds. The company later shut down its rutile mines but it constantly sold its products in other markets in Asia (Mangioni, 2015). The federal court in its decision stated that the compensation payment which was received by the taxpayer company were to be considered as income in nature since the company was not completely put out of business following the cancellation of its overseas contracts but due to the collapse of rutile market. The taxpayer company was still free to sell its mining products to new customers which they did by searching new market in Asia.

As evident in case of ABC Ltd the company contracted with the Indian Shipping Company for a period of 30 years to sell diversified merchandising and financial business. However, due to reorganization of Indian Shipping company affairs, the agency contract between ABC Ltd and Indian Shipping Company got terminated following the operation of 24 years. Consequently, ABC Ltd computed its lost profit which it had anticipated to earn from the agency contract. The Indian Shipping Company subsequently paid the ABC Ltd with a compensation amount of $4 million.  

The sum of $4 million received by ABC Ltd in connection with the cancellation of contract were made during the course of carrying the business for producing assessable income. The amount of $4 million that is received by ABC Ltd must be taken into account as the compensation for loss of profits within the contract and consequently takes the character of income. In other words the amount of $4 million that is paid to ABC Ltd by Indian Shipping Company is deemed to be paid as the substitution for the lost income.

Part 2- What if the agency agreement was entered into on 1 August 1993?

By citing the example of “Heavy Minerals Pty Ltd v FC of T (1966)” the compensation amount of $4 million must be treated as having the nature of income and paid to ABC Ltd as the substitution of lost profit (Barkoczy, 2016). With respect to “sec 25 ITAA 1936” the amount of $4 million will be considered as taxable income to ABC Ltd because the compensation payment were considered to be having income in nature.

Part II: 

According to the “CGT Event C2” under the “sec 104-25 ITAA 1997” it mainly involves receipt of amount that are received from the cancellation of contract or surrender of CGT rights (Braithwaite, 2017). This event is largely associated with the extinction of a taxpayer’s ownership to intangible assets. The “CGT Event C2” takes place where the CGT asset is redeemed or cancelled by the taxpayer or the taxpayer has released a debt, discharged or has satisfied a debt obligation. The “CGT Event C2” takes place when the taxpayer has surrendered any lease or when the taxpayer gets any compensation for the cancellation of contract (Arnold et al., 2019). As noted in “FCT v Mclaurin (1961)” the timing of the event involves the time when the taxpayer entered in the contract which led to an end of asset or if there was no contract when the asset was ended.

In the alternative situation of ABC Ltd if the company has entered into the contract on 1^st August 1993 then a “CGT Event C2” would have happened. This is because in the previous circumstances the transaction was entered into on 1^st August 1985 which is a pre-CGT asset. If the contract was entered in to by ABC Ltd on 1^st August the contract would have been considered as post-CGT asset and the receipt would be considered as taxable within the provision of capital gains (Sadiq, 2019). By referring to “FCT v Mclaurin (1961)”  the amount of $4million received by ABC Ltd as the right to compensation following the cancellation of contract has resulted in “CGT Event C2” under the “sec 104-25 ITAA 1997”. The amount would have been treated as capital gains for ABC Ltd.

The normal proceeds that are received by the taxpayer from the operation of business was considered as ordinary income within the “sec 6-5 ITAA 1997”. In order to ascertain whether the receipt forms the part of normal proceeds of business it is important to ascertain the taxpayer and the relationship among the business and transaction (Robin & Barkoczy 2020). Originally the “mere realisation” of capital asset even to its best of advantage including the improvements was treated as non-assessable capital profit. As noted in the case of “FCT v Whitfords Beach (1982)” the receipts which is derived from the one-off transaction during the course of carrying the business even though it is done in an unanticipated manner might form the part of income from business.

Advising ABC Ltd. of the tax implications of the sale of land and buildings

Where the land is not held on the revenue account the sale of land may not be the subject of tax within the within the provision of capital gains unless it is specifically excluded. Where the land is held not as trading stock the important that must be denoted from the characterisation is that any profits which arises from the transaction will be considered assessable on the net profit basis (Taylor et al., 2017). Within the net profit approach the development expenditure associated to land is not allowed for deduction when they are incurred. The reason for not permitting deduction is because the transaction amount represents a profit making activity instead of an ordinary course of business. Rather, the development expenditure are offset against the capital proceeds derived from selling the property with the resulting net profit or loss being taxable or deductible at the time of settlement.

