Taxation Law

MONASH

BUSINESS

SCHOOL

TYPES OF ASSESSABLE INCOME

LECTURE 4

BTF5965 TAXATION LAW | SEMESTER 1, 2019

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 Task 1 On-line Quiz – Friday 5 April 11am-11pm

– Another practice quiz available this Thursday

 e-Exam guidance

– A general knowledge mock exam available at: https://student- eassessment.monash.edu/enrol/index.php?id=210

 Teacher Consultation sessions will commence next week

– times and places to be advised soon.

WEEK 4 ANNOUNCEMENTS

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Ordinary income (s 6-5 ITAA97)

 Assessment of gains that have an income character in accordance

with principles developed by the courts. Referred to as “income

according to ordinary concepts” or “ordinary income”

Statutory income (s 6-10 ITAA97)

 Assessment of amounts by a specific provision in the income tax

legislation: see list at s 10-5.

 Statutory income generally adjusts the amount assessable, or

covers gaps in the ordinary income concept – eg. capital gains.

ASSESSABLE INCOME:

ORDINARY AND STATUTORY INCOME

| PoTL paragraphs [3.150] – [3.160]

Assessable Income

Ordinary Income

Statutory Income

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 Gains have been characterised by the courts to determine whether

they have an income character “… in accordance with the ordinary

concepts and usages of mankind”

– Jordan CJ in Scott v Commissioner of Taxation (1935) NSWSR

 Generally follow accounting cash flow approaches – but economists

might use a more holistic concept (all aspects of welfare) and

lawyers tend to take a property law approach (from the law of trusts).

 The case law identifies several broad principles:

– Three broad sources of income (i) services, (ii) business and (iii) property

– A fundamental distinction between ‘income’ and ‘capital’ receipts

– Two prerequisites – ‘convertible to cash’ and a ‘real gain’

– Various key characteristics of income:

 Regular or periodical receipts; and

 The flow concept

 Compensation principle, Unrealised gains, Legality, Recipient’s hands,

Constructive receipt, Avoided expenditure, Mutuality

WHAT IS ORDINARY INCOME?

| PoTL paragraph [5.20] – [5.30]

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INCOME FROM

PERSONAL SERVICES

NOT ORDINARY INCOME

Capital receipts

Gifts

Prizes and windfall gains

Reimbursements

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 A receipt cannot be ordinary income unless it fulfils both

prerequisites:

 Note, even if the above prerequisites are satisfied, it is not by itself

sufficient for the gain to be ordinary income (see later,

characteristics of ordinary income)

STEP 1:

PREREQUISITES OF ORDINARY INCOME

Cash or convertible

to cash

Real gain to the

taxpayer

Prerequisites of ordinary income

satisfied

| PoTL paragraph [5.50]

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 A gain cannot be ordinary income if it is not cash or not cash convertible.

– Tennant v Smith [1892] : bank employee’s free house

– FCT v Cooke and Sherden [1980]; door to door sales/free holiday

 What is cash convertible?

– The item must be readily convertible to cash

– not illegal to sell the good: Payne v FCT (1996): frequent flyer points

 Note, statutory override provisions:

– s 21A ITAA36 – deems non-cash business benefits to be convertible

– s 15-2 ITAA97 – includes the value of some employment related benefits

– FBT – employers taxed on ‘fringe benefits’ provided to employees (Week 5)

PREREQUISITES OF ORDINARY INCOME:

(1) CASH OR CASH CONVERTIBLE

| PoTL paragraph [5.60]

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 If a receipt is not a genuine gain (ie the taxpayer is better off

financially), it is not ordinary income

 More likely to apply in employment situations:

– Hochstrasser v Mayes (1960) – reimbursement of loss on sale of

home due to relocation of work not a real gain.

PREREQUISITES OF ORDINARY INCOME:

(2) REAL GAIN

| PoTL paragraph [5.70]

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 Provided both prerequisites of income are satisfied, a gain will be

ordinary income if it shows sufficient characteristics of income:

 Note, the above characteristics are only indicia as to what

constitutes ordinary income:

– Courts can widen their views to reflect modern day practices, eg

FCT v Myer Emporium (1987)

STEP 2:

CHARACTERISTICS OF ORDINARY INCOME

| PoTL paragraph [5.80]

1 • Regular / periodical receipts; or

2 • The flow concept.

