Taxation 1 Week 2 Seminar notes PDF

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Topic 2: Residence, Source and Derivation This topic includes: ● Derivation ● Residence and Source Derivation of Income: Chapter 16 Residence and Source: Chapter 4

Derivation of Income The meaning of Derive Taxpayer’s assessable income includes the ordinary income or statutory income that is derived: s 6-5 The term ‘derived’ is not defined in statute, however in Brent V FCT (1971), Gibbs J comments that it should be determined by: ● Application of ordinary business and commercial principles. ● Method of accounting that reflects the taxpayer’s true income: CT v Executor & Trustee Agency of South Australia (cardens case). See TR 98/7 Income Tax: determination of income; receipts (cash basis) versus earnings (accrual basis).

Cash vs Accruals accounting For tax purposes, “accruals” or “cash” basis can be adopted.

Which Method should be used? Nothing in statute to compel use of a particular method, however case law suggests cash basis for professional practices and small businesses: Henderson v FCT (1970).

Under the accruals method the 10,000 would be “derived” in the year ended 30 june 20x1. Under the cash method, the $10,000 would be derived in the year ending 30 june 20x2. Only one method is appropriate for any one item of income: Henderson v FCT (1970).

For employees, nonbusiness income derived from the provision of knowledge or skill, income derived from investments: Cash basis likely appropriate, however exceptions apply. Business income derived from the provision of knowledge or skill: Cash basis may also be appropriate, however factors such as trading stock activities, outgoings, reliance on capital or consumables, staff or equiptment, related to income derivation (see TR98/1). Trading or manufacturing business: acruals basis usually appropriate. See for example, Rowe and Son Pty Ltd v FC of T (1971). For Professional Practices: It is not always clear. ● Large firms and businesses. ○ The accruals method is the appropriate method for large professional firms: ○ Henderson v FCT (1970) ○ In Henderson it was held that, for a large firm of accountants, the accruals basis was appropriate to reflect its income and the Commissioner could not insist on the firm continuing with the cash basis. Moreover, in the year of changeover, there was no basis for bringing to account any amount for fees earned but uncollected at the end of the immediately preceding year.” [90030] ● Sole Practices: ○ The cash basis is the correct method of tax accounting for professional sole practices. E.g. A solicitor or accountant in sole practice: Firstenberg; Dunn. ○ “Clearly Henderson and Firstenberg represent the extremes and most professional practices lie somewhere in between. The reasoning in each case does not provide any guide as to where the line should be drawn between those cases where an accrual basis is appropriate and those where it is not.” [90-030]

Switching between cash and accruals.

Year 1 on a cash basis: $200,000 taxable income. Year 2 switched to an accruals basis: $600,000 taxable income. $200,000 is not included in year 2’s taxable income. Switching accounting methods (e.g. as the business grows) is allowed and the uncollected amounts earned in a prior year are untaxed earnings: see Henderson v FCT (1970). -

Note - If this happened today, the invoiced amounts no longer escape taxation due to CGT event C2.

Compared to Dormer [2002]: “an accountant was assessable on a cash receipts basis on income received from his former sole practice and on an accruals basis on income derived from a new partnership in the same income years. The Full Federal Court distinguished the case from Henderson on the basis that the new partnership was a different business from the sole practice.” [90-030]

Note: Continual method switching could trigger anti avoidance provisions in Part IVA and impose penalties.

Prepayments & “lay-by” sales Money received in advance of goods or services being supplied, does not constitute income to be “derived”. - See, Arthur Murray (NSW) Pty Ltd v FCT (1965) where prepaid dance lessons were not “derived” until provided.

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Above, income would not be derived in 20X1, but the income year when the services are rendered. Consistent treatment applied to “lay-by” sales where derivation occurs when title to the goods passes to the customer.

Dividends & Delays because of disputes Dividends: ● Dividends are “derived” when they have been paid (cash or through reinvestment), not when declared. ○ See, Brookton Co-Operative Society v FCT (1981) Delay because of a dispute ● For taxpayers that: ○ Account on an accrual basis; and ○ Are owed money at the end of the income year that has not been paid due to bona fide dispute. ○ The disrupted amount is not “derived” in the year when the goods and services were sold/provided: BHP Billiton Petroleum v FCT (2002)

Constructive Receipts Income according to ordinary concepts (ordinary income) - s6-5 (4) In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. Other assessable income (statutory income) - S6-10(3) ITAA97 If an amount would be * statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct.

GST and SBE taxpayers ●

Businesses eligible to be Small Business Entity (SBE) can amount for GST on a cash or accruals basis. ○ A SBE must have an average turnover of less than $10 million (previously $2 million).