When the property is sold on the revenue account the proceeds derived from the sale are treated taxable when the settlement of property happens. However, this do not implies in case of sale proceeds that are treated on capital account (Keyzer et al., 2017). Where the sale of property constitutes a “mere realisation of capital asset” the purpose of capital gains the taxpayer is considered to have obtained the capital gain when the contract for sale is entered into by the taxpayer under “sec 104-10 ITAA 1997”. As held in the case of “McCorkell v FCT (1998)” the law court considered that the sale of subdivided property which was earlier used as orchard was simply a mere realisation (Krever, 2016). While in “Statham v FCT (1989)” the development involving 105 lots over four stages was considered as nothing more than a simple realisation of capital asset.

The case facts established in the case of ABC Ltd suggest that the company has acquired a land for building future warehouse and sales office. After the increase in payment of lease the company started the construction of building on the land. However on 2^nd January 2020 the building was sold for $11 million when Indian Agency decided to purchase it. ABC Ltd made a profit of $4.58 million associated to transaction and included the same in profit and loss statement. By referring to “McCorkell v FCT (1998)” the sale of building will be considered as the mere realisation of property (Butler, 2019). This is because ABC Ltd did not undertook any activities in respect of development apart from those that are necessary to construct the building. There was no such intention of making profit at the time of development of property and the capital gains will be treated on capital account. In other words even though the building has been realised by ABC Ltd in the best advantage but the gains made will be considered as capital profit.

For the purpose of capital gains the taxpayer here ABC Ltd is considered to have derived the capital gain under the “sec 104-10 ITAA 1997” when the changes in the ownership took place or when the contract for sale was entered into by the ABC Ltd (Ferraro, 2016). The amount of capital gains that is made by the company will be considered as taxable gains and will attract tax liability.

The total amount of capital gains are as follows;

Computation of Capital Gains
Particulars	Amount in million ($)	Amount in million ($)
Sales Proceeds		11
Cost Base	1.33
Add: Cost Base Items
Building cost (capital works)	5
Total Cost Base		6.33
Capital gains		4.67

 
As evident from the above stated computation the company here ABC Ltd has included a profit of $4.58 million in its income statement however the total capital gains from the sale of building made during the year stands $4.67 million. Hence, the company here ABC Ltd has understated its profit in the income statement. 

References:

Arnold, B. J., Ault, H. J., & Cooper, G. (Eds.). (2019). Comparative income taxation: a structural analysis. Kluwer Law International BV.

Barkoczy, S. (2016). Foundations of Taxation Law 2016. OUP Catalogue.

Braithwaite, V. (Ed.). (2017). Taxing democracy: Understanding tax avoidance and evasion. Routledge.

Burkhauser, R. V., Hahn, M. H., & Wilkins, R. (2015). Measuring top incomes using tax record data: A cautionary tale from Australia. The Journal of Economic Inequality, 13(2), 181-205.

Butler, D. (2019). Who can provide taxation advice?. Taxation in Australia, 53(7), 381.

Chardon, T., Freudenberg, B., & Brimble, M. (2016). Tax literacy in Australia: not knowing your deduction from your offset. Austl. Tax F., 31, 321.

Feld, L. P., Ruf, M., Schreiber, U., Todtenhaupt, M., & Voget, J. (2016). Taxing away M&A: The effect of corporate capital gains taxes on acquisition activity.

Ferraro, R. (2016). Tax education: Understanding tax law. Taxation in Australia, 51(3), 129.

Jacob, M. (2018). Tax regimes and capital gains realizations. European Accounting Review, 27(1), 1-21.

Keyzer, P., Goff, C., & Fisher, A. (2017). Principles of Australian constitutional law. LexisNexis Butterworths.

Krever, R. (2016). Australian Taxation Law Cases 2016. Thomson Reuters (Prous Science).

Mangioni, V. (2015). Land tax in Australia: Fiscal reform of sub-national government. Routledge.

Paris, C. (2017). Housing Australia. Macmillan International Higher Education.

Robin & Barkoczy Woellner (Stephen & Murphy, Shirley Et Al.). (2020). Australian Taxation Law 2020. Oxford University Press.

Sadiq, K. (2019). Australian Taxation Law Cases 2019. Thomson Reuters.

Taylor, J., Walpole, M., Burton, M., Ciro, T., & Murray, I. (2017). Understanding Taxation Law 2018. LexisNexis Butterworths.