Tax Law Revision Notes 1k5u27

PERSONAL SERVICES INCOME Ordinary Income • •

Income according to ordinary concepts s6-5 ITAA 1997 Features of ordinary income include:

1.

Concept of a Flow

Eisner v McComber (US Case) T owned shares in a company and instead of declaring a cash dividend the company issued a stock dividend. Result was that the value of share increased but no cash flow. Argument whether the receipt of stock dividend should be included as AI. Held: Court used the tree and the fruit metaphor. The fruit itself is income but the tree is capital. Court stated that T’s interest in the company had increased but no gain in the hand of T. The position in Australia is different because statutory provision states that a stock dividend is subject to tax. Notion that gains flowing from an asset are income but gains to the value of the asset are not 2.

Generally Re-current

Dixon v FCT T worked for company before WW2 but decided to enlist. Employer stated that any employee who enlisted would be topped up for any discrepancy between military income and income that would have earned if they stayed at the company – patriotic gesture by employer. Held: Since the amount was paid on a regular and periodic basis, it was deemed OI. Other cases: Harris case court found that a yearly supplement to a pensioner was NOT income because not regular. In Blake’s case a fortnightly pension supplement was held to be regular and thus income. Harris has subsequently been overturned by legislation. Now any supplement to pension is held as income.

1

3.

Must be income in the hands of tax payer

General problem here is in identifying the correct T Federal Coke v FCT Federal Coke (FC) supplied minerals to another company (B), which then on-sold those minerals to an overseas company (C). C broke their contract with B. B demanded compensation from C and requested the money be paid to FC (B’s wholly owned subsidiary). Commissioner assessed compensation receipt on FC. Held: If amount is to compensate for loss of income, then receipt is of an income character. Court held than amount was income in nature but from FC’s perspective it was a windfall gain such that they provided no consideration for the receipt – capital in nature. If assessed on B, would have been income. Could have circumvented this situation by the deemed receipt rule s6-5(4) ITAA 97. Even if T does not receive an amount but directs that the amount be paid to someone else, the amount will be deemed as being received by the initial T. 4.

Must belong to T

Income must be beneficially owned by T Countess of Bective v FCT According to of trust, money was going to be paid to the mother on condition that it goes to maintenance of the daughter. Held: Court accepted argument that mother was not beneficially entitled to the money due to the condition enforced by the trust. Not income in the hands of the mother. 5.

Must be money or money’s worth

If receipt is not cash and cannot be converted into cash, then it is not income Tennant v Smith

2

Bank manager had to live above the bank and could not sub-let premises. Tax office calculated an amount he would have had to pay in rent. They were trying to impute the non-cash benefit of living rent free. Held: Amount was non-cash and could not be convertible since he could not sub-let – therefore not OI. FCT v Cooke and Sherden A married couple sold soft-drinks in a mobile transport service. Employer offered a holiday incentive to the couple who sold the most soft drinks. Commissioner wanted to impute a non-cash value to the holiday. Held: Holiday was non-transferable and thus could not be converted into cash, therefore not income. Court also stated if the receipt saves T from incurring expenditure, the saving is not ordinary income because income is what ‘comes in,’ NOT what is saved from going out. Other Statutory Provisions: •

6. • •

Section 21A ITAA 1936 o When a non-cash business benefit is non-convertible, the amount will be treated as if convertible as measured by an arms length basis. This legislation is not applicable to Tennant v Smith because that was an employer/employee relationship and NOT a business benefit. Capital Receipts are not Ordinary Income Amount received for giving up valuable rights may amount to a capital receipt and NOT ordinary income. It needs to be: o Generally an inducement or ‘sign-on’ fees will be assessable income: AAT Case 822, AAT Case 7422 o Generally a restriction will be capital since T will have given up a field of activity that would have otherwise been open to him.  a restriction/giving up of a significant right: Taxation Ruling IT 2307  restrictive covenants: Higgs v Olivier [3.140], FCT v Woite [3.170] o Payments for alteration of rights: CoT (Vic) v Phillips, Bennett v FCT, AAT Case 7752 are not always capital:  Phillips: assessable income 3

 

Bennett: capital AAT Case 7752: capital

AAT Case 822 - Sign on Fee T was a rugby league footballer who was approached by officials responsible for arranging the Super League. They had a meeting with T and agreed to a three year contract of $225,000 per year. He was also given a $50,000 payment for g the contract. Held: •

Amount is assessable income o Money paid as a reward for services to be provided in the future o The $50,000 was part of the contractual payment for future services o Nexus clearly satisfied o T was not giving up any rights. o Doesn’t matter that payment made by News Ltd and not future employee

AAT Case 7422 – Sign on Fee T was a rugby league payer who signed a lucrative contract to play rugby in Queensland. There was a $5000 payment to ensure the player remains in Queensland. Held: •

The amount is assessable income o Amount is incentive or an inducement by QRL to retain the best players and not a restriction on their ability to play for another state

Taxation Ruling IT 2307 - Payment to sports persons Athlete had promising career as a runner and abandoned senior football to concentrate on running career. In late 1970’s ed VFL club and upon sign on received lump sum of $11,000 for both g on to the club AND also to not participate time as a professional runner. Held: •

The Commissioner made a ruling that this situation is quite different to a ‘normal’ sign on fee as athlete is giving up his rights as a professional runner and thus should be capital.

4

Restrictive covenants: Higgs v Olivier [3.140], FCT v Woite [3.170] Higgs v Olivier Olivier (T) paid 15,000 pounds for agreeing not to appear, produce or direct any other film for another 18 months – ie. agreed to a restrictive covenant. Held: Court accepted the argument that T gave up valuable rights and was a restriction on his freedom to earn income. Payment was a capital receipt. This was followed in Woite: if the player did move to Victoria (from SA), he would go to North Melbourne – received $10k for this agreement Woite v FCT T was a South Australian footballer who won Magarey medal for Best and Fairest. North Melbourne wanted him to play with them. He received $10,000 for g an agreement with North Melbourne that IF he moved to Victoria, he would only play for North Melbourne. He never did move to Victoria but was still allowed to keep $10,000. Held: •

The amount was NOT income thus capital o T had given up valuable rights to play for any other club in Victoria. o In obiter the court also found there was no provision of services. If T did move to Victoria and played with North Melbourne, the character of the $10,000 would change from capital to income.

Payments for alteration of rights: CoT (Vic) v Phillips [3.210], Bennett v FCT [3.220], AAT Case 7752 [3.230] Phillips v Commissioner of Taxes (Vic) T lost director position in company after takeover. He was entitled to 12.5% of net profits of the company. He was paid monthly instalments for the amount he would have received if he saw out the contract. T tried to argue that it was capital because it was a compensation payment. Held:

5

•

Amount was assessable income o Substitution principle states that the amount is of the same character to the payment to which it replaces o The fact that the payment was a monthly payment was also an important factor

Bennett v FCT T was managing director of radio station in which he was given full control. He entered into a new contract on similar monetary but he now had less control. He was given a lump sum for the amendment of the contract. Held: •

Amount was capital in nature o Contract stated that T would receive lump sum in exchange for giving up contractual rights.

AAT Case 7752 T was an employee of an oil company. Employees were entitled to a day off once a fortnight (RDO). Company decided to change working structure to get rid of RDO and increasing working hours from 35 hours to 38 hours per week. Company unilaterally amended employment contracts by removing RDO in exchange for three months wages. T submitted that the amount was capital as compensation for loss of entitlements. Held: •

Amount is capital receipt BUT still assessable under s26(e) o T’s loss of RDO entitlements is the surrender of valuable rights thus capital o However, amount which is received either directly or indirectly in respect of employment is still assessable under s26(e)

Note: Led to introduction of CGT in 1985. Incentive for gains in ‘giving up of rights’ has been diminished, since capital gains are now treated as ordinary income. However, still some preference for capital receipt due to the effective 50% discount. 7.

Only Realised Gains Taxed

6

• • 8.

No unrealized gains are taxed Only situation is accrued interest earned on term deposit yet to mature Income Earning Activity

• Must be a sufficient nexus between the receipt and an income earning activity • The court has identified the following income earning activities: o Provision of personal services → wages or receipts by contractors (active income) o Business Receipts → even one-off profit making schemes (active income) o Use of property → rent, interest, dividends, royalties (ive income) 9. • •

Compensation Receipts Payments received as compensation for loss of income will be deemed as income o Eg. Loss of income for set period Payments received for loss of an asset will be deemed as a capital receipt o Eg. Loss of potential earning capacity

•

When payment includes loss of income AND loss of asset, and the two components are “undissected,” the full payment will be deemed as a capital receipt (Allsop v FCT). This only applied when a case settled pre-trial. If the dispute proceeded to trial, the judge must determine the different components as a matter of necessity.

•

Since introduction of CGT, this incentive to settle is not as important.

Statutory Income • •

Receipts are deemed as income because a provision in ITAA states they are income Examples include: o Employee allowances (s 26(e) ITAA 36) o Profits from a profit-making scheme (s 15 -15 ITAA 97) o Dividends (s 44 ITAA 36)

Summary • •

The notion of ordinary income has been developed by the courts Main features of ordinary income are:

7

o Must be income earning activity o Only monetary gains or gains convertible to money (now FBT) o Does not include capital receipts (now CGT) Income from Personal Exertion of Services • • •

Provision of services as either an employee or independent contractor Income relating activity is the provision of services Must be a sufficient nexus between receipt and services rendered

Employees and Independent Contractors • •

ITAA does not distinguish between payments between employees and payments to contractors. Distinction is important wrt FBT. The way you distinguish between employee and contractor is based on the of the engagement. That is, the control that the employer / person engaging the services has over the person.

Ordinary Income from services •

Must be sufficient nexus with services, eg: o Wages, Director’s Fees, Sales Commissions, Tips

•

In determining whether ordinary income is received, it is deemed to have been received by you (even if money not actually received) if it is supplied or dealt with according to your directions → deemed receipt s6-5(4) ITAA 97

Payne v FCT Employee who worked at KPMG and was required to travel. She ed frequent flyer program. Whenever she booked a ticket, points accrued in her name. Eventually she had enough points to book two return tickets to London in the name of her parents. Commissioner argued that the frequent flyer points were earned because of the course of her employment. She argued that she had a contractual relationship with QANTAS and that she had paid for hip. Also, the points were merely incidental to the course of her employment. Held: There was NOT a sufficient nexus between the benefit received (ie. frequent flyer points) and the course of her employment. The frequent flyer points arose as a

8

‘consequence’ of the employment but not ‘because’ of the employment – not sufficient. Note: TR 1999/6 → Commissioner accepted that flight rewards received by employees on work related travel are not ordinary income. Also, even if employer paid for the hip fee to the frequent flyer program, the points received is still NOT considered ordinary income. Statutory Income from Services •

• • •

Section 26(e) ITAA 1936 includes the value to T of all allowances or benefits given in respect of employment or services o Allowance and benefits → monetary / non-monetary; convertible / nonconvertible o In respect of employment or services (nb Payne and cf Cooke & Sherden) o The value to the T is subjective Largely overtaken by FBT but still has some operation Nb s6-10(3) → also subject to deemed receipt rule Designed to capture those benefits which are generally not considered ordinary income because of non-convertibility.

•

S21A tries to do the same as s26(e) in of business tax payers→ Cooke & Sherden

•

Test to be applied in valuing non-cash benefit is problematic (s26(e)) o No associated rule. Benefits could have been provided to someone else and then not be subjected to tax o Valuation mechanism → subjective rather than objective

•

FBT was introduced in response to the failure of s26(e). The tax now imposed on employer and the valuation rules are now objectively assessed.

•

s 6-25(2) states if amount considered both ordinary income and statutory income, then statutory income takes precedence under s26(e).

Gifts, Windfalls and Prizes •

Some gifts and other windfalls from employers are certainly NOT income, eg o Wedding gifts o Birthday presents

•

Payment where the payer had gone above and beyond their legal obligation may be considered to assessable. Some “gifts” are a reward for services and therefore income, eg. tips.

