Australian Taxation law ( Deduction)

Chapter 16

Tax accounting

 2018 Thomson Reuters (Professional) Australia Ltd. All Rights Reserved. Jonathan Teoh, Monash University

Introduction • Accounting for income tax purposes is different to financial

accounting. Timing differences arise.

• Taxpayers are required to pay income tax each “income year”, which is generally the financial year: s 4-10.

• Consequently, the key issues in this topic are:

Tax accounting

Derivation of income When is a gain

“derived”?

Timing of deductions When is a loss or

outgoing deductible?

PoTL 2018 paragraph [16.10]

Derivation of income: Meaning of “derive” • Taxpayer’s assessable income includes the ordinary income or

statutory income that is “derived”: s 6-5.

• 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.

PoTL 2018 paragraph [16.20] – [16.30]

Derivation of income: Cash vs accruals accounting • For tax purposes, “accruals” or “cash” basis can be adopted.

• Which method? – 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).

Derivation of income Recognition of when income is received:

Accruals basis When invoice sent to

customer

Cash basis When cash actually received

from customer

PoTL 2018 paragraph [16.40]

Derivation of income: Cash vs accruals accounting • Illustration:

• 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.

Invoice issued $10,000

30 June 20X1

Payment received

30 June 20X2

PoTL 2018 paragraph [16.40]

Derivation of income: SBE taxpayers & large firms SBE taxpayers

• Businesses eligible to be a Small Business Entity (SBE) can account on a cash or accruals basis

– A SBE must have an average turnover of less than $10 million (previously $2 million).

Large firms and businesses

• The accruals method is the appropriate method for large professional firms: Henderson v FCT (1970).

PoTL 2018 paragraphs [16.50] – [16.60]

Derivation of income: Switching between cash and accruals • Worked illustration: impact of changing from cash to 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 (eg as a business grows) is permitted and the uncollected amounts earned in a prior year are untaxed earnings: see Henderson v FCT (1970).

– Continual method switching could trigger anti-avoidance provisions in Part IVA and impose penalties.

Cash Accruals Year 1 $200,000 $500,000 Year 2 $800,000 $600,000

PoTL 2018 paragraphs [16.70] – [16.80]

Derivation of income: Prepayments & “lay-by” sales • Moneys 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.

– In the above illustration, income would not be derived in 20X1, but the income year when the services are rendered.

• Consistent treatment applies to “lay-by” sales where derivation occurs when title to the goods passes to the customer.

Prepayment by customer

30 June 20X1

Services rendered

PoTL 2018 paragraphs [16.90] – [16.95]

Derivation of income: 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 accruals basis; and

– Are owed money at the end of the income year that has not been paid due to bona fide dispute.

• The disputed amount is not “derived” in the year when the goods or services were sold/provided: BHP Billiton Petroleum v FCT (2002).

PoTL 2018 paragraphs [16.100] – [16.110]

Timing – deductions and deductibility Expenses: s 8-1 general deductions • A key requirement for a taxpayer to deduct a loss or outgoing

under s 8-1 is that it has been “incurred”. • Term “incurred” is not defined in statute. • Guidance from the Commissioner in TR 97/7, suggests that

“incurred” means, among other things: – As a broad guide, “you owe a present money debt that you

cannot escape” – “the taxpayer is definitively committed in the year of income” – “is ‘completely subjected’ to the loss or outgoing” – “not sufficient if the liability is merely contingent or no more

than pending, threatened or expected”. • If the taxpayer is on a cash basis, a deduction can still be

“incurred” if it is not yet paid.

PoTL 2018 paragraphs [16.120] – [16.130]

Timing – deductions and deductibility Expenses: s 8-1 general deductions • Another key requirement under s 8-1 is that:

– A loss or outgoing must be incurred in gaining or producing the taxpayer’s assessable income (nexus requirement).

• Not necessary to “match” the expense with income earned in the same year, unlike the case with financial accounting. Issues:

Is a loss or outgoing is incurred in ‘gaining or producing assessable income’?