Residence and Source Chapter 4: General Principles A resident of Australia for tax purposes will be taxed on income from all sources: - See, s6-5(2) Income Tax Assessment Act 1997 (ITAA97) A foreign resident for tax purposes will be taxed on income from australian sources only: - See, 6-5(3) ITAA97

Tax residency: impact on individual taxpayers Individual tax rates: - Differ depending on whether the individual tax payer is a resident for tax purposes or a foreign resident. - Broadly, a foreign resident does not receive the benefit of the tax free threshold. Foreign residents do not have access to many personal tax offsets Foreign Residents are not liable for the Medicare Levy.

When is a taxpayer a tax resident of Australia.

Residency tests (overview): individuals Only one out of 4 tests needs to be satisfied for an individual to be considered a tax resident of Australia.

See definition of a resident in s6(1) ITAA36

Resides Test Known as the “residence according to ordinary concepts” test. ● The term “resides” is not defined in statute and its ordinary meaning is ascertained from a dictionary, example: ○ To dwell permanently or for a considerable time (Macquarie Dictionary) ● Ultimately, the determination of tax residency rests on a question of fact and degree: Miller v FCT (1946).

Factors to consider: ● ● ● ● ● ●

Time physically spent in Australia. If the person is a visitor, the frequency, regularity and duration of visits; IRC v Lysaght [1928]. Purpose of the visits to Australia and abroad. The maintenance of a place of abode in Australia for taxpayer’s use. The person’s family, business and social ties: Levene v IRC [1928] The person’s nationality may be considered for borderline cases.

The commissioner of Taxation’s view. •The Commissioner places emphasis on: –Intention or purpose of presence –Family and business or employment ties –Maintenance and location of assets –Social and living arrangements. •In addition to the above behavioural characteristics of the taxpayer, the Commissioner considers there must be sufficient time elapsed to demonstrate continuity, routine or habit. •See, Tax Ruling 98/17.

Domicile Test •Under the domicile test, an individual is a resident of Australia if his or her domicile is in Australia, unless the Commissioner is satisfied that the person has a permanent place of abode outside Australia. •‘Domicile’ is determined according to the Domicile Act 1982: –Domicile of origin at birth –Domicile of choice: country where the taxpayer intends to make their home indefinitely. •Generally applies to individuals moving overseas (eg, usually as a work posting), but not changing their domicile. •The domicile test does not apply when the individual can demonstrate that he or she does not have a “permanent place of abode outside Australia”. •In Federal Commissioner of Taxation v Applegate: –Taxpayer moved to Vila to establish an office of the Sydney law firm in 1981. Stayed there for two years but returned on one occasion when his wife had a baby. The taxpayer became ill in 1973 and returned to Australia. –Commissioner of Taxation argued that this domicile was Australian that he had not satisfied the requirement that his “permanent place of abode was outside Australia”. –The High Court held that permanent does not mean “forever” and is assessed objectively each year.

The commissioner of taxation's view •The Commissioner considers various factors in Ruling IT 2650 to ascertain whether a taxpayer has a “permanent place of abode outside Australia”. Factors include: –Intended and actual length of stay in the overseas country; –Intentions to stay in the overseas country permanently or temporarily; –Location of established home; –Duration and continuity of taxpayer’s presence in overseas country; –Durability of Australian associations (eg, place of education of taxpayer’s children). –See also FCT v Jenkins (1982)

Permanent place of abode: Harding (2019) •Taxpayer found to have a “permanent place of abode outside Australia” by Full Federal Court in Harding (2019): –Taxpayer had worked in Saudi Arabia over long period; –Moved into a house in Australia in 2006, but returned to Saudi Arabia to work in 2009, living in a 2-bedroom apartment in Bahrain for family to visit. Family remained in Australia.

–Visited Australia for a total of 91 days in y/e 30 June 2011. That year the marriage broke down and the taxpayer moved into a serviced apartment in Bahrain. •Court held T not a resident of Australia for the 2011 year: –“permanent place” referred to town or country; –provided residence in Australia permanently abandoned, the test did not require permanent location in particular dwelling. (not referring to individual living arrangements such as house etc. Refers to town/country). (applies on the day you leave Australia and setup a “permanent” place of abode.

183 day test •Under the 183-day test, an individual is a tax resident of Australia when his or her physical presence in Australia, continuously or intermittently, is for more than one-half of the income year. •Exceptions: 1.If the Commissioner is satisfied that the individual’s usual place of abode is outside Australia; and 2.The individual does not intend to take up residence in Australia. •Working holiday visa holder who was in Australia for more than 183 days was not a resident as their “usual place of abode was outside Australia”: Re Koustrup v FCT (2015) –Special rules apply to working holiday makers.