9

Dixon T received money from former employer to make up difference between military pay and salary he was receiving when working at the company. Amount was a patriotic gesture by employer. Held: •

Payments were ordinary income: o Payment was incidental to military service o Irrelevant that payment was made by someone other than current employer (ie. the military). o Regularity / periodic nature of receipt indicated ordinary income. o Motive from the employer is IRRELEVANT. All payments must be considered from the point of view from the recipient. o Court also considered s26(e) but held that provisions did not apply since section requires a current connection between payment and provision of services. Hayes T worked for company managed by Richardson, but also owned a few shares himself. Richardson wanted to acquire control of the company and thus wanted T to sell his shares in the company. Richardson told T that he would “get it back to him one day.” In the years following, even though T was no longer an employee, T gave ongoing advice as a friend. Years later, the company was listed on the share market and Richardson gifted a portion of the returns to T. Held: •

Payment was a gift NOT ordinary income: o There was no nexus between the provision of services by T and the eventual amount received. o The motive of the payer “to get it back to him one day” was not a decisive factor o A ‘personal friendship’ may indicate that amount received is NOT income. o T was already adequately compensated for services

Scott

10

T was a solicitor who had acted for Mrs Freestone and her late husband and represented her in relation to istering his estate. He charged 895 pounds. Just before estate settled, she gave T 10,000 pounds, saying that it was in gratitude of his friendship and assistance. Commissioner was relying on ordinary income provisions and s26(e). Held: •

Amount received was a gift and NOT ordinary income o Gift of an exceptional kind due to the largeness of the ‘tip.’ The provision of money must be a reasonable product of the services provided. T was already adequately compensated for services. o Not enough that there was a link, must be sufficient. o Nexus not satisfied o Personal friendship may indicate amount NOT income

Smith Westpac employee received $570 from employer, described as an allowance for the successful completion of approved course of study. Commissioner argued allowance was assessable under s26(e). T argued that s26(e) only cover noncash amounts. Held: •

Payment was income according to s26(e) o Established scheme encouraging employees to complete an approved course of study, which enhanced the employee’s value to the company. Money was not given in any gratuitous nature → nexus satisfied. o s26(e) clearly covers cash benefits as well as non-cash benefits

Holmes Owner of oil tanker engaged a company to salvage the tanker which had sunk. Owner of tanker also paid of the crew an extra reward. Owner agreed before-hand that if tanker salvaged, then payment (including reward) would be paid. Held: •

Amount was income according to s26(e) o Clear connection between payment and services rendered. o Doesn’t matter if paid by a third party o Doesn’t matter if T has been fully remunerated for work done. 11

Brown Minister for Tourism (Brown) arranged a meeting between Australian property development company and Japanese investor. Brown went with Australian company to Japan to settle the sale of land. The company transferred a beach front property to Brown valued at $1,000,000. There was a contract between Brown and company stating that he was owed $1,000,000 for introducing the two parties and assisting in the settlement of property. Brown argued that it was merely a gift. Held: •

Value of property assessable as non-cash business benefit s21A (s26(e) equivalent) o Nexus between services provided and receipt of property clearly satisfied. o Irrelevant that his work for the company was not his main source of income – ie. employment as a politician.

Prizes •

Is there a sufficient link between prize and the provision of services

Kelly T was a footballer who received match payments in SANFL during 1978 from his football club. T won the Channel 7 Sandover medal award and received $20,000. Commissioner argued either ordinary income or s26(e). Held: •

Amount was assessable under s26(e) o T’s eligibility to receive payment was the fact that he was a footballer and thus there was a sufficient nexus. o The payment was NOT for services rendered but rather a recognised incident of his employment as a footballer. o Fact that payment made by third party (ie. channel 7) is irrelevant.

Stone T was a javelin thrower and was also employed by Queensland Police Department (main source of income). Department gave her time off to let her train. She received various amounts during 1998 year to assist her preparation

12

from sponsors and grants from various bodies. She accepted that appearance fees were ordinary income. She argued that some of the prizes she had received during the year were NOT income. Commissioner argued that competing in events in which you receive prizes necessarily involves provision of services Held: •

T was not in business and therefore amounts received are not income o Person may pursue sports as a hobby as opposed to someone who pursues sports in the form of a business. o NOTE: High Court allowed commissioner’s appeal finding amounts were income.  The fact T received sponsorship funds was decisive in court finding that she was carrying on a business

UK Cases Seymore v Reed • •

Gate-taking receipts given to cricketer due to years of excellent service. Court held not income because given voluntarily due to personal qualities of cricketer. NOTE: This is not good law.

Moorhouse v Dooland • • •

Gate-taking of cricketer testimonial deemed as income because in his contract that he was entitled to receipts Clearly provision of services Doesn’t matter that amount was given by spectators

Fringe Benefits Tax •

•

Fringe Benefits Tax Assessment Act (FBTAA) introduced in 1986 o broaden income base o address problems in s 26(e) eg objective valuation rules o employer pays tax at 48.5% o may encourage “salary sacrificing” [3.335] and [7.65] – the number of benefits are tax concession The commissioner (in 3.335) – tax ruling: o Accepts that if you have entered into the salary sacrificing arrangement before you have earned the remuneration, then it will be effective for tax purposes

13

o If you have earned it, s 654 will apply. Applying the FBTAA • • •

Section 66(1) FBTAA 1986 states that FBT is payable by the employer. Deemed receipt or constructive receipt rule under the Act  deemed to have the 20k as you have directed it. There are tax advantages in the employer making super contribution

• • •

Step 1: Is there a fringe benefit? Step 2: calculating the taxable value of the fringe benefit Step 3: calculating the FBT payable

Step 1 Definition • ‘Fringe Benefit’ defined in 136(1) – general definitions section o A benefit provided to employee or associate o Provided during the year by employer or associate / third party of employer o Provided in respect of employment – sufficient and material connection between the benefit provided and employment (J&G Knowles) • • • •

•

An employee is any current, future or former employee Employer is someone who is obliged to pay salary and wages An associate can be family relatives (including de facto spouse) or associated entities If a third party provides a FB where there is an arrangement between the employer and the third party, in which the employer has knowledge and participates in the arrangement, the FBT will still be paid by the employer. FB excludes certain things (s136 para f – r definitions section) o Salary and wages, bonuses and allowances o Voluntary contributions to employee super funds (para J)

Knowles v FCT Making of an interest free loan. The recipient of benefit was both an employee of company and a shareholder. The commissioner argued that the benefit was made in respect of employment and therefore subject to FBT. Held:

14

• •

In the case of Smith, court held that it is not enough that there is some connection, but must be sufficient and material connection between benefit and services provided. In this case, court held that benefit was provided to employee in their role as a shareholder of the company. The loan would not have been available to an ordinary employee.

Types of Fringe Benefits • •

FBT legislation identifies 11 particular benefits and tells you how to tax them. If benefit does not fall within divisions 1 – 11, it will be caught as a residual benefit (div 12). o Cars Fringe Benefit (Div 2)  Arises on any day which the car is available for private use. Deeming rule that if car is kept in the garage of the employee then it is still available for private use. o Loan Fringe Benefit (Div 4)  Loan is taken to exist in any year when a portion of the loan remains unpaid. However, if loan is at market rates, then there may be NO taxable value o Property Fringe Benefit (Div 11)  There is a benefit when employer provides a discount to employee for goods sold in their store. o Expense payment Fringe Benefit (Div 5)  Where employer makes a payment for employee OR employee makes payment and is reimbursed by employer. Payment must be of a personal nature or not a business related expense

Road Traffic Authority v FCT Employees negotiated with employers that their transport expenses would be covered by the company. Employees were given option as to what mode of transport they chose and did not have to provide receipts. The commissioner argued that this was a reimbursement of an expense and thus a fringe benefit. Held: • •

Amount was NOT a reimbursement Reimbursement is when employee is compensated EXACTLY for expense already incurred.

15

•

A requirement that the recipient vouches for the cost would indicate a reimbursement.

•

TR 92/15 → payment is an allowance when recipient is given an amount expected to cover an expense, regardless of whether it is used or not. If characterized as an allowance, then considered salary and wages, thus the employee will pay tax. Hence, the distinction is important.

Exemptions •

There are some benefits which are exempt from FBT o Child Care services on premises (s47(2)) o Minor benefits (s58P). Notional taxable value is less than $100 and provided infrequently. o Work related items (s58X). Includes mobile phones, lap tops and diaries. o Property benefits (s41). If property provided to employees and is consumed on the premises. Includes in-house dining facilities. o First $500 of ‘in-house’ fringe benefits per employee (s62).

Interaction between FBTAA and ITAA • • •

s 66(1) → FBT is payable by the employer s 23L(1) → a FB (including exempt FB) is treated as exempt income of the employee s 26(e)(iv) → a FB (including exempt FB) is excluded from s 26(e) statutory income of employee

Step 2 – Calculating the taxable value *See worksheet provided by Ann O’Connell •

Cars o Statutory formula x Base Value x (Days of Private Use / 365) o Log book method

•

Loans o Any difference between interest rate provided and the statutory interest rate o Loan amount x (Statutory Interest Rate – Interest Rate Provided) o Statutory interest rate at 31 March 2005 is 7.05%

16

•

Expense Payments o Taxable value will just equal the exact amount of the reimbursement o Eg. Employer paid airline ticket for $1000. The taxable value will be $1000

•

Property Benefits o In-house fringe benefits → taxable value is 75% of the lowest price you would sell to the public (s42) o External fringe benefits → taxable value is the amount paid by the employer for the benefit (s43)

Reduction Factors of Taxable Value •

Contribution by employee (recipient’s contribution) o Eg. if employee pays for petrol on use of car

•

The ‘otherwise deductible’ rule o If fringe benefit is used for business purposes, it should be subject for less tax. If employee could have claimed a deduction for the expense if he had paid for it, then the taxable value is reduced.  Eg. Employer provided airline ticket for $1000 for business trip. If employee made expenditure, they could have made a deduction, thus the taxable value is reduced to zero.  Eg. Interest on loans will be deductible to employee if the money is used for an income producing purpose. If interest rate provided by employer is 5% for an income generating purpose, then the taxable value is reduced to zero. If money is used half for income generating purpose and half for private use, the taxable value is halved.

Step 3 – Calculating the FBT Payable •

All of the employers taxable values are added together on all employees fringe benefits • Total of taxable values ‘grossed up’ to represent the amount that would have been paid if they provided an after tax cash amount. • Employer subject to tax at 48.5% of the grossed up taxable value • Employer entitled to deduct pre-grossed up taxable value AND actual FBT paid. • Thus there is no incentive two pay between salaries & wages or fringe benefits. The only advantage to fringe benefits is the concessional rules in which certain benefits are exempt. INCOME FROM BUSINESS

17

Is there a “business”? •

If T carrying on business, proceeds will be assessable and expenses deductible

Ferguson T was a naval officer who wanted to start a primary production business. T purchased 5 cows to start business. He engaged a management company to manage the cows for a period of 10 years. Eventually T hoped to have over 200 cows. Court had to determine whether costs were deductible. Held: • •

•

Start up costs are generally not deductible, but CAPITAL in nature Court stated must look to a number of factors: o Nature of activities – commerciality (ie. profit motive) or hobby o Repetition and regularity of activity. However, every business must start somewhere, so the first expense can be deductible. o Organised nature of the business o Size of organisation Held that T was carrying on a business.

Walker T was an employee of a company but decided to purchase an angora goat, which produced offspring. A number of the offspring and the original goat died. Held: • • • • • • •

Planned on selling the goat when market was high Eventually made a loss, but still had a profit making motive Hired a manager to oversee operation Maintained ing records Scale of the operation was rather small. The court still held that T was in business A person can carry on a business, even if it is small in nature.

Hypothetical Is T carrying on a business?

