Tax Theory - tax rules PDF

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Week 1 - Introduction to the Australian taxation system Types of taxes  Collection: direct vs indirect  Burden falls: progressive vs regressive vs proportional Criteria in evaluating a tax system:  Equity: horizontal and vertical  Simplicity (vs complexity)  Certainty  Neutrality  Flexibility, Evidence, & Fiscal adequacy  Political acceptability and macro level objectives Commonwealth Constitutional powers:  Section 51(ii) – power to make laws with respect to tax without discriminating between States or parts of States  Section 53 – Senate cannot introduce or amend tax laws  Section 55 – Laws imposing tax cannot deal with other matters Sources of taxation law  Primary o Legislation o Case law  Secondary o Legal commentary, textbooks, practitioners’ handbooks, tax rulings Week 2 – Assessable Income S4-10 (3): Income tax payable = [Taxable Income x Rates] – Offsets S4-15 (1): Taxable Income = Assessable Income – Deductions S6-1 (1): Assessable income = Ordinary Income + Statutory Income Assessable income  S 6-1(1): Assessable income consists of ordinary income (income according to ordinary concepts) and statutory income (stated in the legislation). If a receipt is classed as both ordinary and statutory income, statutory income prevails. (S 625(2))

1. Ordinary Income

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S 6-5(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income. S 6-5(2) If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

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S 6-5(3) If you are a foreign resident, your assessable income includes:

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The *ordinary income you *derived directly or indirectly from all Australian sources during the income year; and Other ordinary income that a provision includes in your assessable income for the income year on some basis other than having an Australian source.

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Ordinary income is income according to the ‘ordinary usages and concepts of mankind’ Scott v DCT (NSW) (1935) 35 SR (NSW) 215.

Features of ordinary income 1. Income is what comes in to a taxpayer beneficially It cannot come to the taxpayer in another capacity e.g., as trustee. Also, if it is not received it cannot be income (Brent) 2. It must be money or money’s worth:  This means it must be in cash or convertible in to cash. At common law if something was not convertible into cash it was not income according to ordinary concepts: see Cooke and Sherden  FCT v Cooke & Sherden 80 ATC 4140 o Taxpayers sold soft drinks door to door under an arrangement with the manufacturer of the soft drinks – not employees, but contractors. The manufacturer offered its vendors a “free” holiday to Fiji if the sales reached a certain target. Taxpayers made the sales and took the holiday. o ATO tried to assess the value of the holiday under s 25(1) (prior s 6-5) as income, or under s 26(e) as a benefit. Taxpayers could not cash in the holiday nor swap it for anything else. o The Full Federal Court held: the holiday was not income as it was not convertible to cash à ‘income must be money or money’s worth’.  Note s 21A was put in ITAA36 to overcome this omission of income, but it only works to deem amounts not in cash to be convertible to cash in a business context.  Note that if the benefits had been given in an employment context, s 26(e) ITAA36 (now s 15-2 ITAA97) would have applied. Conversely such a benefit provided from 1 July 1986 would be a fringe benefit and would be subjected to FBT.  Note also, barter transactions are usually regarded as income (IT2668) 3. Income must be received as income That is, we focus upon the recipient at the time they received it and ask in what context did the person receive this amount? Federal Coke Co Pty Ltd v FCT 4. Income is generally recurrent and regular  However, this is not something that is necessary. In Dixon’s case the High Court relied upon this feature as one of the indications that the amount was income  However, there are also many cases where a one off payment is treated as income – for example, Kelly’s case 5. Normal proceeds of personal exertion, property or business are income This simply states the proposition that sales of stock or services by a business will always be seen as income; as will wages, rent received, interest received etc. 6. If an amount is received to compensate for lost income, then it is also treated as income With insurance or other type payments need to look at what is being compensated - is it lost income (e.g., lost wages) or is it for personal injuries?  If it is a mixture, then it is generally not treated as income. 7. The fact that the receipt is illegal etc does not affect its assessability as ordinary income Lindsay v IRC [case involved a whisky smuggler]  This is based on public policy grounds.