Superannuation test Applied in relation to Commonwealth superannuation funds. Under the superannuation test, the member of a Commonwealth superannuation fund (i.e, commonwealth public servants) and the member’s family are deemed to be tax residents of australia.

Period of residence A person may be a resident for a whole or part year, depending on the residency test used.

Tax free threshold in the individual progressive income tax rates is pro-rated for the residency period.

Temporary Residents - individuals (Div 768) Temporary residents are provided with tax relief, even if they meet a residency test. -

Most foreign sourced income is not taxed in Australia Pay tax at the Australian resident income tax rates Capital gains arising from disposal of assets not having necessary connection with australia disregarded. - From 8 may 2012: no longer entitled to 50% CGT discount - From 9 may 2017: no longer access the CGT main residence exemption (existing properties grandfathered until 30 june 2019). Taxpayers are temporary residents if: - They hold a temporary visa under the Migration act 1958 - They or their spouse is not an australian resident within the meaning of the social security act 1991.

Working holiday markers. •“Backpacker tax”. •A taxpayer is defined as a working holiday maker if they are in Australia under the following visa categories: –417 (working holiday) –562 (work and holiday). •From 1 January 2017 the first $37,000 of taxable income is taxed at 15%, with the balance taxed according to their residency status (see topic 1).

Residency tests (overview): companies Only one out of three tests needs to be satisfied for the company to be considered a tax resident of australia.

See s6(1) ITAA36

Place of incorporation test •A company that is incorporated in Australia under the Corporations Act 2001 (Cth) is automatically a tax resident of Australia, regardless of any other factors.

Central management and control test

Commissioner’s interpretation of Bywater.

Second limb: central management and control •Question of fact to consider is where the “real control” of the company is located, taking into account the following factors: –Where actual high level decision-making processes are made / developed. –Where the monitoring of overall corporate performance occurs. –See, Malayan Shipping Co Ltd v FCT (1946). –CM & C can be split between different jurisdictions – See North Australian Pastoral Company Ltd v FCT (see Barkoczy casebook –CCH Database) –Day-to-day control over the business operations of a company does not amount to CM&C of the company: Koitaki Para Rubber Estates v FCT (1940). •See Bywater Investments Limited & Ors v. Commissioner of Taxation [2016]

Controlling shareholders test Two limb test: 1. Voting power is controlled by shareholders who are residents of australia (50% of the voting power at General Meetings.); and 2. The company is carrying on a business in Australia (same as the first limb of the central management and control test).

Sources of Income: Overview: •If a taxpayer is a foreign resident, the taxpayer is only taxed on ordinary and statutory income sourced in Australia, unless deemed assessable income on some other basis. •Question of source has been described as “something which a practical man would regard as a real source of income” and a “practical, hard matter of fact”: Nathan v FCT (1918). •Source rules based on a combination of common law principles and statutory provisions. •Practically, it requires classification of income into different classes to determine source.

Categories of income: Trading or business profits: •Sale of goods (trading stock): –Generally, the place where the trading activities take place. –If multiple locations, apportion between locations: C of T v Kirk [1990], but if no value added by one jurisdiction no allocation: C of T (WA) v D & W Murray Ltd (1929) •Income from Contracts: –Where relevant acts consist largely making of contracts and the place of performance is unimportant, place where contracts are made may be the only significant determinant of source. –Where the contracts are of little importance, place of performance may be the only relevant factor: Thorpe Nominees (1988) –See also Tariff Reinsurances Limited v C of T (Vic) (1938) •Services: –Generally, the place where the performance of services occurs: FCT v French (1957); FCT v Efstathakis (1979).

•Efstathakis (1979): salary paid by the Greek Government to a Greek national working in Sydney –Exception: if creative powers or special knowledge involved is to such a high degree that the place utilised is relatively unimportant, in this case the dominant source may be the place of contract: FCT v Mitcham (1965) •FCT v Mitcham (1965): NOT place of work – Place of Contract outside Australia – Place of Payment outside Australia •Sale of property other than trading stock: –For real property, the place where the property is located: Rhodesia Metals [1940]; Thorpe Nominees (1988) •Rent: –Where the property is located for real property, even if lease is executed elsewhere –If rental income is from goods, greater significance may be placed on contract location, rather than location or use of goods: James Fenwick & Co Ltd v FCT (1921) •Interest: –Emphasis on the place where the contract for the loan was made and where the money was advanced: Spotless Services v FCT (1993); Studebaker Corporation of Australasia Ltd v FCT

•Dividends: –The place where the company derived its profits: Esquire Nominees Ltd v FCT (1973). •Royalties: –The place where the location of the industrial or intellectual property from which the royalty flows....