18

Start by saying that if T is in business, any income is assessable and expenses are deductible. If hobby not assessable or deductible. Look to TR 97/11 for list of factors to see if carrying on a business or not. No one factor is decisive. Must look at all factors and decide on a holistic approach. FACTORS: o Repetition  Volume of independent sales o Organisation of business like activity  Hire a manager to look after activities (Ferguson and Walker)  Keep records of sales and expenses with ing package  hip of professional body o Size/scale  The larger the activity the more likely carrying on a business  However, can use Walker to assertion that just because small in size does not mean precluded from carrying on business. If so, need evidence of planned expansion (Ferguson and Walker)  Must also consider whether she has started a business YET? Softwood Pulp and Paper case identifies person undertaking feasibility studies to see if they would start business. o Profit Motive  T should charge more than cost price  Just because there are sales does not necessarily mean there is a profit making intention o Majority of income  According to Stone, Ferguson and Walker, existence of other employment did not preclude finding that they were in business. If you conclude that she is carrying on a business MUST SAY that receipts are assessable and expenses are deductible. Business / Hobby distinction •

Proceeds from a hobby are not AI, and expenses not deductible

Stone •

The case of Stone has now been decided in High Court

19

•

Once T receives sponsorship, they are considered in business and therefore prizes and grants are deemed as assessable. • Not all sportspersons will be held to be liable for tax → must receive sponsorship • This case isn’t too instructive as it turns on the facts Trautwein v FCT T was a punter who was successful over a long period in gambling and betting on horse races. T also engaged in other business activities such as running a hotel. T spent a considerable amount of time betting. T also involved in breeding horses. There was no real system of organisation as he did not keep ing records. In the previous year T claimed deductions for gambling (so obviously he thought it was a business). In the current year T had more winnings than deductions and thus claimed gambling was his hobby. Held: •

T carrying on a business of betting thus winnings AI o Betting was systematic and frequent o A lot of time devoted to betting o T’s involvement in training and breeding horses reduced the element of chance in betting and thus distinguishable from a normal ‘punter.’

Evans v FCT T was a punter who was successful in betting on racehorses over a five year period. T also owned racehorses but was not profitable for T. Held: •

T was NOT carrying on a business o T lacked essential elements of system and organisation. T did not spend large amount of time studying form guide, did not subscribe to tipping information service, nor did he speak to other trainers o The fact T owned racehorses is irrelevant o Activity involving a high level of chance which makes it less likely to be a business.

Note: Courts tend to regard gambling as a matter of chance and not something business like in nature. On other hand, something taking on a more business like nature could not be said to be a hobby. For example, an actuary engaging in futures trading.

20

Timing •

An expense may be incurred prior to the commencement of the business. If so, they are NOT deductible and form part of the capital cost of establishing the business.

Softwood Pulp & Paper Ltd v FCT T was a company which was undertaking feasibility studies in relation to establishing a paper production facility. T incurred expenses of $230,000 in acquiring supplies of timber for proposed mill. The venture was abandoned, thus paper production never went ahead. Held: •

T was not carrying on a business and thus expenses not deductible o T never reached a stage remotely near carrying on of a business o All that had been done was an investigation as to the feasibility of whether a business would be economically viable

FCT v Osborne T had a leasehold interest in farming property. T intended to grow chestnuts on a commercial basis. T planted lupin seed and ploughed the soil to prepare the land for chestnut cultivation. However, T decided it was not viable and abandoned the venture due to shortage of water. T tried to deduct cost of sowing the crop. Held: •

T was carrying on a business BUT expenses NOT deductible → capital in nature o Sufficient scale to be more than a hobby since time and money invested, as well as profit making intention o Preparing the soil was not merely preparatory to carrying on a business o It is difficult to ascertain when a business of PP begins but it is certainly well before trees bear fruit. Note: T does not need to identify a particular stage at which business begins.

AGC (Advances) Ltd v FCT

21

T was a business financing the purchase of goods under hire purchase agreements. T was subject to investigations and ceased to operate in 1968. Business allowed to recommence 16 months later. There was some reorganization of the business. T tried to claim bad debts during the intervening period. Held: •

T had continued to carry on the same business and thus expenses deductible o Break in years was relatively short o Irrelevant that company changed name and address o Nature of the company activities were exactly the same o A continuation of company after termination is a question of fact to be determined on a case-by-case basis

Ordinary / statutory income from business •

Ordinary income concepts (s 6-5) o AI includes receipts in the ordinary course of business and may include receipts outside the ordinary course of business

•

Statutory income o s 15-15 ITAA97  AI includes profits arising from a profit-making undertaking or plan  Does not include: • Profits assessable as ordinary income. If amount could be ordinary income and profit income under s15-15, then tax as ordinary income. • Profits arising from sale of property acquired after 20/9/1985 o s 21A ITAA36  Non-cash business benefit that is not convertible to cash shall be deemed convertible and ed for at arm’s length value  Introduced because Cooke & Sherden (soft drink suppliers received a business holiday from supplier and held s 26(e) because T was carrying on a business

Isolated profit-making ventures •

Profits from isolated profit making ventures can be either ordinary income or s15-15

22

Scottish Australian Mining Co Ltd v FCT Note: this was Australian position before Whitford’s Beach which now applies T was a mining company which operated a coal mine on land which it owned. When the coal was exhausted in the mid 1920s, T decided the sell-off the land. Due to the size of the land, T carried out an extensive subdivision and development of the land. Commissioner argued T should be assessed on the profits on the resale of the land because T was either carrying on a business of land dev (ordinary income principles s6-5) or alternatively, profits made from undertaking a plan (statutory income → at the time under s 26A, now s 15-15). Held: •

Profits were not assessable o T was not in the business of land development o T had not acquired the land intending to develop it. o T was merely realising an asset when it could no longer be used a part of mining business. Even though there was extensive subdivision activity, that is not enough to convert a realization of a capital asset into a business. o Profit derived from sale of a capital asset, undertaken in an enterprising manner is NOT ordinary income

FCT v Whitford’s Beach Pty Ltd Land acquired by Whitford’s Beach Pty Ltd as a recreational fishing company in 1954. In 1967 an experienced land developer (T) decided to purchase the shares in Whitford’s Beach Pty Ltd, which owned the land for $1.6m. Obvious that if T purchased land outright from the company it would be a business venture and thus taxed on profit derived from sale. This strategy was based on reasoning in Scottish where court found developing land and realizing it in an enterprising manner is not assessable. T changed articles of association to allow land development. T subdivided and built infrastructure on land between 1967 and 1969. T eventually sold the land in 1970 and derived profit of about $7m. Commissioner argued profit assessable as either ordinary income (s 6-5) or statutory income (now s 15-15 then s 25A) Held: •

Profit derived was assessable as ordinary income s 6-5 o The activities involved in developing land constituted business activities

23

o Mason J critical of Scottish Mining by suggesting that land development of that scale could not possibly be mere realization. Possibly realization if on a small parcel of land. Extensive nature of activity enough to classify the activity as a business. o Look through the ‘corporate veil.’ The business was a different business after 1967. Purpose of those acquiring the company was to begin a business venture for profit making purposes. o Profit could have been s 15-15, but since s15-15(2) states if potentially both, ordinary income (s6-5) takes precedence. o Overall principle is that if a T develops land itself, it is treated as having commenced the business of land development. o Court also looked at the ‘net gain’ as ordinary income and NOT gross receipts. Unfair to look at gross receipts due to huge potential capital appreciation since property acquired in 1954 and thus huge potential profit and tax bill. Deduct cost of development and value of land at acquisition, ie, 1967. Receipts in Ordinary Course of Business •

Includes both ordinary business receipts and receipts incidental to the ordinary course of business

GP International Pipecoaters v FCT T was a company that won tender to do pipe coating work with SEC of Western Australia. Contract stipulated that T would build factory near pipeline, which would be reimbursed by SEC, but still belong to the taxpayer. Not considered a gift or windfall because the building would be obsolete at the end of the contract. Contract stated SEC would pay 15% of contract price up front, ie. $4 million to build the factory. Commissioner argued upfront receipt was assessable. T argued it was a capital receipt because the amount was intended for the construction of the building. Held: •

The receipt was income o T was remunerated under the contract to establish factory AND coat the pipes. As the amount received was stipulated under contract, it was in the ordinary course of GP’s business. o Must determine the nature of the receipt in the hands of the recipient.

FCT v GKN Kwikiform

24

T was a company which hired out scaffolding to the public. The leasing transaction with customers included a fee for damaged or non-returned equipment. Issue was whether these fees are income or capital. Held: •

The fees charged are income o Fees were charged purely to re-imburse T. Fee was not a ‘sale’ of the property to the customer at end of leasing agreement. o The receipt is analogous to an additional fee payable in respect of the hire of goods and thus income o Receipt is incidental to ordinary business activity

FCT v Hyteco Hiring T was a company which hired out forklifts. T acquired forklifts on a lease arrangement from financier. T would eventually sell the forklifts once they became redundant. Commissioner argued that sale of redundant forklifts was an incidental aspect of ordinary business. T argued that its business did not include the sale of redundant forklifts. Held: •

Sale of forklifts outside the scope of T’s business thus not ordinary income o Distinguished GKN Kwikiform on the basis that profit in present case was not inevitable, nor did it arise from leasing transaction itself o Sale of forklifts was a sale of the very apparatus with which T conducted business, and not a profit from the process by which T operated to earn regular returns.

FCT v Montgomery – lease incentive payment There was a glut of commercial tenancies. Landlords offered an incentive payment for ‘headline’ tenants. Cases often involved legal firms g up for long-term leases and then receiving incentive payment from landlord. T was one such legal firm. T argued that the payment was outside ordinary incident of their business which merely involved provision of legal services. Further argued payment related to structure of the business. However, evidence was produced that T moved to this new building due to the incentive payment. Held: •

Incentive payment is within the ordinary incidents of firm’s activities thus income

25

o Clearly not part of firm’s legal activities BUT moving to new premises from time to time is a part of the firm’s business. o Payment does relate to business structure BUT the partners exploited the business structure for a profit making purpose thus ordinary income. FCT v Myer Emporium Ltd Myer Emporium lent subsidiary Myer Finance $80m at 12.5% for 7.25 years. Three days later Myer Emporium assigned the right to receive the interest to Citicorp. Citicorp in exchange for that right paid a lump sum of $46.3 million. Thus, for the next 7.25 years, Myer Finance would pay interest and then at the end of contract they would pay lump sum of $80 million to Citicorp. Motivations Myer wanted to borrow money externally, but was restricted by debenture trust deed which said that it could not borrow any more externally. Hence, set up subsidiary Myer Finance. Citicorp was prepared to lend money to the group. Citicorp was indifferent to who it got the interest from. $46.3 million was the NPV of the $80 million loan discounted by 12.5%. Thus, Citicorp received no real benefit in of return on its investment. However, Citicorp had accumulated tax losses to off-set the interest revenue. The period of assignment had to be more than 7 years, because anything less would trigger anti-avoidance measures. Market rate of interest set so as to not be accused of tax avoidance. Entering into transaction of this nature was not really in Myer’s ordinary course of business as Myer was primarily a retail store. Myer also argued that it was a capital receipt for asg its rights to the loan. The commissioner argued that it should still be considered as a business receipt even though it was an extraordinary receipt. Held: •

$46.3 million was ordinary income. Court revealed two strands of reasoning: o Proceeds of a transaction outside the ordinary course of business will be considered income if it is entered into with a profit making purpose.  However, if you take this rule, then EVERY transaction entered into by a business will be profit making purpose o Myer converted income stream (interest) into a lump sum ($46.3 million)  Substitution principle

26

Criticism of Myer •

On the facts, where is the profit?

•

Court ruled ordinary income, even though could have been s 15-15. In exam question, should mention that courts have favoured ordinary income over s15-15, even though their tax treatment is the same

•

Seems to suggest that every receipt by a T in a business is assessable, but see Westfield v FCT.

Westfield v FCT T purchased land to develop a shopping centre. proceed and T sold land at a profit.

Shopping centre did not

Held: •

Profit derived was of a capital nature and thus NOT ordinary income o It does not follow from Myer that every receipt by a business is income. o The mode of profit making must be one of the considered alternatives at time of entering into transaction – subjective intention o T’s profit making purpose was to develop and manage a shopping centre NOT to sell the land at a profit o The sale is not in the ordinary course of business nor is it incidental.

Taxation Ruling 92/3 •

Sets out commissioner’s view on what Myer stands for. o Profit from isolated transaction when:  Intention of T was to make a profit or gain; and  Profit was made in the course in carrying out the business

•

Commissioner states the mode of profit does NOT need to be specifically contemplated by the taxpayer. This is inconsistent with decision in Westfield. Tax ruling is only commissioner’s opinion thus not decisive.