In an earlier income year

When a business has ceased to be owned by the

taxpayer

The reduction of

future expenses

When no income is generated but may be in the future

PoTL 2018 paragraphs [16.120] – [16.130]

Timing – deductions and deductibility Expenses: s 8-1 general deductions Expense of an earlier income year

• An expense is deductible in a later year when the event that gave rise to the expense occurred in an earlier year.

– See, for example, Placer Pacific Management Pty Ltd v FCT (1995) where the taxpayer successfully claimed a deduction for settlement of a claim in a later year (1989) that related to the sale of a defective product sold in an earlier year (1981).

PoTL 2018 paragraph [16.140]

Timing – deductions and deductibility Expenses: s 8-1 general deductions Incurred after business ceases to operate

• Likely to be deductible providing the expense relates to the time when the business was operating.

– See, for example, FCT v Jones (2002) where interest on a business loan was deductible even after the business was sold. At the time the loan was drawn down, it was for gaining or producing assessable income.

Loan drawn down

Business ceases

Interest accruing & payable Nexus still maintained

PoTL 2018 paragraph [16.150]

Timing – deductions and deductibility Expenses: s 8-1 general deductions Relevant to reduction of future expenses

• Expense is deductible in the current financial year even though it relates to a reduction of future expenses.

– No matching of the expense to the benefit is required.

– See, W Nevill and Co Ltd v FCT (1937).

When no income is being generated

• Expenses may be deductible even though no income is derived at the time the expense is incurred but where, as a result of the expense, the taxpayer may generate income in the future.

– See, Steele v DCT (1999).

PoTL 2018 paragraphs [16.160] – [16.170]

Timing – deductions and deductibility Prepaid expenses • Apportionment of a deductible outgoing is generally required

when it relates to advance expenditure greater than one tax year (ss 82KZL to 82KZMG ITAA36):

• Aim is to spread the deduction to the tax year in which the expense relates to.

• Exceptions: – Amounts specifically excluded – Certain payments made by small business entities and non-

business taxpayers.

PoTL 2018 paragraphs [16.180], [16.186]

No. of days of eligible service period in the income year

Total number of days of eligible service period

Expenditure

Timing – deductions and deductibility Prepaid expenses Amounts specifically excluded

• Certain expenditure are excluded from the 12-month rule, for example:

– Amounts of less than $1,000

– Payments of salary or wages (under a contract of service)

– Amounts incurred by a general insurance company relating to the issue of policies or payment of reinsurance premiums

SBE & non-business taxpayers

• Immediate deduction available where expense relates to a service up to 12 months.

PoTL 2018 paragraphs [16.182] - [16.185]

Timing – deductions and deductibility Provisions Long service leave and annual leave

• Leave (and expense) provisions not deductible as there is no actual liability until the employee takes his or her leave.

• Common law position:

– The provision is not “incurred”. “Incurred” does not require payment but does require a fixed liability not subject to contingencies: Nilsen Development Laboratories Pty Ltd v FCT (1981); and FCT v James Flood Pty Ltd (1953).

• Statutory position:

– Section 26-10 provides that leave can only be deducted in the year that it is paid.

PoTL 2018 paragraphs [16.190] – [16.210]

Timing – deductions and deductibility Provisions Bad debts

• Provisions for bad debts are not allowable deductions as no loss or outgoing has been “incurred”.

• Statutory position:

– See specific deduction provision s 25-35 (discussed in PoTL 2018, paragraph [13.80]).

PoTL 2018 paragraphs [16.220]

Timing – deductions and deductibility Provisions Insurance companies

• Deduction based on an estimate of an expected future liability.

– Absolute liability to pay claims under insurance policies is when an accident occurs and hence “incurred” for s 8-1.

– Quantum calculated usually by reference to historical experience or educated estimates.

– See, RACV Insurance Pty Ltd v FCT (1974); and Commercial Union Assurance v FCT (1977).

PoTL 2018 paragraphs [16.230] – [16.240]

Chapter 17

Trading stock

 2018 Thomson Reuters (Professional) Australia Ltd. All Rights Reserved. Jonathan Teoh, Monash University

Introduction • Division 70 ITAA97 contains a statutory tax accounting

regime for “trading stock”.

• The purpose of the regime is to essentially match the cost of the trading stock with the revenue from the sale.