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 A gain that is regular or periodic is more likely to be ordinary income

than a gain that is paid as a lump sum

 Contrast FCT v Blake 1984 withs FCT v Harris 1980

 Exceptions can occur – eg instalments of capital Foley v Fletcher 1843

 When regular, expected and depended upon for support, a gain can

constitute ordinary income, even if they do not flow from an earnings

source:

– Government aged pension: Keily v FCT (1983)

– Youth Allowance payments: Anstis v FCT (2010)

– Certain “top-up” payments: FCT v Dixon (1952)

CHARACTERISTICS OF ORDINARY INCOME:

(1) REGULAR / PERIODICAL RECEIPTS

| PoTL paragraph [5.90], [5.130]

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 The flow concept is expressed in terms of ‘fruit’ and ‘tree’ in Eisner v

Macomber 252 US 189 (1920) by Pitney J:

CHARACTERISTICS OF ORDINARY INCOME:

(2) THE FLOW CONCEPT

| PoTL paragraph [5.110]

‘Tree’

represents: capital

‘Fruit’

represents: income

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 For a gain to be considered ordinary income where it is likened to

the fruit from the tree, it will have the following two related traits:

 Eisner v Macomber held that the value of bonus shares issued to a

shareholder was not income (not severable from the source).

CHARACTERISTICS OF ORDINARY INCOME:

FLOW – IMPORTANT TRAITS

| PoTL paragraph [5.110]

1 • Nexus (a connection) with the earning source

2

• Severable from its earning source

• ie the gain can be extracted without the affecting the underlying earnings

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 Income is commonly categorised into three broad types (or ‘sources’

of income:

CHARACTERISTICS OF ORDINARY INCOME:

FLOW - COMMONLY RECOGNISED SOURCES

| PoTL paragraph [5.30]

1 • Income from property

2 • Income personal services and employment

3

• Income from business (including extraordinary and isolated transactions

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What is interest?

 Interest is the return that flows from the lending of money and is the

compensation for the loss of use of that money. Capital sum lent is

not affected by the payment of interest,

– Riches v Westminster Bank Ltd (1947) Bank repaid a debt and deducted a sum for income tax payable on the ‘interest’ component of the amount.

 Discounts and premiums

– A higher interest rate (premium) may be paid due to risk of non-repayment. A discount or premium may be applied to the amount repayable. See Lomax v Peter Dixon (1943)

– Deferred interest arrangements - Timing of interest payments may be determined by Div 16E etc.

INCOME FROM PROPERTY:

(1) INTEREST

| PoTL paragraph [9.20]

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 The definition of a ‘dividend’ includes (s 6(1) ITAA36):

– Any distribution to shareholders in the form of money or property and

any amount credited to shareholders …

– Note – Div 7A ITAA36 – deemed dividends include loans, excessive

remuneration, forgiven debts etc

 Dividend income is subject to the imputation system which

– for resident taxpayers - includes a grossed up value of the dividend in

assessable income plus a franking offset (refundable)

– for foreign taxpayers – no gross up and no offset but WHT applies at

0% for franked amount of the dividend and for unfranked amount either

30% (non-DTA countries) or 15% (DTA countries) – ITAA36 Div 11A

INCOME FROM PROPERTY:

(2) DIVIDENDS

| PoTL paragraph [9.150] and [22-290]

Company Shareholder

Dividend

Dividend assessed as

statutory income:

s 44 ITAA36

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DIVIDEND IMPUTATION:

GROSS UP AND TAX OFFSET MECHANISM

| PoTL paragraph [15.80] – see also [21.210] and [22.280]

Illustration: operation of the dividend tax offset where

shareholder is a resident individual:

Company level $

Taxable income 100

Less: income tax payable (assume 30%) 30

= Net profit available for distribution 70

Shareholder level

Dividend 70

Gross up by franking amount 30

= Taxable income 100

Shareholder’s tax payable

Tax on taxable income 45

Less: tax offset equal to franking amount (30)

Income tax payable 15

Where

shareholder

a resident

company

70

30

100

30

(30)

0

Where

shareholder

has TI

<$18,200

70

30

100

0

(30)

(30) refund

Where

shareholder

a non-

resident

70

na

70

0

na

0

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Rent

 a payment by one party in exchange for the use of the other party’s

property for an agreed amount of time.

 ordinary income under the flow concept, even if received as a lump

sum, still constitutes ordinary income

Lease premiums

 Payment by a tenant to a landlord as inducement for lease agreement.