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Note that whilst at common law the reverse also operated (taxpayer got a deduction for expenses), this has been overturned to some extent by s 26-54 (illegal activities)

8. Mutual receipts are not income  This comes from the fact that income cannot be received from yourself.  It essentially applies to clubs and societies where members are the owners for the time being of the club and hence cannot be said to pay themselves income.  The club (which generally is a company for tax purposes) does not receive income when members deal with it by way of buying meals or drinks. It will do so though if non-members deal with it in the same way. 9. Capital receipts are not income at common law  One of the fundamental aspects of Anglo Australian concepts of ordinary income is the distinction between income and capital.  At common law, capital gains are NOT assessable. o However, they are now likely to be caught as statutory income under s102-5.  Difficult sometimes to make the distinction and a number of tests may be used as a guide o Once and for all - As income often has the characteristic of being recurrent, a once off payment may indicate it is capital. But this is not a certain rule – just a indicator. o Enduring benefit - if a payment compensates for the loss of an enduring benefit it is likely to be a capital receipt. o Business entity test - Ask whether the receipt comes from the profit making structure or the profit making process?  The profit making process would be for example, the sale of an item of stock. The profit making structure would be for example, the sale of a building in which a firm’s operations are conducted.

Ordinary income – Types 1.Income from personal exertion is defined in s6(1) ITAA36 Income consisting of earnings, salaries, wages, commissions, fees, bonuses, pensions, superannuation allowances, retiring allowances and retiring gratuities, allowances and gratuities received in the capacity of employee or in relation to any services rendered … o But does not include: rent, dividends or interest a) Voluntary payment o Generally if payment linked to a service then that will make it income - ask is it the product or result of employment or service provided o Even if it’s paid voluntarily Dixon’s case o Can be for a past service: Dixon’s case; Brown’s case o It does not matter that the payment is by a third party: Kelly’s case; Brown’s case à thus bonuses, tips and gratuities to waiters or taxi drivers, etc will be income. Case Examples: FCT v Dixon (1952) 86 CLR 540 o Periodic payments were made by the taxpayer’s former employer to make up the shortfall between his former rate of wages and his military service wage. o The Full High Court held the payments to be ordinary income although they did not consider them to be additional remuneration for past services rendered to the donor because they took the character of that which they had replaced, namely salary and

wages. The payments were expected, periodic, and relied upon by the taxpayer for his and his family’s maintenance. Brown v FCT (2002) ATC 4273 o The voluntary gift of an investment apartment was not considered a gift. o The Government Minister received an amount (an actual townhouse) from a Japanese property developer in gratitude for helping the developer to get the necessary approvals and in finding sub-contractors to build the complex o It was held that the townhouse was not a gift but a reward for services rendered – It was worth $1 million, which equated to a 10% commission. Kelly v FCT 85 ATC 4283 o Phil Kelly was a professional Aussie rules football player in WA. o A TV station wanted to publicise its support of AFL to attract viewers to its station, so it provided $20,000 for an award to the ‘best and fairest player’ (the Sandover Medal) o Kelly won the $20,000 prize (contemporary value: $88,600) in the 1978/79 tax year. o The prize money was held to be assessable income – there was a sufficient nexus between the prize and Kelly’s employment as a professional footballer. b) Voluntary payment – Gifts o There are situations where despite services having been rendered to the payer, a receipt has been treated as a gift and not income. o It appears that it must be shown that the taxpayer was recognised as a personal friend, and the gift was in that capacity rather than because of the services: Scott’s case; Hayes’ case. Case Examples Scott v FCT (1966) 117 CLR 514 o The taxpayer was a solicitor who had, over a period or years performed various legal services for a widow, Mrs Freestone. o the solicitor had previously acted for her former husband and a personal friendship developed between the taxpayer and his client. o In 1960 the client made an unsolicited gift of £10,000 (contemporary value: $277,320) to the taxpayer which was expressed to be in appreciation of his friendship rather than for any legal services performed. o The Commissioner argued that the nexus test was satisfied because the gift was a “consequence”, however indirect, of services rendered. o High Court held - The nexus test was rejected– Windeyer J said: “an unsolicited gift does not … become part of the income of the recipient merely because generosity was inspired by goodwill and the goodwill can be traced to gratitude engendered by some service rendered.” o Factors supporting the characterisation as a gift included:  the size of the gift;  the unusual circumstances in which the gift was made;  the fact that the taxpayer had been fully renumerated for services rendered;  the fact that gifts had been made to other persons at the same time;  the fact that it was unexpected and unsolicited. Hayes v FC of T (1956) 96 CLR 47 o A one-off gift of a large share parcel were held by the High Court to be a mere gift as the taxpayer had already been fully remunerated for his work done in the donor’s direct employ and by the companies controlled by him.