• The key issues in this topic are as follows:

Trading stock

Meaning of trading stock

Accounting for trading

stock

Trading stock on

hand Special rules

PoTL 2018 paragraph [17.10]

Meaning of trading stock • “Trading stock” is defined in s 70-10 and includes:

• “Anything” can be trading stock: FCT v St Hubert’s Island Pty Ltd (1978)

– Necessary to determine the purpose for which it is held.

• An item can be trading stock of a taxpayer even if the taxpayer is not its legal owner.

(a)

• Anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and

(b) • Livestock

PoTL 2018 paragraph [17.20]

Meaning of trading stock: Common items of trading stock • Distinction between goods and services:

Goods

• Raw materials and partly finished goods constitutes trading stock of a manufacturer: FCT v St Hubert’s Island (1978).

• Spare parts held for the purpose of exchange in the ordinary course of business constitutes trading stock.

Services

• Unbilled work in progress of a professional services firm is generally not trading stock: Henderson v FCT (1970).

PoTL 2018 paragraph [17.30]

Meaning of trading stock: Common items of trading stock • Intangibles (eg, shares) may constitute trading stock if held with

the relevant purpose: Patcorp Investments Ltd v FCT (1976).

– Share trading vs passive investing.

• Consumables used by a service provider in the course of providing services may constitute trading stock:

– Items must be separately identifiable things before and after the services are provided

– Ownership of items must pass to the customer.

• Packaging materials held by a taxpayer may be trading stock where they are disposed of, and closely associated with “core goods”: Ruling TR 98/7.

PoTL 2018 paragraphs [17.30] – [17.40]

Accounting for trading stock • A taxpayer will have tax consequences arising:

1 • From the acquisition of trading stock

2 • From disposals of trading stock

3 • At year end

PoTL 2018 paragraph [17.50]

Accounting for trading stock: Acquisitions and disposals • Generally, the tax treatment on the acquisition and disposal of

trading stock is as follows:

Acquisitions

• The acquisition of trading stock by a taxpayer is a deduction under s 8-1 ITAA97, subject to the conditions in s 70-15:

• (i) The trading stock being “on hand”; or

• (ii) When an amount is included in assessable income in relation to the disposal of trading stock

Disposals

• Disposals of trading stock in the ordinary course of business will be assessable as ordinary business income: s 6-5

• Included in assessable income when the trading stock ceases to be “on hand”: s 70-5(2)(b)

PoTL 2018 paragraphs [17.60], [17.80] – [17.90]

Accounting for trading stock: Acquisitions and disposals • Non-arm’s length transactions:

Non-arm’s length acquisitions

• Under s 70-20, a deduction equal to the market value of the trading stock should be adopted where the:

• (i) Buyer and seller did not deal at “arms length”; and

• (ii) The expense is greater than the “market value”.

Non-arm’s length disposals

• Where an adjustment to the purchaser’s deduction applies, the market value is included in assessable income of the seller: s 70-20.

PoTL 2018 paragraphs [17.70] – [17.100]

Accounting for trading stock: Acquisitions and disposals • Disposals outside the ordinary course of business (eg,

disposed on sale of a business, gifts or donations provided):

– Taxpayer disposing the trading stock includes the market value in assessable income: s 70-90.

– Purchaser is deemed to acquire the trading stock for the same value: s 70-95.

PoTL 2018 paragraph [17.110]

Accounting for trading stock: Year-end adjustments • An adjustment is required to ensure the taxpayer only accounts

for a deduction when there is an actual economic decline.

• Taxpayers are required under s 70-35 to compare the “value” of trading stock on hand at the start and at the end of the year:

Value of trading stock at year-end

Value of trading stock

at start of year

Difference is included in assessable

income

Value of trading stock at year-end

Value of trading stock

at start of year

Difference is included in deductions

PoTL 2018 paragraph [17.120]

Accounting for trading stock: Year-end adjustments • Value of trading stock at start of year:

• Equals value of trading stock at the end of the previous income year: s 70-40.

– Value at the end of the previous income year must have been taken into account for tax purposes to be used as the value at the start of the following year: Hua Wang Bank Berhad v FCT (No 19) (2015).