Generally a capital receipt but CGT applies as it is regarded as a

proceeds of disposal an interest in the asset itself. Exceptions:

– The taxpayer is in the business of receiving lease premiums: Kosciusko Thredbo

Pty Ltd v FCT (1983)

– The lease premium is in reality a substitute for rent: Dickenson v FCT (1958)

INCOME FROM PROPERTY:

(3) RENTAL AND LEASE INCOME

| PoTL paragraph [9.160]

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 Section 15-25 states that amounts received by a lessor from the

lessee due to failing to comply with a lease obligation to repair the

premises is assessable income, provided:

– The lessee has used the premises for producing assessable

income; and

– The payment is not ordinary income

PAYMENT FOR NOT FULFILLING LEASE OBLIGATIONS

| PoTL paragraph [9.180]

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 A royalty payment is a payment that is calculated based on the usage

of intellectual property or quantity/value of a substance taken.

Common examples:

– Taxpayer is paid for physical resources (eg. minerals, coal, oil)

based on quantity of resources taken (eg barrels of oil)

– Taxpayer is paid for the use of intellectual property, eg a publisher

pays an author of a book a specified amount per book sold

 Contrast: McCauley v FCT (1944) where payment was based on

quantity and Stanton case (1955) where payment was a

predetermined lump sum.

 Section 15-20 ITAA97 deems royalties to be assessable as statutory

income, except where royalties constitute ordinary income

INCOME FROM PROPERTY:

(4) ROYALTIES

| PoTL paragraphs [9.190] – [9.200]

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 An annuity is a stream of payments that occurs at regular intervals

(eg monthly or quarterly pension). Types of annuities:

 Full amount of the regular annuity payment is treated as ordinary

income: Egerton-Warbuton v DCT (1934)

 Certain annuities are subject to s 27H ITAA36 which makes the

annuity’s return of capital component tax free

INCOME FROM PROPERTY:

(5) ANNUITIES

| PoTL paragraph [9.210]

Fixed-term

Payments made for a pre-determined amount of time

Life

Payments made for the rest of the recipient’s life

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 A receipt from employment and providing personal services may be

subject to income tax for the employee (or entity providing services),

or fringe benefits tax:

2. INCOME FROM PERSONAL SERVICES

| PoTL paragraph [6.10]

Receipt from personal services and employment

Is it a Fringe Benefit? – see ITAA36 s 23L non-assessable non-exempt income but

taxable for employer (Topic 5)

Ordinary income (assessable under s 6-5)

Other non-cash benefits & allowances (assessable under s 15-2)

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 A connection or “nexus” with a receipt resulting from a taxpayer’s

personal service constitutes ordinary income

 PERSONAL SERVICES <------- WAGES [clear nexus]

<------ GIFT [unclear nexus]

 Courts have used a two-step approach to determine if an amount

is ordinary income from personal services:

1. Identification of the activity undertaken; and

2. Determining whether the receipt is a reward for performing

that particular activity

FLOW CONCEPT: NEXUS WITH SERVICES:

| PoTL paragraphs [6.20] – [6.30], [6.60]

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 Nexus clearly established for common items of personal services,

including:

– Salary and wages

– Commissions

– Bonuses

– Fees charged for services rendered

– Ancillary payments that are an incident of labour

 Nexus not negated by lump-sum or one-off receipts for the

performance of a specific task, see Brent v FCT (1971) – wife of the

Ronald Biggs – the ‘Great Train Robber’ - link

 It is irrelevant who pays or when it is paid: Kelly v FCT (1985)

NEXUS WITH SERVICES:

| PoTL paragraphs [6.40] – [6.50]

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 Unexpected or voluntary payments received as an incidence of

employment constitutes ordinary income. For example:

– Christmas bonuses paid to employees paid in the form of

redeemable gift vouchers: Laidler v Perry (1965)

– Tips received by a taxi driver: Calvert v Wainwright (1947)

 Note, possible to characterise as ordinary income based on the

nature of payment (income characteristics), rather than nexus:

– Additional periodic payments as a substitute for wages that were

relied upon by the taxpayer: FCT v Dixon (1952)

VOLUNTARY PAYMENTS

| PoTL paragraphs [6.70] – [6.80]

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 payments based on personal qualities or friendship are not regarded as

ordinary income.