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Hayes was actually a close friend of the donor. Also, significant was that the employer made many such gifts to charities, and family members as well as the taxpayer.

c) Voluntary payments - Sportspersons  There are a number of issues that arise in respect of sportspersons.  If a person plays sport professionally then direct payments for their performance is income: Moorehouse v Dooland  This is so even if the payment is by a third party and is voluntary: Kelly  If a person is not completely professional then it may be less clear, but the sport may be classed as a business which will have the effect of making prizes, grants and appearance monies income: Stone Case Examples Moorehouse (Insp of Taxes) v Dooland [1955] 1 All ER 93  Professional cricketer (that is, employed).  Employment contract said could make collection from crowd for ‘meritorious performance’  in one season he did this 16 times out of 50 games  IRC said crowd collections were income as linked to his employment – the UK Court of Appeal agreed as collections arose in the ordinary course of the taxpayer’s employment, and they were provided for under his employment contract. FCT v Stone 2005 ATC 4234  Joanna Stone was a Qld police officer and also a world class javelin thrower.  In the lead up to the 2000 Olympics she took leave from her police job and received prizes, sponsorship and appearance fees, and government grants.  The Full High Court held this was a “business of deriving financial reward from competing and winning in the athletics arena” – hence the amounts received were income. d) OTHER ISSUES  If you surrender rights for a payment, that is generally regarded as a capital payment rather than a payment for services.  Giving up his amateur status was regarded as disposal of a capital asset by a footballer: Jarrold v Boustead  Payments for restrictive covenants are typically capital in nature.  Similarly where an actor was paid not to act in any movie for a period of time it was seen as capital: Higgs v Olivier Case examples Jarrold v Boustead (1964) 41 TC 701  The taxpayer was a Rugby Union player who received a “signing-on fee” to play for a Rugby League Club  The fee was characterised as being compensation for the giving up of the player’s amateur status, and therefore not as remuneration for services to be rendered  Consequently it was a capital receipt and not taxable.  If a player is already a professional, a signing on fee (an inducement to enter into a services contract) would be a normal incident of employment: Case R107 84 ATC 717. Higgs (Inspector of Taxes) v Olivier (1951) 1 Ch 899

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The taxpayer, Laurence Olivier was a famous actor. In 1943 he entered into a contract to produce, direct and act in a film of the Shakespearean play, Henry V. The film was completed in Dec 1944. In order to better promote the film, the film company in 1945 entered into a restrictive covenant with Olivier in, which prevented him from acting in, directing or producing any films for rival companies for a 18 month period. The UK Inspector of Taxes attempted to assess the £15,000 (c.v. £578,245) that Olivier received under this agreement as a profit of his acting occupation. The UK High Court held that the payment under the restrictive covenant was capital in nature and was not assessable as income. This case is an authority in Australia for the proposition that payments under restrictive covenants are capital. But note that such a payment would be taxed under the CGT regime in Australia today (CGT event D1)

Although payments made under restrictive covenants are typically capital in nature, they will be treated as ordinary income when: o the restriction is to operate during the currency of the existing employment, or it really only payment in advance for services to be rendered (Riley v Coglan); o the covenant is a normal incident of a particular employment (Case A14 69 ATC 80); OR o there is in reality no significant restriction on the recipient’s freedom of activity (Case A14 69 ATC 80).