•

CAPITAL RECEIPTS FROM BUSINESS

27

Compensation Receipts • •

Compensation for termination of structural contracts is a capital receipts Compensation for termination of trading contracts is assessable income

Californian Oil Products T had a contract to be exclusive agent of brand of petrol in NSW for 5 years. In first year, contract was cancelled whereby T was entitled to compensation. Received compensation in 10 half-yearly instalments, measured by reference to future income of T. The agency was the sole business of T. Following the termination of contract T went out of business. Commissioner argued assessable because regular nature of receipt and compensation for lost income. Held: •

Compensation payment is a capital receipt o Payment was for the relinquishment of the loss of the ENTIRE business. o T’s business was premised on the existence of the exclusive agency contract and thus had no other choice but to close down upon termination

Heavy Minerals T was a company which mined a mineral called rutile. T entered a number of long-term supply contracts while price for rutile was high. The price of rutile dropped causing buyers to cancel the contract. T was paid out for the remainder of the outstanding contracts. After cancellation of contracts T went out of business. Held: •

Compensation receipts were assessable as ordinary income o Contracts were not structural assets because T still had the use of the rutile mines. T was free to mine and sell the rutile if he could find a buyer. All that happened was a fall in price which made mining of rutile unprofitable. o Distinguished from California Oil because here T still had capital assets and thus opportunity to continue mining.

Merv Brown

28

T was wholesaler of clothing made both within Australia and also imported garments. T had quota rights on the sale of imported clothing. T decided to sell those quota rights which were unprofitable and focus on those quota rights that were profitable. Held: •

Receipt from sale of quota rights capital in nature o T was primarily concerned with future structure of business operations, in of what lines of clothing he would sell. o Quotas were a structural asset of T’s business o Transactions were neither normal incidents of T’s business nor a purpose for which T carried on business.

London Australia Investment Co Pty Ltd T was an investment company which had a policy of holding income yielding investments rather than to derive profit by trading in shares. When a shares yield dropped below a certain standard, T would sell the share, irrespective of share price. Commissioner wanted to assess the receipt on the sale of shares Held: •

Receipt on sale of share assessable income o Sale of shares was a normal aspect of carrying on a business of investing in shares. Even though policy was not to sell shares at a profit necessarily, it was clearly an ordinary aspect of business.

AGC Investments T sold a significant portion of its share portfolio because it thought the market was about to crash. Issue before the court was to characterize T’s purpose in acquiring the shares. T argued that the shares were acquired on a long term basis and thus were only realized in these exceptional circumstances, thus should not be assessable. Held: •

Profits from sale of shares are capital in nature and thus NOT assessable o T did not acquire shares with intention of realizing a profit o Distinguished this case from banking and finance cases

Summary 29

• • • • •

Receipts in the ordinary course of business or incidental to it will be ordinary income. Issue may be whether T is carrying on business Receipts outside the ordinary course of business may be income if there is a sufficient profit-making purpose (OI or s 15-15) (Myer Emporium) Receipts from isolated profit-making ventures may be income (OI or s 15-15) (Whitfords Beach) Receipts that compensate for loss of income will be income (eg Heavy Minerals cf Calif Oil where it was to compensate for the loss of entire business) Receipts from disposing of assets will be capital unless disposal is part of business (eg London Australia Investments cf AGC)

INCOME FROM PROPERTY Royalties •

There are two types of royalties: o General law royalties o Statutory royalties

•

General law royalties (ordinary royalties) are assessable under either: o Ordinary income s 6-5; or o Statutory income s 15-20

•

General law royalties are ALWAYS assessable irrespective of whether they are ordinary income or capital.

•

Essential feature of general law royalty is that payment is calculated by reference to use or exercise of the right.

McCauley v FCT T was a dairy farmer who owned land on which tree were growing. T entered into contract to sell the right to cut and remove the timber trees growing on his property. Contract stipulated that T would be paid 3 shillings for every 100 feet of timber cut. Purchaser agreed to pay in monthly instalments based on the amount of timber cut. Held:

30

• •

The agreement was a general law (ordinary) royalty because payments were made in direct relation to the quantity of timber cut and removed Even though it was OR, held to be capital in nature thus assessable under s 15-20 (formerly s26(f)).

Stanton v FCT T was a grazier who sold the rights to cut and remove a set quantity of standing timber on his land to a sawmiller for a fixed sum. Payments were made quarterly by sawmiller and expressly stated NOT to be related to the removal of timber. Held: •

The amounts paid to T were NOT an ordinary royalty because it was not related to the amount of timber cut and removed from T’s land.

Hypothetical • •

Whether it is income from business or payment for services Is T an Australian resident or not? o If not Australian resident look to see if falls within definition of royalties under s6-1. o If Australian resident, must see if ordinary royalty (OR)?  It will be OR if payment received is dependent on the extent of use of the right.  Stanton → paid fixed sum regardless of how much timber removed therefore NOT an OR.  If you have OR then always AI.  Must check to see if OR is assessable as ordinary income under s6-5 or statutory income under s15-20.  See whether T has sold their entire right to property such that they cannot do anything with it in the future. If so, OR is capital and assessable under statutory provisions s15-20. In McCauley court found OR was not ordinary income, BUT capital in nature and thus statutory income because once timber removed, cannot use it again.  If T has only sold the right to use property for certain period and thus retains the ability to use the right in the future, OR will be assessable as ordinary income s 6-5. For example, T sells license to use copyright for 5 years when T holds the original copyright for 15 years. T retains ability to use right in the future.

31

CAPITAL GAINS TAX Introduction • • • •

•

Pre-1985 gains on sale of assets held to capital → not included in ordinary income Example of statutory income s6-10 ITAA 1997 Not a separate tax Net gains included in assessable income but net losses are “quarantined” – capital losses are not offset against other income o Losses carried forward – and offset them from future capital gains (quarantine) Some exceptions and concessions o Cars o Main residence o Concessions – the discount

Framework for Approaching CGT •

Do you have a CGT asset or not? o Generally not really an issue o Just state that ‘x’ is a CGT asset (s108-5)

•

Need to check that there is a CGT event o A1 → Disposal of CGT asset (s 104-10) o C1 → Loss or destruction of CGT asset (s 104-20) o C2 → Cancellation, surrender or similar ending (s 104-25) o See summary table under s104-5

•

Need to check if it is a personal use asset o Definition important (s 108-20(2)) o Losses from personal use asset are always disregarded (s10820(1)) o Gain from personal use asset disregarded IF CB is less than $10,000 (s118-10(3))

•

If you don’t have personal use asset just check to see if collectable o Definition important (s 108-10(2)) o Losses from collectables are quarantined against gains from collectables (s108-10(1)) o Gains AND losses from collectables are disregarded if CB less than $500 (s118-10(1))

32

o Total CGT exemption for some personal use assets or collectables (s118-5)  Includes car, motor cycle or similar vehicle •

• • •

Need to consider rollover relief exemptions o Death (ss128) o Replacement asset (s124) o Same asset rollover (s126) From this point can calculate net gains or losses Discounting only occurs AFTER all losses are offset against all gains Cannot discount capital gain which arises from a D1, D2 or D3 event (s11525(3))

Step 1: Does the transaction give rise to CGT consequences? CGT Event A1 • • • • • •

Disposal of CGT asset Dispose of CGT asset if change of ownership occurs from you to another entity Time of CGT event is generally when you enter into contract. If no contract, then occurs when change of ownership occurs. Covers 95% of CGT events Sale of real estate generally change of ownership occurs at settlement. However, CGT event officially occurs when the parties enter into contract Giving of a gift means no contract therefore CGT events occurs when change of ownership

CT v Sara Lee HBC Aust Ltd T was a US company (Sara Lee) sold pharmaceutical subsidiary business operating in Australia and other countries. They signed a global contract on 1 May 1991. They then sat down and negotiated the of the contract and made amendments. They increased purchase price for $1 million and substituted a different company as the purchaser. This amendment agreement was signed in August 1991. T argued that the time of disposal was the August 1991. T’s motivation was to utilize capital losses in the 91/92 financial year to offset the capital gains of this disposal. They did not have capital losses in 90/91 to offset these amounts. Held: • •

Contract was entered in May 1991 When there are two or more contracts, you must determine which of the two contracts creates an obligation to dispose:

33

o Work out which of the contracts is properly seen as the source of the obligations to effect the disposal. o This was the first contract that gave right to the obligation (SL argued that the 2nd one was substantially different) McDonald v FCT T purchased land in 1985. T entered into oral contract on 18 September 1985. T only entered written contract on 31 October 1985. The relevant date is important to determine whether acquisition was pre or post CGT. Held: • • •

Clear practice in NSW to enter into sale of land with a written contract. It was appropriate to say that there was no disposal of land until Oct written contract. Require clear evidence of intention to proceed if there is only an oral contract.

CGT Events C1 and C2 •

Event C1 happens when CGT asset you own is lost of destroyed. o Eg. Building destroyed by fire → the time of the event is either when you first receive compensation for the loss of destruction OR if you receive no compensation when the loss or destruction is discovered / occurred.

•

Event C2 happens when ownership of intangible CGT asset cancelled / expired / abandoned / exercised. o Eg. Debts & contractual rights, shares → contractual right comes to an end and you are entitled to $100 compensation. $100 is capital gain.

FCT v Orica T (Orica – ICI) owed money under public debenture. T entered into debt defeasance agreement with MMBW (government agency) to transfer the obligations in exchange for $62m (PV of $98m debenture liability over term of 10 years). Orica included a historical cost profit amount of $36m. FCT wanted to tax that amount as AI. Issue here is that there is no ‘receipt’ of $36m. Orica is merely better off by $36m. Commissioner wanted to tax $36m as AI but problem because there was no ‘flow’ of money to pay the tax.

34

Held: •

T’s contractual right when entering into agreement with MMBW is a CGT asset. • CGT applied – the equivalent of CGT event C 2 applied because under the arrangement the TP remained nominally liable to each of the debenture holders – they simply assigned the interest.

•

Every time MMBW makes a payment under agreement to debenture holders, part of T’s CGT asset is discharged. • Everytime MMBW repaid part of the debt – the obligation of TP to repay expired – and so for each year until debentures were fully repaid there would be a capital gain arising to TP that would eventually add up to 36M.

•

NOTE: Problem with this case is that every time someone performs obligations under contract should not mean a CGT event. However, not many cases since Orica where broad approach applied. When contractual rights discharged may be a CGT event

•

Collectables A collectable is → s 108-10(2) (a) (b) (c)

Artwork, jewellery, antiques, coins, medallions; A rare folio, manuscript or book; A postage stamp or first day cover used or kept mainly for personal use or enjoyment

•

Note: TD 1999/40 → ‘antique’ is something over 100 years old

• •

Capital Gains AND Losses disregarded if CB less than $500 → s 118-10(1) Capital losses from collectables are quarantined → s 108-10(1) o Can only offset capital losses from collectables with capital gains with collectables

Personal Use Asset

• •

• Any other CGT asset used or kept mainly for personal use or enjoyment, except land (s 108-20(2), (3)) Capital gains disregarded if CB less than $10,000 (s118-10(3)) Capital losses from personal use assets are disregarded (s108-20(1))

35

CGT Exemptions •

Anti-overlap provisions → s 118-20 o A capital gain from a CGT is reduced to the extent it has already been included in your assessable income OR exempt income o Eg. Property Developer likely to have sale proceeds as income o Also see below •

Depreciating assets → s 118-24 o Capital gain or capital loss from disposal of depreciating asset is disregarded o Machinery and plant items are excluded from CGT o See s 40-30 for definition of depreciating asset

•

Motor vehicles → s118-5 o enger vehicle designed to carry less than 9 people and weighs less than 1 tonne

•

Trading stock → s118-25 o Disposing of it everyday o Special rules

•

Exempt capital receipts → s 118-37 o Compensation for personal injury or wrong suffered in occupation o Gambling receipts, game, or competition with prizes

•

Small business exemptions → Div 152

Main residence exemption (Subdiv 118-B) •

Only available if T is an individual and dwelling is “main residence” o However, notion of main residence is not defined o Can include an ading residence within 2 hectares

•

Issue when you own more than one dwelling: TD 51 (1992) o Cannot choose your MR o The identification of MR is a question of fact  Length of time spent at each residence  Whether T moved personal belongings into residence  T’s mailing address  T’s address on electoral roll

•

Absence from dwelling → s 118-145

36

o If posted overseas and renting out MR for example, provided that you do not purchase another dwelling, you can still have it as MR even if absent for a period of up to 6 years. Entitled to another period of 6 years each time dwelling becomes and ceases to be MR. o If you don’t rent out property and don’t purchase a second dwelling, doesn’t matter how long you are absent for •

May only be entitled to partial exemption → s 118-190 o If ¼ of property used for business purposes, then ¾ of property CGT exempt o If owned property for 20 years but were absent for 10 years, can only claim exemption for ½ the time o Having a home study does not affect main residence exemption

•

Note: if acquire MR from deceased estate: s 118-195 o Any gain will be disregarded if sold within 2 years of death; or o Beneficiary lives in the house and then sells it

Rollovers • •

•

If rollover applies it means that CGT liability is deferred Effect of death o Disposal on death disregarded, ie. no tax liability → s 128 -10 o Beneficiary taken to acquire asset on date of death → s 128-15 o Rule: o if the deceased acquired asset before Sept 1985 – then B’s cost base is the market value on the date of death (effect of this is that any gain that accrued up to the date of death is disregarded) o If the deceased acquired the asset after 1985 – then beneficiary is taken to have acquired the asset on the date of death but at the deceased’s cost base (deferral of the gain until B disposes of it) o S 118 – 195: part of main residence exception – if asset that es to B is deceased main residence then it will be exempt in the hands of the B if either B lives in the property or it is sold within two years of death

Replacement asset rollovers → Div 124 o Asset lost and new asset acquired o New asset will have same characteristic as old asset o Eg. If old asset was pre-1985, the new asset will also be CGT exempt

37

•

Same asset rollovers: Div 126 o Marriage breakdown rollover (see s 126-5)  CGT event will occur if a transfer occurs between spouses under an order of the family court  If wife transferring half share of land to husband, then no capital gain or loss is recorded to transferor.  If post-1985 asset, transferee deemed to acquired asset at date of settlement  If pre-1985 asset, transferee deemed to acquired asset at original date acquired by transferor  If post-1985 asset, transferee deemed to acquire asset for the existing CB at the date of settlement.  If pre-1985 asset, then entitled to still be pre-CGT asset.