PoTL 2018 paragraph [17.130]

Accounting for trading stock: Year-end adjustments • Value of trading stock at end of year:

• Taxpayer has three choices to determine the value of trading stock on hand at end of the year: s 70-45:

1 • Cost

2 • Market selling value

3 • Replacement value

PoTL 2018 paragraph [17.140]

Accounting for trading stock: Year-end adjustments • Cost: should be determined in accordance with accounting

principles: Phillip Morris Ltd v FCT (1979): – Manufacturers, retailers and wholesalers should use the

accounting “absorption cost method”. – The first-in-first-out method should be used where it is not

possible to track individual items: Australasian Jam v FCT.

• Market selling value: is the amount for which the taxpayer could sell the stock in the ordinary course of business.

• Replacement value: is the amount the taxpayer would have to spend to replace the stock.

• Note, for obsolete stock: taxpayer may value trading stock at a value lower than the 3 methods if it is obsolete and the value used by the taxpayer is reasonable: s 70-50.

PoTL 2018 paragraphs [17.150] – [17.190]

Trading stock on hand • Concept of trading stock “on hand” determines:

• General guidance on what constitutes “on hand”, includes: – Taxpayer having dispositive power: Farnsworth v FCT (1949) – Dispositive power may not include legal ownership: FCT v

Sutton Motors (Chullora) Wholesale Pty Ltd (1985) – Dispositive power does not require physical possession of

the goods: All States Frozen Foods v FCT (1990).

1 • When gross receipts is included in assessable income

2 • When a deduction is claimed for acquisitions

3 • Value of trading stock at year-end

PoTL 2018 paragraphs [17.220] – [17.230]

Special rules • The characterisation of an item as trading stock depends on the

taxpayer’s purpose in holding the asset.

• Special rules may apply when the taxpayer’s purpose changes.

• Special rules include:

1 • Asset of taxpayer becomes trading stock

2 • Item ceases to be trading stock but continues

to be owned by taxpayer

3 • Lost or destroyed stock

PoTL 2018 paragraph [17.240]

Special rules: Asset of taxpayer becomes trading stock • Where an asset that is owned by the taxpayer becomes

trading stock: – Taxpayer is deemed to have disposed the item; and – Re-acquired the item: s 70-30.

• The taxpayer has a choice as to whether the deemed disposal and re-acquisition is done at “cost” or at “market value”: s 70- 30(3).

• Other tax considerations: – Balancing adjustment if the asset was a depreciating asset – CGT event K4 if the asset was a CGT asset and disposal

and re-acquisition done at “market value”.

PoTL 2018 paragraph [17.250]

Special rules: Item ceases to be trading stock • Where a taxpayer ceases to hold an item as trading stock, but

continues to own it: – Taxpayer is deemed to have disposed the item; and – Re-acquired it for “cost”: s 70-110.

• The cost on re-acquisition becomes the asset’s cost base (for a CGT asset) or cost (for a depreciable asset).

• Commissioner provides reasonable estimates of the value of goods taken from trading stock for private use for certain businesses: TD 2017/9.

PoTL 2018 paragraph [17.260]

Special rules: Lost or destroyed stock • Any lost or destroyed stock taken into account through the

year-end adjustment as stock is not “on hand”.

• Any compensation received for lost or destroyed stock is included in the taxpayer’s assessable income under s 70-115.

PoTL 2018 paragraph [17.270]

Small business entities • Definition of a small business entity (SBE):

– A sole trader, partnership, company or trust that operates business, for whole or part year, and has an aggregated turnover over less than $10m.

• Concession for SBE: – If the difference between opening and closing stock value is

less than $5,000, the taxpayer may choose not to account for changes: s 328-285(1).

PoTL 2018 paragraph [17.280]

Interaction with other income tax rules • Where trading stock also qualifies as a CGT asset:

– Any capital gain or loss is disregarded if, at the time of the CGT event, the CGT asset is classified as trading stock: s 118-25.

• Where trading stock also qualifies as a depreciating asset subject to the capital allowances regime: – Trading stock is excluded from the definition of a

“depreciating asset”: s 40-30(1)(b).

PoTL 2018 paragraph [17.290]