E) Allowances vs reimbursements  Where a taxpayer is paid an allowance it is normally assessable. This is a fixed amount to cover an expected expense, but does not directly relate to the actual costs incurred. Assessable under s 6-5 (or s 15-2)  On the other hand if a taxpayer is reimbursed for an expense incurred then that is not seen as income – this is because reimbursements are expense payment fringe benefits.  Non-assessable Personal Exertion income  Attempts to capture non-cash benefits paid to employees generally failed under the former s 26(e) ITAA36. To overcome this fringe benefits tax (FBT) was introduced. This is a tax on employers in relation to the provision of such benefits.  As a result, fringe benefits are non-assessable non-exempt income for the employee recipients: s23L ITAA36  Frequent flyer points and similar reward schemes are not seen as income: Payne’s Case Case Examples Payne v FCT 96 ATC 4407  Mrs Payne was an employee of KPMG who was required to undertake considerable travel as part of her employment – KPMG paid for the flight  During a business trip, the airline gave her membership forms for its frequent flyer program - members accrue point based on travel  Reward tickets could only be used by the taxpayer or her permitted nominee - the tickets were not transferable and if sold were subject to cancellation  The taxpayer used the points to obtain free airline tickets for her parents  ISSUE: Were the frequent flyer points income for Mrs Payne?  The taxpayer argued that because the provision of the free tickets only resulted from the crystallising of a contractual entitlement (between her and Qantas) and was therefore not a benefit allowed, given or granted to her.  The Federal Court agreed – the tickets were not money and could not be turned to pecuniary account, and were therefore not income.

2. Income from property is defined in s6(1) ITAA36 as ‘all income not being income from personal exertion. Ordinary income from property is assessed under s 6-5. This will include income in the form of interest, annuities, dividends rent, and royalties.  Note that we need to distinguish the income from the capital in respect of property – so if a bank makes a loan to customer and the customer makes a repayment, only the interest component is income.  Also, the income must be from the property itself not from personal services associated with the property.  Interest is the cost of borrowing money, so when you lend money you earn interest at a given percentage on the amount lent.  Annuities An annuity is a future income stream paid for by a lump sum.  Dividends: Dividends are sums of money paid by companies to their shareholder members out of their profits.  Although these are income under ordinary concepts they are specifically included in assessable income under s 44(1) ITAA36 (that is, they are treated as statutory income)  Rent is a payment for the use of land, building or other physical property. o However , inducements paid by a potential lessee to obtain a lease in a lump sum will sometimes be regarded as capital.  Royalties are usage-based payments for the use of another’s property. Examples are royalties paid to authors or musicians or to the owners of mining rights. o The common law meaning of royalty is extended by a definition for tax purposes in s 6(1) ITAA36 and there are several provisions dealing with them, which you do not need to know for this course. 

Effect of GST on Assessable Income taxpayer is registered for (GST) and makes a taxable supply, then: The amount of GST payable is NOT assessable: s 17-5 ITAA97. That is, the enterprise will only include the GSTexclusive component in their assessable income. if a GST registered enterprise (say a furniture shop) sells a table for $220 including GST; then they will only be assessed on 10/11 of the price à 10/11 x $220 = $200 Week 3 – Assessable Income – Income from business   

Section 995-1 of the ITAA97 provides an inclusive definition of business o "business" includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee Taxation Ruling TR 97/11 provides guidance in assessing whether a series of activities constitutes a business or not, by describing and summarising the various business indicators that have been developed by the courts over the years. Paragraph 13 of TR 97/11 summarises the relevant business indicators (as outlined in Ferguson v FCT (1979) 9 ATR 873 at 876) as to whether a series of activities constitutes a business.

1. Business Indicators as outlined in TR 97/11 – what is a business 1. Whether the taxpayer has more than just an intention to engage in business. 

A series of activities is more likely to constitute the carrying on of a business rather than a hobby where the taxpayer intends to carry on a business: Thomas v FC of T

For example, if the taxpayer has drawn up a comprehensive business plan, this will evidence their intention. In addition to intention, the taxpayer must also demonstrate that they have undertaken some activity to further that intention: Inglis v FCT 80 ATC 4001 o For example, setting up shop or hiring staff. This indicator is particularly related to: o Wheth...