Step 2: Calculating the gain or loss from a CGT event • There will be a capital gain if the capital proceeds > cost base of the asset • There will be a capital loss if the capital proceeds < cost base of the asset Capital proceeds → s 116-20 •

• 30

Includes: o Money received; and o Market value of property received Modify capital proceeds for “market value substitution rule” if → s 116o No capital proceeds; or o Proceeds can’t be valued; or o Non-arm’s length dealing → where parties have pre-existing relationship

Cost Base → s 110-25 •

Includes: 1. Money paid or market value of property given to acquire asset 2. Incidental costs on acquisition and disposal → s 110-35  Legal fees  Payments to professional advisors → valuers / auctioneers / brokers

38

 Transfer costs  Stamp duty  Advertising 3. Non-capital costs (non-deductible costs) of ownership  Interest or rates  But don’t include these costs if they are deductible 4. Cost of capital improvements made to property 5. Capital expenditure in respect of title  Court costs defending title • • • •

Various elements of CB can be indexed if they meet s 114 requirements except non-capital costs of ownership. If there was no consideration given for the property the MVSR applies. You are taken to have acquired the property at market value → s 112-20 “Reduced cost base” used when there appears to be a capital loss → s 11055 1. Do NOT include non-capital costs of ownership 2. Indexation does NOT apply to a reduced cost base

Step 3: Calculating net gains and losses •

A net capital gain is included in assessable income (s 102-5) o In order to determine liability for particular year – add up all gains and subtract all capital losses o but subject to some special rules for collectible and personal uses. o If net gain – net gain is incl. in assessable income.

•

A net capital loss is not offset against other income but may be carried forward and offset against future CGs “quarantined” (s 102-15) o May be carried forward indefinitely until a net gain is there to offset. o Capital losses are thus quarantined.

•

Special rules for some assets: o Collectables  Include gains in assessable income  Capital loss can only be offset against capital gain from collectables (s108-10) o Personal use assets (more than $10,000 in value)  Include gains only  Losses are disregarded (s108-20)

Step 4: Applying the Discount

39

2 Methods: 1. Discount method 2. Indexation method • • •

Before 19 September 1985: o No CGT Between 19 September 1985 and 21 September 1999: o May choose b/w method 1 or 2 Post 21 September 1999: o Discount method

Indexation → Div 114 • •

CB increased to take into inflation Less significant since 1999 1. CGT discount was introduced in 1999. 2. Cannot use discount AND indexation. 3. Corporate T’s CANNOT use the discount → MUST use indexation. 4. Indexation was frozen in 1999 → I 123.4

•

For indexation, asset must be held for at least 12 months → s 114-10

Discount Percentage → Div 115 •

CGT discount introduced in September 1999

• • • • •

Individuals and trusts may exclude 50% of capital gain → s 115-100 Superannuation funds get 33.3% discount → s 115-100 No discount for companies Asset must have been held for 12 months (s 115-25) If asset acquired before 21 September 1999 T has choice between discount or indexation → s 114-5(2) If asset acquired after 21 September 1999 only discount available Cannot have both indexation AND discount CGT discount and trusts (s115-215) 1. Trust itself pays no tax. 2. Legislation recognises beneficiaries will pay the tax. If individual is beneficiary, will be entitled to discount. If beneficiary a company, will NOT be entitled to discount.

• • •

Reconciling income tax and CGT If a gain could be both ordinary income and also a CGT, the non-CGT provision takes priority (s 118-20) (“anti-overlap provision”)

40

•

Eg a property developer who sells property (business income, and disposal of CGT asset) – profits will be ordinary business income, not subject to CGT

Taxing investment gains lower than wages The effect of CGT concessions is that capital gains are taxed at a lower effective rate than ordinary income gains. Meant to encourage investment. The effect of the 12 month holding rule is to encourage longer term capital investment. Truly rich don’t pay as much since they generate most of their profits from capital gains. Therefore, equity implications, since tax burden shouldered more heavily by ordinary wage earners. Skews incentive for capital investments, thus inefficiency distortions. DEDUCTIONS •

All T’s can claim deductions under: 1. General deduction provision → s8-1 ITAA97: or 2. Specific deduction provisions

•

Difference between a deduction and a tax offset/rebate is that an offset directly reduces tax payable, ie. Tax Payable = (TI x Rate) – Tax Offset 1. See Divs 12 and 13

The General Deduction Provision •

Section 8-1 ITAA97 (formerly s51(1) ITAA36) o 2 positive limbs o 4 negative limbs The Positive Limbs 1. 2. 3. 4. 5. 6. 7.

Relationship between two positive limbs Nexus Meaning of incurred Timing Apportionment Significance of purpose Substantiation

1. Relationship between the two positive limbs •

Deduction allowed for loss or outgoing to the extent that it is: 1. Incurred in earning assessable income

41

2. Necessarily incurred in carrying on a business o Hence, there must be a sufficient nexus between expense and producing AI o First limb applies to all Ts cf second limb only applies to business Ts o Many expenses would satisfy both limbs o Little practical significance in difference Loss or Outgoing •

Unusual examples outlined in the following cases:

Charles Moore & Co Pty Ltd v FCT T was a retail department store. As was usual practice, two of T’s employees were on their way to the bank to deposit the previous day’s takings. Employees were held up at gunpoint and monies were stolen. T was trying to claim a deduction for monies lost Held: •

T was allowed the deduction o Not expenditure or outgoing BUT court considered stolen money a ‘loss’. o Deductible because banking was a necessary aspect of conducting business and therefore earning AI o Rejected notion that expense was unpredictable and indirectly related to earning income

FCT v La Rosa T was a convicted drug dealer. He buried $220,000 proceeds from a drug deal. Someone came to his backyard and dug up the money and stole it. Commissioner brought the case to court to try and assess the proceeds. T was trying to claim a deduction for the loss. Commissioner tried to argue that there was a public policy argument to not allow deduction for illegal activity. Held: •

$220,000 was a loss and therefore deductible o Court applied the Charles Moore conception of ‘loss’ o Rejected Commissioner’s policy arguments by stating that punishment of those engaged in unlawful activities will be punished by criminal law 42

NOT laws in relation to income tax. Parliament can enact legislation if they want to amend the law. 2. Nexus Ronpibon Tin NL v FCT T was incorporated in Australia but carried on mining operations in Thailand. T ceased operation when Japanese occupied Thailand during WW2. Prior to occupation, T earned substantial income which was deemed exempt overseas income in Australia. During occupation, T continued to incur expenses from Australian head office and a few expenses in Thailand. T also had a very small amount of AI from investments in Australia. When they had been receiving exempt income and small amount of AI, they were allowed small percentage of investment income as deduction to represent head office cost allocation. Once occupation began, T started paying an allowance to employee family in Australia. Commissioner and did not allow allowances to employee families. T objected and tried to claim ALL head office and allowance expenses. Held: • • •

Cost of allowances to family NOT allowed Head office operating costs allowed to the extent they were referable to investment income. Remainder of operating costs capital in nature because incurred for prospect of earning income in future thus not deductible. Court held that you can only claim deductions if it is incidental and relevant to the earning of AI.

Neville & Co Ltd v FCT T was a company that employed a new managing director. The new managing director was not performing to expectation, thus T asked him to resign. They negotiated a settlement of 2500 pounds. T tried to claim a deduction for the full amount. Commissioner argued that this was not an expense in earning AI. T argued that they needed to re-structure to improve efficiency. Held: •

Allowed the deduction o Sufficient nexus between the expense and the activity of the business o Purpose of expenditure was to incur a short-term cost to increase longterm income. Thus court relied on efficiency argument.

43

FCT v Snowden & Wilson T was a building contractor who built speculative homes and sold them. T was named in a Royal Commission as engaging in questionable conduct. T took out an ment to counter adverse publicity. T also engaged a lawyer and other professional services to gain advice regarding the royal commission. T tried to claim a deduction for all expenses. Held: •

T was allowed all deductions o Expenses were ‘necessarily incurred’ (second positive limb) in upholding T’s reputation and thus maintaining AI o Expenditure was not of a capital nature because proceedings were not going to close down the business, but rather may have caused a decline in business o Necessarily incurred covers expenses that are:  Imposed on a business, such as taxes and fees  Incidental to the conduct of T’s business  Incurred by T to protect business reputation

FCT v Total Holdings T borrowed money at commercial rate of interest and used the money to buy shares in its wholly owned subsidiary AND provided an interest free loan to the same wholly owned subsidiary. Commissioner contended the interest component on the first commercial loan which relates to the interest-free loan was not deductible because no nexus with earning AI. T argued the loan was made to ensure that the subsidiary became profitable and thus earned greater dividends for T. Held: •

T was allowed the full deduction of commercial rate of interest on the first loan o Court agreed with T’s argument that interest free loan intended to make subsidiary profitable and thus earn increased dividend income for T o Deduction was an incidental and relevant to derivation of income

Sked Pty Ltd v FCT T was a company which received a loan at commercial rates from a related finance company. T subsequently loaned the money to a subsidiary. T claimed 44

a deduction for the interest on the first loan, by contending that it was incurred in deriving dividend income from the subsidiary. Held: •

T was disallowed the deduction o T’s purpose or objective was NOT to earn dividend income from subsidiary o Deduction was NOT necessarily incurred in deriving income

3. Incurred •

Can claim a deduction where there is an existing obligation to pay o Not necessarily when you actually pay the amount o Generally when you receive an invoice for services

FCT v James Flood Pty Ltd T was obliged to pay employees 2 weeks annual leave a year. T was claiming a deduction in the s even though no amount had been paid. Held: •

T was disallowed the deduction o Only entitled a deduction when there is a firm commitment that the employee is going to take annual leave. Expense should only arise when employee applies for leave

4. Timing Issues FCT v Maddalena T was employed as an electrician and was also playing rugby league at a professional level. T was invited to play rugby at a new club and incurred legal and travelling expenses in making and negotiating the contract. T tried to claim a deduction for the legal and travelling expenses. Held: •

T was disallowed all expenses

45

o Expenses were incurred ‘too soon’ to be regarded as incurred in gaining AI. o Expenses were capital in nature as they were incurred in gaining employment. o A taxpayer cannot obtain a deduction for expenses of gaining employment. o If a taxpayer’s employment is continuous with the one employer, legal expenses incurred in negotiating subsequent contracts WILL BE deductible. Steele v FCT T acquired property with borrowed funds and incurred interest expenses. T’s intention was to always build a motel or town-houses. In the meantime she had just purchased some horses and used the property for agistment purposes, for which she earned a small amount of AI. After 6 years land was still sitting idle as she was not able to form appropriate partnership to build hotel / townhouse venture. T tried to claim deduction for interest over 6 years. Commissioner contended no nexus between deduction and income. Commissioner also argued interest expenses of a capital nature. Held: •