 Uncertainty arises where a gift is made and within an employment or

commercial connection

– importance of a personal relationship between the parties: see Scott v

FCT (1966) at POTL p 144 and Hayes v FCT (1956) at p 145

 Various ‘non-determinative’ factors to consider in borderline cases:

– Expectation of the gift: Scott v FCT

– Lump sum or regular payments: FCT v Blake (1984)

– Motive of the donor (note, weight placed on the nature of receipt in the

hands of the recipient): Scott v FCT

– Whether the recipient has been fully remunerated for services provided:

Scott v FCT; Hayes v FCT (1956)

– Personal relationship: Scott v FCT; Hayes v FCT

GIFTS

| PoTL paragraph [6.90]

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 Prizes and chance winnings are non-assessable if derived by “luck”

or ‘windfall gains’ – eg lottery prizes

 See Case 37 (1966); Winnings of a casual participant on a TV show not

ordinary income: Ruling IT 167

 Alternatively, ordinary income if derived by exercising degree of skill

(personal services) that sufficiently outweighs “luck”

– Gambling cases – Babka, Evans - could be business income

– Professional sporting people: Kelly v FCT (1985) p 148

– Irrelevant that the payment does not come from employer

PRIZES

| PoTL paragraph [6.110]

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 Difficulty with determining the sufficient degree of skill that outweigh

“luck”. Relevant factors include:

PRIZES

| PoTL paragraph [6.120]

1 • Degree of professionalism

2

• Whether the reward is for services rather than personal qualities

3 • Whether the reward is paid before or after service

4

• Whether the reward is related to the taxpayer’s contract

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 Prerequisites of ordinary income:

 A non-cash benefit may have a nexus with personal services,

however if not ‘convertible to cash’ it is not ordinary income:

– frequent flyer points accrued from work-related travel: Payne v

FCT (1996) POTL p 150. Held - Not convertible to cash and not

within former s 26(e) ITAA36 as they arose form a private arrangement.

 Note, other NCBs may be assessable under s 15-2 ITAA97 (see

below) – which replaced s 26(e) or subject to fringe benefits tax

NON-CASH BENEFITS

| PoTL paragraph [6.130]

Cash or convertible

to cash

Real gain to the

taxpayer

Prerequisites of ordinary income

satisfied

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 Also necessary to distinguish between ordinary income receipts

connected with services and capital receipts (not ordinary income)

DISTINGUISHING CAPITAL RECEIPTS

| PoTL paragraph [6.140]

Gain from personal services

Income

Reward for services

Capital

Giving up a valuable right

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 A gain from a change to entitlements under employment or service

contracts takes the character of what it replaces:

– Relinquishing employment rights (eg rights to control a company

as managing director): Bennett v FCT (1947) p 152

– Loss of employee entitlements: AAT Case 7,752 (1992)

CHANGES TO ENTITLEMENTS

| PoTL paragraph [6.150]

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 Restrictive covenant or restraint of trade may be formed:

 Ordinary income if connected with the current employment

agreement (ie payment of future services)

 Capital characterisation:

– Separate agreement to give up valuable rights: Higgs v Olivier

(1952); FCT v Woite (1982)

– No nexus with earning activity (eg payment made at end of

contract): Hepples v FCT (1991) - early CGT case

– Note, capital gains tax may apply (CGT events C2 and D1)

RESTRICTIVE COVENANTS

On entering a contract

During the contract’s operation

On conclusion of

a contract

| PoTL paragraphs [6.160] – [6.170]

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 Sign-on (enticement) fees as part of normal practices of attracting

people into a new employment contract:

– Characterised as a payment for future services (ordinary

income): Pickford v FCT (1998); Ruling TR 1999/17

THE COMPENSATION PRINCIPLE

– See Comm of Tax v Phillips (1936) - A company directed got

retrenched but company agreed to continue paying his salary at

same rate for remainder of his original contract period. Held to

be income.

SIGN-ON FEES

| PoTL paragraph [6.180]

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 Broad provision that brings the value of certain gains from labour

into assessable income, including non-cash benefits that are not

convertible to cash under ordinary concepts

– Consider application of s 15-2 only if s 6-5 does not apply

 Applies when the following three requirements are satisfied:

 Not much case law – see Smith and Holmes cases re former s 26(e)

STATUTORY INCOME: s 15-2 ITAA97

| PoTL paragraph [6.190]

1

• There is an “allowance, gratuity, compensation, benefit, bonus or premium”

2 • The above is “provided to you” (being the taxpayer)

3 • There is a nexus with employment or services rendered

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 Relationship with other tax provisions:

– Section 15-2 will not apply under certain circumstances. Key

exclusions include:

OTHER STATUTORY INCOME CATEGORIES

 S 15-3 Return to work payments

 Div 82 – Employment termination payments

 Div 83 – Genuine redundancy payments

STATUTORY INCOME: s 15-2 ITAA97

| PoTL paragraph [6.240]

1

• Amount is assessable under ordinary income (s 6-5)

2

• The gain is a fringe benefit (not assessable under income tax: s 23L(1) ITAA36)

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Topic 5: Business Income

– What is a business

– Normal proceeds of a business

– Treatment of trading stock

– Fringe Benefits Tax

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