T was allowed the full interest deduction o T’s intention was always to go through with the venture and earn AI. This is not altered by the fact that income was never produced o Interest held to be re-current and thus revenue in nature and thus not capital o NOTE: This case is quite unusual compared to Maddalena and other ‘expenses prior to earning income’ cases. It is distinguished on the fact that this case related to interest, which will generally not regarded as capital. Amalgamated Zinc v FCT T was a company carrying on mining business which ceased operations in 1924. T commenced carrying on an investment business from which it derived AI. However, T was required by law to make payments to former mining employees to compensate for ‘health issues’. T tried to claim a deduction for the expenses 9 years after mining operations had ceased. Held: •

T was disallowed the deduction o No sufficient nexus between the expense and earning AI o Expenses related to a business which the T had ceased to carry on 46

o NOTE: decision in this case criticised by Barwick J in AGC (Advances) and effectively overturned in Placer Pacific Placer Pacific T used to operate a business that produced conveyor belts. Proceedings were brought against T by former customer under a warranty claim. T negotiated a settlement with the customer and tried to claim a deduction for the settlement amount. Commissioner argued that T had failed the continuing business test outlined in Amalgamated Zinc. Held: •

T allowed the entire deduction o Sufficient nexus because the settlement amount was in relation to faulty conveyor belt which raised a liability against T while the business was operating and deriving AI. o Deductibility not affected by the fact that outgoing incurred a year later than the income year in which the relevant AI was derived o Deductibility not affected by the fact that outgoing incurred at a time when T had ceased to carry on the business which gave rise to the expenditure. o NOTE: Effectively reverses decision in Amalgamated Zinc even though Placer was a Federal Court case and Amalgamated Zinc a High Court case

5. Apportionment •

A T may have to apportion an expense if not wholly incurred in earning AI o “To the extent that…” o Eg. In Ronpibon Tin v FCT, taxpayer only entitled to claim a portion of expense

6. Taxpayer’s Purpose •

Is it relevant under s8-1 that T has a purpose other than gaining AI?

Cecil Bros v FCT T was a company which sold shoes. T generally acquired trading stock from wholesaler for a certain price. T entered into new arrangement by establishing new company (B). B purchased shoes from wholesaler for that same price but 47

then sold it to T at an inflated price. T established company B so as to claim deductions. T sought to deduct the inflated price for tax purposes. Commissioner argued that T should be restricted to the original price it should have paid. Held: •

Inflated price is wholly deductible o Inflated price was a cost incurred in earning AI and therefore can deduct whole amount. o Note: As a result of this case legislation was enacted regarding trading stock that deemed T’s to have acquired trading stock at market rates NOT some inflated amount.

FCT v Phillips T was an ing partnership which set up a unit trust to takeover some of the non-professional activities of partnership, ie. ownership of furniture and other assets of the partnership. The partnership then hired back the assets from the unit trust at a certain markup. The purpose of this arrangement was twofold; Firstly, to protect assets of ing firm from potential negligence claims. Secondly, distribute profits of partnership to family who were beneficiaries of unit trust. Commissioner argued partnership should not be able to deduct full amount of the leasing costs. Held: •

Full amount of leasing costs deductible Expenditure represents reasonable commercial rates If non-commercial rates paid to relative of T, may raise presumption that expenditure was not wholly payable for the services and equipment provided, but some other purpose. Taxpayers who use this arrangement have the ability to shelter assets and split income among family IF the pay commercial rates.

Europa Oil Cases Two cases which went to Privy Council in 1972 and 1976. T was a NZ company which entered into arrangement with a US company for the supply of oil. Oil market heavily regulated. US company forced to supply oil at ‘posted price’. T and US company tly set up an intermediary in Bahamas, which was a tax haven. US company sold and then repurchased oil from intermediary at a markup, earning arbitrary profits for intermediary. US company able to sell oil to T at ‘posted price’ but effectively offered a discount to T due to profits from Bahamas. T sought to claim deduction for the full regulated price.

48

Held: • •

In Europa Oil (No.1) deduction reduced by the discount obtained through the arrangement. o Privy Council adopted a substance over form approach In Europa Oil (No.2) full deduction was allowed o Privy Council read down the ratio from earlier case by stating that an examination of the reality (substance) of the arrangement only means examination of the legal character of the arrangement o T successfully argued that collateral advantages of profits from intermediary should be ignored. o Adopted Cecil Brothers decision

Ure v FCT T was an individual who borrowed funds at commercial rate of interest. T on-lent those funds to wife and a family company at 1% interest. T was required to charge some rate of interest because otherwise there would not have been an income earning activity for T to claim a deduction for interest on original loan. T effectively created a tax shelter through negative gearing. Held: •

T allowed to claim deduction for portion of interest which related to earning AI o Court looked to T’s purpose → provide financial benefits for wife, secure house to live in, create tax shelter as well as earning AI. Because dominant purpose was not earning AI, he could only claim a portion of the deduction which related to earning AI.

Fletcher v FCT T was a partnership which borrowed $2 million at commercial rates of interest for 15 years. T used funds to purchase 20 year annuity and thus repayment of capital and income stream. T was going to use income from annuity to offset interest. Loan arrangement provided T would incur large interest expenses in the first few years and then reduce in later years. The arrangement also allowed for early termination after 5 years at T’s discretion. T planned to spread AI stream from annuity evenly over 20 years. T gained tax benefit with respect to the fact that they could claim higher deductions in early years and then terminate. Held: •

T’s interest repayment deduction was limited to the amount of income generated from annuity each year. o Relevant to look to T’s purpose. 49

o If revenue derived is greater than expenditure incurred, no reason to examine purpose of T. o Look to T’s purpose when deductions are greater than income for a particular activity. If on looking to T’s purpose, that T was trying to obtain a tax benefit as well as earning AI, T only entitled to claim a portion of deduction. o Court mentioned that if T had allowed scheme to run its full course without termination, the deductions may not have been limited. Hart v FCT Financial institution was marketing a product called a ‘split loan’. There would be two loans, one which related to place of residence and another that related to an investment property. Loans linked, such that all repayments made would go to repay the home loan since no deduction for home loan repayment. That meant that interest payable on investment property would be capitalized and therefore T required to pay compound interest on capitalized portion and thus incurred a greater deduction. This issue in dispute is the compound interest component of the deduction. Federal court held compound interest component was deductible → not necessary to look to purpose. Commissioner appealed. Held: • •

High Court did not have to decide whether compound interest component was deductible because applied Part IVA anti-avoidance provisions NOT s8-1. Note: Look at this in more detail in ‘tax avoidance’ topic.

7. Substantiation • •

Under self assessment Ts must be able to prove expenses incurred Certain expenses must be able to be proved by specific documentary evidence ie work, car and business travel: Div 900 ITAA97

Negative Limbs •

Section 8-1(2) provides that an expense may not be deductible if it is: o Capital in nature (see next topic) o Private or domestic o Incurred in earning exempt income → eg. Ronpibon o If a specific restriction

50

Capital Expenses •

See next topic notes: page 56

Private or Domestic Expenditure •

Commonly known as ordinary living expenses. Essential character of these expenses is to live rather than earn AI. Examples include:

•

Food

Cooper T was claiming cost of food he consumed. T was a professional rugby player. He had been given explicit instructions by his coach to eat 3kg of steak, bread and potatoes each meal, a dozen cans of beer a week, etc. T argued that expenses incurred in earning AI. Court held the expense was of a private nature. •

Home office expenses

Handley T was a barrister who tried to claim a deduction for a separate room in the house as a home-office. Separate room made up 7% of total floor space. He wanted to claim 10% of all house expenses, including interest on mortgage, rates, insurance, heating, cleaning, etc. Court said there are two different types of costs; holding costs and running costs. Can only claim running costs, ie. heating, cooling, etc. Cannot claim holding costs, ie. interest on mortgage, rates and insurance. T entitled to claim 7% of all running costs on the house. Note: This may restrict CGT exemption on main residence. •

Travel

Lunney & Hayley T’s were employee and dentist respectively and sought to claim deduction from home to place of work. Court held cost of commuting between home and work was a non-deductible expense. Court said that where you lived is a matter of

51

personal choice and T should bear cost of travel. Note: cost of travel between places of work is deductible. Payne T lived and carried on business of deer farming near Tamworth. T also employed as a pilot by QANTAS based at Sydney Airport. T claimed cost of traveling between farm and airport. Court majority rejected claim because the two places of earning income were unconnected. Note: Legislation was then enacted to allow deduction of travel between two unconnected places of work. See p443 textbook for specific provisions. •

Child minding expenses

Lodge T was a law clerk and stated that child minding expense was essential in allowing her to earn AI. Court disallowed claim. Child minding expenses are of a private nature. Rebate would be more appropriate because of ‘up-side-down’ effect → someone on top marginal rate, the value of a deduction for child minding would be more valuable. •

Self-education

Finn T was an architect who went to Europe and claimed a deduction for visiting all architectural sites of Europe. Court accepted argument. Expenses allowed T to improve chances of promotion and ability to earn AI. Dixon CJ noted that this case was exceptional because T dedicated himself specifically to the study of architecture whilst overseas. The trip wasn’t just a junket. Hatchett T was a teacher and undertook a higher certificate course which allowed her to be promoted within the Department of Education. At the same time, T completed an Arts degree at University. T sought to claim deductions for both the higher certificate and Arts degree.

52

Court held that deduction allowed for higher certificate because allowed T to be specifically promoted and earn higher AI. Deductions relating to Arts degree NOT allowed because more vague and personal in nature. Note: General principle that course related study expenses will be deductible if T can show it helped them be promoted or earn higher AI. Studdert T was a flight engineer who claimed costs of flying lessons. Court allowed the deductions. Held there was a sufficient connection because lessons would make T more proficient in his job as a flight engineer and increase chances for promotion. Note: Commissioner argued subsidiary purpose of T regarding re-training as a pilot and thus should not be deductible (Fletcher). Court dismissed this argument. Taxation Ruling 1998/9 Para 14 & 15 make the point that if you are undertaking an undergraduate degree, there is not a sufficient link with earning income. However, if undertaking post-graduate degree, there could be a sufficient link with greater chance of promotion, etc. •

Clothing, cosmetics

Mallalieu (UK Case) T claimed cost of dark suits worn underneath gown as a barrister. T argued that she would never have worn the suits in her every day life. Court did not allow the deduction. Court held it was ordinary clothing. Edwards T was an aide to the governor’s wife. T was required to accompany governor’s wife to official functions. T had to purchase fancy hats and gowns, etc. T sought to claim deduction for this expenditure. Court held that costs were deductible. Note: This case is isolated on the facts. Mansfield T was an air-stewardess. T claimed costs of cosmetics due to different sorts of make-up, moisturizers, shoes and stockings required due to influences of cabin pressure, etc. Court allowed deductions. Court disallowed deduction for hairdressing costs.

53

Morris 10 taxpayers in this case who all claimed deduction for sun protection items such as hats, sunglasses and sunscreen. Court allowed the deduction. There was a sufficient nexus because all T’s required to work outdoors to earn AI. Specific Deduction Provisions • •

Repairs → s25-10 Tax Losses → Div 36

Repairs • • •

Repairs are deductible but not if replacement, improvement or initial repair Real problem is with work that actually improves the property If improvement should be properly regarded as capital expenditure – this would mean that it would be added to the cost base of the asset

•

What is a Repair?

Thomas o Item is restored to its former condition without changing its character o Item returned to former level of efficiency Lindsay o Performed extensive work on shipyard ‘slipway.’ T argued that it restored slipway to its former condition thus deductible. Court held that they had effectively replaced the whole slipway and thus not a repair and not deductible. Repair involves repair or replacement of defective parts, rather than the renewal or replacement of the entirety. Taxation Ruling 97/23 o A repair can include painting, maintaining plumbing, repairing electrical appliances, mending leaks, replacing broken parts of fences and windows and repairing machinery. o Costs to prevent or anticipate damage or deterioration can constitute repair o See p473 for guidance on what constitutes an entirety

54

•

Repair v improvement

Thomas – Repair • •

TP purchased a building and had to carry out a large number of repairs to the roof, floor and walls in order to make it fit for its purpose Court: o test for determining whether some action constituted a repair was whether it returns the item to its former condition o Here all the things that had been done were all repairs

Western Suburbs Cinema – Improvement o T was owner of cinema and wanted to repair damaged ceiling. T decided to ‘repair’ ceiling with new material which was more durable than old material. T also received a quote for the cost of using the original material. T only claimed deduction for the cost of alternative quote, ie. original material, which was significantly less than the actual costs of ‘repairs.’ Court held that the new material constituted a replacement/improvement and thus no deduction allowed. o Held  This was clearly an improvement – new material had been used – so not repair  Can only claim deduction for actual expenditure, not some amount that you would have spent in repairing it – no deduction for notional repairs  Even though can show quote of 600 – it wasn’t actual expenditure  Expenditure was capital (have to be treated as part of cost of that building) •

Initial Repairs

Law Shipping Co v IRC o If item requires repairs before the item can be used, the ‘initial repair’ costs become capital cost of acquisition and thus not a deduction. •

No deduction for notional repairs

Western Suburbs Cinema

55

o If T has choice to either repair or replace an item and decides to replace the item in its entirety, T is not allowed to claim a deduction for the notional cost that would have been paid to merely repair it. Note relationship between the general deduction provision and specific deduction provisions, s8-1. Claim under provision which is more appropriate. Tax Losses • • •

• •

Deductions exceed AI and exempt income s36-10(4) Tax losses post 1989-90 can be carried forward indefinitely and offset against future income → s36-15 o Tax losses prior to 1989-90 only carried forward for 7 year limit There are some restrictions on tax losses for companies → Div 165 o Must have same owners and same control throughout the period from the start of the loss year to the end of the income year o Must be carrying on the same business There are some restrictions on trusts → Schedule 2F ITAA 1936 (see p579 text book) Note: non-commercial loss rules (see anti-avoidance provision notes)

Restrictions on Deductions Fines and Penalties • •

Not deductible: s 26-5 Cannot deduct any amount under this act described as a penalty under Australian law or foreign law. o Eg. Parking and speeding fines not allowed as a deduction

Payments to related entities (s26-35) • •

• • •

If you can deduct an amount for a payment that you make to a related entity – can only deduct so much as the commissioner considers reasonable (so can’t pay a related entity twice what you would pay normally) Who is a related entity? o Including a relative → spouses, de facto spouses, children, parents, etc o Corporate partnerships Deduction only allowed to the extent reasonable by the Commissioner Not a prohibition on deduction, but merely a restriction Market or commercial rates are generally considered ‘reasonable’

56

Stewart v FCT T was the wife of a doctor. Doctor was in a three person medical partnership. Each partner was paying a sum of money to their wives for answering the phone out of hours. In return for that service, they were paid $2000 per year. Commissioner decided this was not reasonable and only allowed $1000 deduction per year. T argued that if look at commercial rates, if someone on-call 24 hours a day, then $40 per week is reasonable. Held: •

Deduction restricted to $1000 per year ($20 per week) o Wives were just living at home, as good wives do and thus were not engaged in work on-call for 24 hours → $2,000 deduction not reasonable. o Held: Not really a commercial arrangement – wives weren’t doing very much for the money o Court will only overturn Commissioner’s discretion if it were deemed as inappropriate or no logical basis.

Entertainment Expenses •

Since 1985 no deduction for entertainment expense to the extent that it is for food, drink, recreation, accommodation or travel → s 32-5

•

May be deductible if FBT applies: s 32-20 o Main exemption to this section is where FBT applies, ie if it is subject to FBT, then not subject to entertainment rule o If employer provides food and drink to employees, ie. employer takes employees out to dinner, it will be subject to FBT. Govt decided that since they are paying FBT, amount should be deductible and thus not taxed twice.

•

If there is a mixed audience of clients and employees, the proportion provided to employees is deductible and subject to FBT. Portion relating to clients is not deductible.

Non-Commercial Loss Rules See anti-avoidance provision notes Summary

57

• • • • • •

Loss or outgoing deductible if sufficient nexus with earning income (s8-1) Note: incurred, timing, apportionment, purpose No deduction for private/domestic expenses No immediate deduction for capital expenses (see week 9) Expense may be deductible under specific provisions May be a restriction on deducting certain expenses

CAPITAL EXPENSES • • •

An expense is not deductible if capital → s8-1(2)(a) Current or ‘revenue’ expenses are deductible under s8-1. If it is a capital expense then different tax treatment General tests to determine whether capital: o Does the expense provide an enduring benefit? o Is it just a ‘once and for all’ expense? o Does the expense relate to the business structure (ie. capital) or to the process of earning income (ie. current)?

Sun Newspapers → Legal Fees T was a newspaper company. T paid an amount to a competitor to agree not to produce a rival newspaper for a period of 3 years. The question before the court was to determine whether the payment was a current expense or a capital expense. T argued that the payment was made to secure temporary absence from competition and thus benefits obtained were revenue or ‘current’ in nature. Dixon J wrote the leading judgment. Held: •

Distinction between capital expense and current expense determined by reference to whether the payment effected the business structure (capital expense) or the process of carrying on business (current expense). Consider three factors: o Character of advantage sought and lasting qualities provided  Enduring benefit → Inappropriate to claim whole costs in year 1 o The manner in which it is to be used, relied upon and enjoyed  Enduring benefit → Not likely to be a recurrent expense o The means adopted to obtain it  If payment lump sum more likely to be capital. If it is periodical in nature, more likely to the expense

Application of test: •

Expenditure was of a large sum to remove competition

58

• • •

Not recurrent, ie. it was a lump sum Chief purpose was to maintain current business structure in earning income Dixon J held that it was a capital expense

Hallstroms → Legal Fees T was a refrigerator manufacturer who copied a design feature from a competitor. T did this once the patent of the competitor expired. Competitor submitted application to have patent extended. T incurred legal expenses in successfully opposing the competitor’s application for extension. T sought to deduct the legal expenses under the general deduction provisions. Held: •

Majority held expense was current and thus deductible o Expense was necessarily incurred in carrying on of T’s business in earning AI. o BUT Dixon J (dissenting) said that if T didn’t win the ability to use design feature meant he would go out of business → expense goes to the structure of the business. Dixon J’s dissenting judgment is favoured in future cases

Broken Hill → legal fees T operated a picture theatre in Broken Hill. Someone submitted an application to establish another theatre in Broken Hill. T incurred legal costs in successfully defending application. T produced evidence that each application can be made annually. T argued that it was a re-current expense and therefore deductible. T also showed that he had to defend application a number of times previously. Held: •

The expense defending the application is a capital expense and thus no deductible o Despite the factors argued by T court held that it was capital (applying Dixon J in Hallstrom) because T acquired absence of competition. o Rejected T’s argument that it was a ‘recurrent’ expense because at the time of the expenditure it was unknown when or if someone else may make another application in the future. Thus, it is an isolated expense. o The lasting character of the advantage is not necessarily a decisive factor (questionable) o Note: This case and Sun Newspapers are the key cases

City Link → Fees to operate a toll road 59

T paid concession fees to state government for the right to operate the City Link Toll Road. The payment was semi-annual for a fixed period of time. Issue more complicated because of the structure of the payments. Fees were to be satisfied by ‘concession notes’ which could vary. No actual payments had to be made by T until 2034. Issue as to whether an expense was actually incurred (not dealt with in this course). Commissioner argued that the payment was for T’s monopoly right over particular aspect of transport system and thus should be capital. Held: • •

Full Federal court held fees were current and thus deductible. Payments were particularly for the right to operate the tollway and receive income from it. NOTE: Case is on appeal in High Court

Steele → expenses incurred in acquiring income producing asset T acquired land for purpose of developing motel and residential complex. Borrowed money to purchase land and so incurred interest expense. Land was sold after 6 years without any development of land. There was a small amount of income earned from agistment of horses on the property during the 6 years. The main issue is whether the interest is current or capital. Commissioner argued that interest related to acquiring an asset. T sought to claim deduction as necessarily incurred in earning AI. Held: •

Interest expenses were deductible. o Interest expenses are regarded as incurred in earning AI. o High Court held interest is a re-current expense which relates to the use of loan funds and should therefore be treated as re-current in nature.

Firth → Interest expense on capital protected loan T borrowed money and incurred interest to acquire shares. Generally interest to acquire shares is deductible. Loan has special feature that if the value of the shares dropped, then T would not have to repay the full value of the loan. Called a capital protection or ‘limited recourse loan’ – some of the risk is removed. However, because of reduction in risk, T is required to pay at much higher rate of interest. T sought to claim the entire interest expense since the loan was to raise and maintain working capital for his business.

60

Commissioner doesn’t like these kinds of products. Commissioner believes they are not really an investment expense because investor is protected against any downside. Therefore only a part of the expense is incurred in earning income and part of the interest is a capital expense incurred in protecting capital. Held: •

Entire interest expense fully deductible. o Accepted T’s arguments o NOTE: Government announced that it was going to change legislation to deny the deductible component of capital protection loans. Taxpayers only entitled to deduction to the rate of interest charged by RBA for personal unsecured loans. Legislation has not been introduced yet. However, since the press release was announced, has virtually become law as no one has taken up such products.

Eastern Nitrogen → Payments under sale and leaseback arrangement T owned some plant and machinery. T entered into arrangement with a financier whereby T sold the plant to financier and then leased it back. Normally lease costs would be deductible as ongoing recurrent expense. Previously because he owned the plant and equipment, T was only able to depreciate. Lease payments more than depreciation deduction. The arrangement stipulated that T was entitled to purchase back the plant and machinery at the end of the lease, ie. standard hire purchase arrangement. Commissioner argued that payments were partly deductible and also partly a payment to re-acquire the plant. Commissioner also argued this was an antiavoidance arrangement. Held: •

Lease payments were current expenses. o Notion that there was reduction in future purchase price (as argued by commissioner) was too remote. o Court also stated there were no anti-avoidance issues.

Summary re current / capital distinction •

Test used to determine distinction in Sun Newspapers per Dixon J o Expense related to the business structure → capital o Expense related to the process of carrying on business → current

•

Consider following factors:

61

o Will the expense produce an enduring benefit (last beyond the current year)? o Is it an expense that is likely to be ongoing? o Is the payment by lump sum or by regular payments? Tax Treatment of a Capital Expense •

If expense relates to a ‘depreciating asset’ o Uniform Capital Allowance Regime

•

If expense relates to a CGT asset o Add to CB of asset for CGT purposes o Tax recognition is deferred till disposal of the asset

•

If not depreciating asset or CGT asset o Expense may not be recognised for tax purposes  Blackhole provisions → s 40-880 o Depreciating assets and CGT assets are mutually exclusive

Non-Deductible Capital Expenses • • •

•

Non-current, no deduction → often referred to as blackholes No tax consequences → cannot offset again AI Examples include: o Business startup costs incurred prior to earning AI o Legal costs that do not relate to acquiring an asset  Expense incurred in unsuccessful takeover bid Recent statutory recognition of some blackholes in s 40-880

Section 40-880 •

Certain expenses can now be deductible over a 5 year period, ie. expenditure o To establish the business structure o To re-structure the business o To raise equity for the business o To defend against a takeover o To make a takeover bid that is unsuccessful

•

A successful takeover bid on another company will be capital and form part of the CB on the company and recognised upon disposal.

62

The Uniform Capital Allowance Regime • • • • •

From 1 July 2001 → Div 40 ITAA 97 Can deduct amount equal to decline in value of a depreciating asset used for a taxable purpose that was held during the year → s40-25 ‘Depreciating asset’ → s 40-30 Who is entitled to depreciate → s 40-40 Measuring decline in value → s 40-65

Depreciating Assets • •

•

Asset with a limited effective life and can reasonably be expected to decline in value: s40-30 (note: asset has ordinary meaning, ie. property) But not if: o Land o Trading stock o Intangible assets (except as listed → can depreciate intellectual property) Common examples of depreciating assets include: o Computers o Cars o Furniture o Machinery o Fixtures

NOTE: Improvements to land or fixtures on land, irrespective of whether the fixture is removable from the land or not, can be depreciated → s40-30(3) •

Distinction between what is a ‘depreciating asset’ and what is a ‘structure’ is important. Structures subject to more limited capital works write off provision in Div 43.

Wangarrata Woolen Mills T built a special purpose factory for the woolen mill. T argued that walls were not really ‘walls’, ceiling not really ‘ceiling’ because they had been built with specialized equipment fitted in. They all had special purposes and therefore ‘plant and equipment.’ Held: •

Court allowed the depreciation of the walls and ceiling as ‘plant and equipment’

63

o The interior walls and ceiling were used as integral part of the production process. Only the exterior walls were disallowed from depreciation. o NOTE: The facts of this case quite exceptional. Generally accepted structures are not ‘plant’ if they merely provide shelter to workers and machinery. Who can claim Depreciation? • • • •

General rule is that the legal owner of asset can claim depreciation → s 4040. Where asset is leased, the lessor is entitled to claim the deduction→ Item 10 Where asset subject to hire-purchase arrangement, the lessee is entitled to claim the deduction → item 5 Where item is subject to a lease and is fixed to land, the lessor is entitled to claim deduction where the right to recover the fixture exists → item 4

Measuring Decline in Value •

Cost of the asset is to be spread over its effective life o Determining effective life of asset → s 40-95, either: Accept commissioner’s standard determination; or Self-assess

•

Spreading cost o Diminishing cost method → s 40-70  Gives rise to higher deduction initially and then lower deductions as term of life goes on  Deduct at 150% divided by the life of asset Eg. 100,000 x (150% / 5 years) = $30,000 70,000 x (150% / 5 years) = $21,000

•

o Prime cost method → s 40-75  Cost is spread evenly over effective life In exam question sufficient to note that T has choice between prime cost or diminishing value

Other Provisions •

Special rules for low cost assets → s 40-80(2) o Immediate deduction allowed for asset which cost less than $300 o Only allowed for non-business tax payers due to rorting

64

o Commissioner allows everyone (business and non-business taxpayers) to claim immediate deduction for costs less than $100 •

Asset which cost less than $1000 (but more than $300) can all be added together into low value pool and written off using diminishing value method over 4 years (?) → Div 40-E

•

Balancing adjustments provisions when depreciating asset is disposed of → s 40-285 o If WDV > TV → Deduction o If WDV < TV → AI

•

May need to apportion balancing adjustment to the extent depreciating asset was used for private purpose o The extent used for private purpose may be subject to CGT → s 40-25

Balancing adjustments (Div 40-D) and CGT •

S 118-24 states that capital gain or capital loss from a depreciating asset is disregarded for CGT purposes

•

S 40-25 states can deduct decline in value but only to the extent that it used for a taxable purpose. The extent used for private purposes may be subject to CGT

Summary re capital expenses • •

“Current” → immediately deductible s8-1 “Capital” → not immediately deductible o If depreciating asset – write off expense under UCA over effective life o If CGT asset include in CB of asset on disposal o If no asset – “blackhole” ie. not recognised for tax purposes unless statutory provision in s 40-880

TAX AVOIDANCE What is tax avoidance? •

Tax evasion is reducing tax by not complying with the law. o Understate income and/or claiming deductions that were not incurred. o Criminal behaviour

65

• Tax planning is minimising tax to the extent legally possible and commercially practical Legitimate course action to minimize tax • Tax avoidance is taking steps to reduce tax where the sole or dominant purpose it to obtain a tax benefit. o Technically correct according to tax legislation o Not criminal but not in the spirit of the law Judicial approaches to tax avoidance •

• • •

Adopted a fairly strict or literal approach as compared with substance approach: IRC v Duke of Westminster (1936 UK) • NB: this case wasn’t followed in Aus – but that general attitude held sway for a long time • HC – particularly under Barwick – took an approach to tax legislation that it should be construed strictly in favour of TP. Transaction treated as a ‘sham’ such that it was described in one way when in fact the nature was something totally different: Richard Walter v FCT No legal or moral obligation on people to pay the maximum amount of tax Judicial attitudes have now changed to reflect community attitudes to tax avoidance. Tax avoidance no longer encouraged.

IRC v Duke of Westminster (1936 UK) Duke employed a large personal staff to run country estate. He was paying them salary and wages – purely domestic expenses thus not deductible. Entered into arrangement with employees to pay a fixed amount for seven years in the form of an annuity. Under UK law those payments were deductible. Inland Revenue Commission argued that they were effectively salary and should treat them as non-deductible. Held: • •

Court had to decide whether they were going to look to the substance of the arrangement or alternatively the legal form of the arrangement. Court decided to look to the ‘form’ of the arrangement and therefore allowed deduction

Richard Walter v FCT T described receipt of money as a ‘loan’ when in fact it was a distribution from a unit trust, of which T was a beneficiary.

66

Held: • • •

The arrangement was a sham Receipt was not a loan, given there was no interest, obligation to repay, etc Not a loan BUT trust distribution and thus AI

Specific Anti-avoidance Provisions •

Section 26-35 ITAA97 → Payment to related entities o See General Deductions notes – ‘restrictions on deductions’

•

Div 35 ITAA97 → Non-commercial loss rules o Where deductions from business activity > income from that business activity deemed to be ‘non-commercial’ o Applies only to individual taxpayers who also carry on business operations o Can only offset expenses from business activity against income from that activity. Cannot offset against other AI. Any excess deductions are quarantined and can be deducted in subsequent years → s 3510(2) o Quarantining provision will NOT apply if T falls into one of the exceptions:

•



Activity is a Primary production or professional arts business, AND other AI (excluding net capital gain) < $40,000 → s3510(4)  Professional arts includes author, artist, musical business



AI from non-commercial business > $20,000 → s 35-30(a)



Business produced profits in 3 of past 5 years → s 35-35(1)



Value of real property used in the business > $500,000 → s 3540(1)  NOTE: there are some exceptions (see p467 TB)



Other assets (apart from real property) have total value > $100,000 → s 35-45(1)



Commissioner can also apply his discretion → s 35-55  Especially when farmer has a bad year

Look to Part IVA after examining potential exceptions

67

•

Note also cases of Ure and Fletcher where court looked to the purpose of T and denied / apportioned deduction because of it

General Anti-Avoidance Provisions •

Section 260 ITAA36 → judged to be ineffective o Every arrangement entered into, so far as it has the effect of altering payments of income tax will be denied o This provision was very narrowly interpreted by court such that it was hardly used to strike down tax arrangements o Abolished in May 1981

•

Part IVA ITAA36 → “GAAP” (from May 1981) o Proposed provisions seek to give effect to policy that such measures should strike down blatant, artificial and contrived arrangements – Treasurer John Howard 1981 o It is a provision of last resort

Part IVA ITAA36 •

Applies if: 1. Scheme entered into after 27 May 1981 (including outside Aust.) → s 177A 2. T obtained tax benefit → s 177C 3. Scheme was for the purpose of obtaining the tax benefit → s 177D

1. ‘Scheme’ o Any arrangement, scheme, plan, proposal or course of action → s177A(1) o Includes a unilateral scheme, plan, proposal or course of action → s177A(3) o Issue as to how you identify what comprises a scheme: Peabody and Hart o Generally not very difficult to satisfy this element. Almost anything can be characterized as a scheme. 2. ‘Tax Benefit’ o Includes an amount not being included in AI if an amount would have been included, or might reasonably be expected to have been included: s177C(1)(a), also;  Reasonable expectation/hypothesis test

68

Commissioner must show what would have happened if scheme was not entered into → counter-factual difficult to prove Deduction being allowed → s177C(1)(b) Capital loss being incurred → s177C(ba) Franking credit trading schemes: s177EA Just need to identify whether there has been a gain in deduction or reduction of AI 

o o o o

3. Relevant Purpose o Did any person enter into the scheme for the purpose of enabling T to obtain the benefit? o Most important consideration in general anti-avoidance provision o If more than one purpose, must be the dominant purpose → s177A(5) o Must be either sole or dominant purpose, determined by looking at 8 matters in s177D → relate to ‘form and substance’ and ‘financial effect’ Cases on Part IVA Hart v FCT → Split loan facility Financial institution was marketing a product called a ‘split loan’. There would be two loans, one which related to place of residence and another that related to an investment property. Loans linked, such that all repayments made would go to repay the home loan since no deduction for home loan repayment. That meant that interest payable on investment property would be capitalized and therefore T required to pay compound interest on capitalized portion and thus incurred a greater deduction. This issue in dispute is the compound interest component of the deduction. Federal court held compound interest component was deductible → not necessary to look to purpose. Commissioner appealed. Held: • • •

Part IVA Applied → didn’t need to consider whether deductible under s8-1 Tax benefit obtained was the interest paid on the capitalized interest component NOTE: Three different judgments in relation to what constitutes a scheme. Gummow and Hayne JJ allowed an extremely wide interpretation, by enabling commissioner to rely on a broad scheme OR even a narrow scheme OR both to identify a relevant tax benefit. o Broad scheme → all steps leading up to and implementing loan arrangements

69

o Narrow scheme → ‘wealth maximiser option’ on loan allowing payments to be made on one of the properties thereby enabling interest to be capitalized on the other loan FCT v Peabody → value shifting scheme T was beneficiary of Peabody family trust. Trust owned 62% of shares in company (P). Another man, Mr K, owned 38%. Peabody wanted to float the company so they acquired 38% of shares from K. Tax position was such that the trust having acquired the 38% shares would have to pay tax on the disposal since did not hold on to shares for 12 months. Trust held onto shares and converted 38% shares into non-preference shares reducing their value from $8.6m to $500, thereby increasing the value of the original 62%. They floated the company and only had to pay a small amount of tax on the 38%. Commissioner argued that the whole arrangement was a scheme. Clearly a tax benefit obtained. The purpose was to obtain tax benefit. Held: • •

•

Commissioner lost because he sued the wrong T. He should have gone after the trust NOT the beneficiary Mrs Peabody. Court still discussed the issue of ‘scheme’ itself o Extremely wide interpretation of ‘scheme’ o Commissioner is allowed to have a broad interpretation of scheme, or in the alternative can potentially narrow the focus of the scheme, ie. the idea of scheme within a scheme o If scheme was just the conversion of the shares, then much easier to say dominant purpose was tax benefit. However, looking to the arrangement as a whole, ie. business wanting to float, had to buy shares, required to pay tax, etc, then appears to be very much more commercial in nature. Tax benefit o Commissioner had to present ‘reasonable hypothesis test’ o Present a counter-factual such that must show what might reasonably be expected if the scheme had not been carried out, which would give rise to NO tax benefit

FCT v Spotless → Off-shore income T had $40 million to invest. Chose to invest in Cook Islands. The interest rate in Cook Islands was 4% lower than in Australia but still invested there because they didn’t have to pay much tax in Cook Islands. Thus T obtained a tax benefit. The main issue in this case was to determine the relevant purpose of the transaction. Federal court held that it was a sound commercial arrangement, the 70

dominant purpose of which was to maximize returns on money invested after payment of all applicable costs and tax. Commissioner appealed to High Court. Held: •

Part IVA applied o Having regard to the 8 factors, the dominant purpose was to obtain a tax benefit o The collateral tax advantaged obtained in investing in Cook Islands was the key to the whole transaction. o The dominant purpose of a transaction can still be to obtain a tax benefit notwithstanding the fact that it is a sound commercial decision. o Dominant purpose is an objective test o Dominant purpose means the “ruling, prevailing or most influential purpose” o Transaction would make “no sense” without the tax benefit

Eastern Nitrogen → Payments under sale and leaseback arrangement T owned some plant and machinery. T entered into arrangement with a financier whereby T sold the plant to financier and then leased it back. Normally lease costs would be deductible as ongoing recurrent expense. Previously because he owned the plant and equipment, T was only able to depreciate. Lease payments more than depreciation deduction. The arrangement stipulated that T was entitled to purchase back the plant and machinery at the end of the lease, ie. standard hire purchase arrangement. Commissioner argued that payments were partly deductible and also partly a payment to re-acquire the plant. Commissioner also argued Part IVA. Held: •

Part IVA did NOT apply o The ruling, prevailing or most influential purpose was to obtain a very large financial facility on the best reasonably available. The fact the arrangement included outgoings which were deductible is incidental to the purpose, but not the dominant purpose of the transaction.

Consolidated Press Holdings → Tax advisors • •

An individual tax payer who engages in a scheme to obtain a tax benefit may still be subject to Part IVA even if he was unaware of the possibility of the benefit tax, which tax advisor had made him aware of. Overcomes the subjective assessment of intention of T

71

Consequences for Breach Part IVA •

Deduction reduced to the extent of the tax benefit received → s177F o Hart → Interest on the capitalized component disallowed but T still entitled to the interest deduction on the ‘normal’ part of the rental property loan

•

Penalties according to s 284C Tax istration Act 1953 (see p699 TB) • 50% of amount of tax avoided; or • 25% if ‘reasonably arguable position’

72